Ceres Power Holdings — Update 24 February 2016

Ceres’s investment proposition is based on achieving its aim of developing solid oxide fuel cell technology that is competitive with other types of electrical generation. This means the technology must be efficient at converting chemical energy into electrical energy, can be manufactured using materials and processes that make the technology cost-competitive and is sufficiently robust to give an adequate payback period for consumers installing products based on the technology. In addition, since Ceres has decided to focus on developing fuel cell technology rather than complete power generation systems, it needs to secure long-term relationships with partners capable of taking complete systems to market in different geographies. At this stage of evolution, progress towards achieving these goals is more significant that the financial results themselves.

The latest release of the V3 Steel Cell technology platform, announced in December, has improved efficiency and power density to the point at which Ceres is able to address power only applications for the commercial scale market, as well as significantly improving the economic case for the residential market. V4 is on track for release to customers in the summer of 2016. This will incorporate manufacturing advances that reduce the cost of production together with further efficiency improvements.

Following the adoption of a new business model in 2013, Ceres has focused on developing the fuel cells and stacks for partners to integrate into their own power generation systems. However, to demonstrate what is possible to potential customers, Ceres has developed a complete prototype system, the Steel Gen, which has been made available to OEM partners. The system has achieved Ceres’s stated target of 50% net electrical efficiency. This will allow partners to create fuel cell power systems for residential use that are more efficient than the best centralised generating plant when operated in power only mode, are at least equivalent to the best systems currently available commercially in Japan and achieve overall efficiency of up to 90% when operated in CHP (combined heat and power) mode. High electrical efficiency is particularly important in the Japanese micro-CHP sector, because the “spark-gap” between gas and electricity prices in the country is small. In addition, the design is one of the most compact residential fuel cell systems available, which is key for penetrating the market for installations in high-rise apartments in Asia where space is at a premium. The system runs on natural gas, so does not depend on ready availability of pure hydrogen to be usable and is fully compliant with all emission standards.

Higher electrical efficiencies are also important for entering the commercial and light industrial business sectors where fuel cells are beginning to be used for power-only and back-up power applications. During H116 Ceres has developed its first modular stack concept based on the V3 Steel Cell technology. In its initial testing, this achieved 55% net electrical efficiency, significantly exceeding the 50% level at which the technology becomes viable for commercial and light industrial scale applications. This has enabled Ceres to address new market applications and attract new potential partners (see below).

Significant progress was made on production scale-up projects intended to provide demonstration and validation of a production process suitable for high-volume fuel cell manufacture at market cost points. The key innovation is based on changing the way in which the thin ceramic layers forming the electrolyte layer inside individual cells are laid down. Originally this was done by spraying. Ceres has recently commissioned its high-speed print line, which is used to deposit the thin ceramic layers. The new print line has reduced print cycle time from 30 seconds to three, as management predicted, thus substantially improving throughput. The technique also gives a better-quality deposition layer.

Following a year-long evaluation of the Steel Cell technology, which concentrated on performance, robustness and ability to handle repeated power cycles, in October 2014 Ceres Power signed a JDA with Honda to jointly develop a fuel cell stack using the Steel Cell technology. Stacks have been built in the UK and tested in Japan with the intent to ultimately deploy in 1-5kW systems. The results from this phase met the performance targets, leading to the signature of a follow-on JDA in January 2016. The relationship is clearly strengthening, as this was the first time that the client had given permission to be named. Moreover, this new phase also includes a third party, which is being lined up with the intention that it may ultimately manufacture fuel cells in volume using Ceres’s proprietary process. Management notes that this agreement is the first of several key commercial partnerships that it expects to sign during calendar 2016, in line with the target initially stated at the AGM in December 2015 of securing five leading OEMs within the next two years.

All the testing undertaken in KD Navien’s facility under the Technology Assessment Agreement completed successfully, including aggressive accelerated testing for cycleability and steady-state running. At the partner’s request, Ceres provided KD Navien with an additional system on which it has carried out extended validation. All of the performance requirements have been met to date, including the extended validation. Management opened a sales office in South Korea during H116 since the current pipeline of opportunities in Japan is attributable in part to having a sales office in the country. This local presence in Korea, together with the appointment of an experienced chief commercial officer (see below) is expected to help advance the commercial relationship with KD Navien further during calendar 2016 as well as supporting the development of additional customer relationships in the country.

