ERM Power — US update and focus on energy solutions

ERM’s strategy is focused on delivering continued medium-term growth in its core Australian electricity supply and production activities, while at the same time expanding in new growth markets and areas: energy solutions and US supply. While Australian supply and power production currently generate all the group’s cash flow, ERM Power expects the growth to come from US retail (a business which ERM Power entered in 2015) and energy solutions, the most innovative product offering of the group. In its latest trading update, ERM Power has stated that activities in Australia are performing in line or better than management expectations in FY18 (in line for FY19), while the short-term outlook for the US activities has been reduced. We have updated our forecasts to reflect lower contribution from the US but higher estimates for energy solutions (forecasts for other Australian activities are broadly unchanged), on the back of our analysis following an investor briefing, which has provided new elements on the growth potential of the division. We estimate that the medium-term development of the business could drive up to 40% of group EBITDA and 16% in a mid-case scenario (12.5% market share and 40% gross profit margin). The next catalyst for ERM Power is the FY18 results presentation on 23 August. We expect the company to provide more details on the challenges and outlook for the US activities, as well as updated guidance for the core Australian electricity supply activities.

ERM Power will present FY18 results on 23 August. We believe key investor focus will be on:

FY18 results: we now forecast FY18 underlying EBITDA of A$84m, +8% y-o-y, underlying NPAT of A$8m (vs -A$26m in FY17) and DPS of 7 Australian cents (stable y-o-y; H2 DPS 3.5c). For our previous forecasts and forecasts changes, see Exhibit 5.

Australian supply outlook: current guidance for FY18 gross supply margin is A$4.7/MWh “with upside potential” and A$4.0-5.5/MWh in the medium term. In its latest trading update, released at the end of May 2018, ERM Power said Australian activities were performing in line or better than expectations in FY18 and in line for FY19.

US supply outlook: we expect ERM Power to provide more details on current challenges, which led the company to materially reduce the outlook for unitary gross margins to A$3.7/3.3/MWh respectively for FY18/19 in its latest trading update.

Balance sheet capacity: we forecast that ERM Power will be A$40m net cash positive at end FY18 (non-recourse debt in power generation assets is more than offset by the cash in the holding), and see room for additional balance sheet redeployment, including acquisitions and/or a continuation beyond 2018 of the recently announced A$20m share buyback programme.

We have assessed the earnings growth potential of ERM Power’s recently launched division, Energy Solution, on the back of the company’s Investor Day on 29 May. Based on the information provided, we have built a sensitivity analysis to illustrate the potential positive impact on earnings of the growth in this new business.

The energy market in Australia (and globally) is undergoing significant transformation as a result of the energy transition, the emergence of new technology, and customers' demand for higher energy efficiency and sustainable solutions. Sophisticated C&I customers, who represent the company’s core business, increasingly require a comprehensive energy service in addition to delivery of the physical commodity, with the objective of reducing costs and consumption and improving their environmental footprint. All of these trends are supported by more stringent government regulations (eg energy efficiency, renewables growth and carbon reduction), an increase in electricity costs for commercial and industrial customers, and corporates’ desire to target a reduction in carbon emissions to reduce costs and achieve sustainability targets.

ERM’s product offering includes the following services:

ERM power highlighted that a key achievement over the last few years was to increase the proportion of revenues from multi-product deals (to >50% in FY18e from 0% in FY16), as opposed to single-product deals and to increase the proportion of revenue from projects over A$100k (to c 90% in FY18e from less than 50% in FY16).

Currently, the energy services industry is fragmented and dynamic, with new players that have recently entered the markets. We believe ERM Power faces significant competition from the following:

In this highly competitive environment, we see the following competitive advantages for ERM Power:

We believe delivery on the growth potential of energy solutions activities represents a significant value creation opportunity for ERM Power. For example, the global utility player ENGIE completed 33 acquisitions of energy services companies at an average multiple of 9x (pre-synergies) over the last five years. Applying this multiple to our FY22e EBITDA for energy solutions (A$21m) and discounting back to the end of FY18 would generate a valuation for this business of A$126m, equivalent to c 35% of ERM Power’s current market cap.

As described in our note US outlook downgraded; Australia in line or better (published on 29 May 2018), ERM Power issued a trading update on 25 May 2018. Although the company said it expects the Australian activities (retail, generation and energy solutions) to perform in line or above expectations for 2018 (in line for 2019), it expects slightly lower volumes in the US and significantly lower gross margins. For the US business (17% of 2018e group revenues), ERM Power expects volumes of c 6.3TWh in FY18 (vs 6.5TWh previously), increasing to c 7.2TWh in FY19. The US gross margin in FY18 is expected to be c A$3.70/MWh (vs A$4.50/MWh previously), reducing to A$3.30/MWh in FY19. ERM Power also said that although it sees a significant improvement in US gross margins in FY20 vs FY19, it will provide an update in FY19 regarding its current guidance that the US business will be NPAT break-even in FY20.

The new guidance has a negative impact on our FY18 and FY19 net income forecasts of A$4m and A$13m respectively (vs our previous forecasts). Although we see the downgrade in the US outlook as disappointing, we believe downside risks for the ERM Power group are limited. In our view, the current negative impact on group earnings of the loss-making US business will eventually be eliminated, either because ERM Power manages to improve the profitability of this business to at least break-even, or because the business, which is independently financed, is sold/closed down. Hence the risk to the company is of a limited duration, in our view.

We have updated our US forecasts to reflect a larger NPAT loss in the short term and a delayed NPAT break-even point (we now assume 2021 vs current company guidance of FY20).

Our forecasts for core Australian supply and generation activities, which produce all the cash flow of the group, are unchanged. Overall, our FY18-21 EBITDA forecasts change by -6%, -14%, -9% and +7% and these impacts are amplified at the bottom line. We show the full changes to our forecasts in Exhibit 5.

We value ERM Power using a sum-of-the-parts approach, which we believe allows us to capture the different risk profile and asset life of the various activities. We value the various divisions mostly with DCF valuations (with an average WACC of c 11%) and we back-test this approach by comparing the implied valuation multiples with comparable companies for each activity. Our base case SOTP valuation is unchanged at A$2.6/share, implying significant upside vs the current share price of A$1.46. As this valuation excludes any value for US activities and energy solutions, and forecasts for core Australian supply and generation activities are unchanged, there is no change to our valuation. Including a valuation for energy solutions and the US business (with updated forecasts, as described earlier in the note) would increase the SOTP valuation to A$3.2 (vs $2.8/share before; the increase in valuation is driven by a higher valuation for the energy solutions business on the back of higher forecasts). Our recent outlook note Offering solutions to corporate energy challenges, published on 29 March 2018, includes more details on our valuation methodology.

Key risks to our valuation and investment case are higher/lower supply and power generation margins in Australia, higher/lower supply margins in the US, and higher/lower growth in energy solutions.