The US remains an important key market for Ceres because of business and householder concerns about continuity of electricity supply. The newly appointed chief commercial officer, who has been recruited from Ballard Power Systems, is based in North America, though he is also working with potential customers in Asia and Europe.

As a result of the advances in system efficiency, which position the technology for deployment in higher power applications, in early February Ceres announced that it has signed an evaluation agreement with a new potential customer who is a leading global OEM. Ceres has commissioned a complete Steel Cell system for a period of rigorous testing at the customer’s site. Under the terms of an additional Memorandum of Understanding, if this testing proves successful, the two parties intend to enter into a joint development of a multi kilowatt system later in calendar 2016.

Ceres has yet to generate commercial revenues, so its value resides in the potential royalty streams generated once distributed power systems incorporating Steel Cell technology are eventually commercialised. In Exhibit 1 we present our scenario analysis which explores potential royalty revenues and profit generated in each of the key markets as commercial partners take significant share in their respective markets. Noting that Honda is active in the genset market, we include an analysis of potential revenues and incremental profits attributable to this partner. Our analysis excludes any potential royalties arising from the agreement with the leading global OEM, which we will add as more information about the potential applications becomes available.

Although it is likely that Ceres will adopt a business model in which some of the potential royalties related to single customer engagement are paid upfront as a one-off licence fee, with the payment offset against lower royalty rates, for simplicity our analysis assumes a royalty rate of 7.5% of customer sales, but no upfront licence fees. For the earnings calculation we apply cost of sales as 7.5% of licence revenue, 20% tax and model a base level of operating costs at FY17e levels (£14.0m) split equally between activities in Japan and Korea. The analysis is the same as that presented in our January note, but with current currency conversion rates, thus giving higher values when converted to sterling. Since it is not possible at this stage to determine the potential dilutive impact of any financing activity, we are not attempting to derive an indicative share price from this analysis.

H116 revenues and other operating income were at similar levels to H115 at £0.5m. It is encouraging to note that revenue primarily generated from customer evaluation and joint development agreements increased from £0.1m in H115 to £0.2m. Operating costs were 17% (£1.0m) higher than during H115, reflecting the increased number of employees engaged in R&D and initiatives to improve the company’s test and manufacturing capability. Reported operating losses increased by £0.9m to £6.2m.

We leave our FY16 and FY17 estimates unchanged. Our model assumes that engagement with existing partners will intensify during FY16 and that discussions with potential partners will mature into evaluations and development programmes, as discussed in our initiation note, resulting in a strong ramp-up in revenues through the forecast period. We estimate that annual revenues from technology evaluations could be £100-200k per partner, scaling up to £500-1,000k for a joint development agreement. The recent announcements regarding Honda (who has signed a JDA) and the global OEM (who has signed an MoU advising of the intention to proceed to a JDA if the ongoing test programme is successful), support our assumptions regarding revenue development. Clearly any delays in progressing individual customer engagements will have a significant impact. At this early stage, we exclude any potential licence and royalty fees from our financial model, giving scope for substantial upside. We estimate that a single licence fee could be worth tens of millions of pounds.

H116 cash consumption totalled £5.4m (compared to £4.5m H115, excluding funds raised from issue of shares). This included £1.0m invested in the new print line and additional test equipment. We do not capitalise any of this R&D expenditure. Net cash (including short-term investments) reduced from £18.2m at end June 2015 to £12.8m at end December 2015. Management expects the July 2014 placing, which raised £19.6m (net) and was oversubscribed, to provide funding well into calendar 2016. However, the company intends to raise further funding by the calendar year end to finance the growing opportunity for higher power applications. In the absence of any one-off licence payments, which we treat as upside, our estimates show c £4m funding gap in FY17, which we model as satisfied through debt.