ERM Power — Refocusing on core business

ERM Power

Refocusing on core business

Business update

Utilities

31 October 2018

Price	A$1.64
Market cap	A$419m

Net debt (A$m) at 30 June 2018		108.7

Shares in issue	255.4m
Free float	75%
Code	EPWX

Primary exchange	ASX

Share price performance

%	1m	3m	12m
Abs	(3.0)	9.3	24.1
Rel (local)	3.8	18.2	26.1

52-week high/low

A$1.9

A$1.3

Business description

ERM Power is an Australian commercial and industrial energy retailer and trader founded in 1980 and listed in 2010. It operates an electricity supply business (second-largest retailer to C&I customers) and two gas-fired generation plants. A key area of growth is energy solutions, while the company has recently announced the sale of its US business.

Next events

H119 results

February 2019

Analyst

Dario Carradori

+44 (0)20 3077 5700

industrials@edisongroup.com

Edison profile page

ERM Power is a research client of Edison Investment Research Limited

ERM Power is refocusing on its core business by selling the US business and investing in the highest growth part of its Australian activities. We have increased our forecasts to reflect the accretive effect of the recent transactions and see more upside potential to the share price following the recent recovery as valuation multiples appear undemanding and the dividend yield is attractive.

Year end	Revenue (A$m)	EBITDA (A$m)	EPS* (c)	DPS (c)	P/E (x)	Yield (%)
06/17	3,127	78.4	(10.5)	7.0	N/A	4.3
06/18	2,047	97.5	12.0	7.5	13.6	4.6
06/19e	2,074	96.7	11.2	8.0	14.3	4.9
06/20e	2,133	107.1	14.5	8.0	11.3	4.9

Note: *EPS is diluted and normalised, excluding amortisation of acquired intangibles, exceptional items and share-based payments.

Refocusing on the core Australian business

Over the last few months, ERM Power has announced two transactions that refocus its activities on the core Australian business. First, in October, the company announced the sale of the US business for A$38m. We view the sale positively as 1) unitary margins of the US business have reduced significantly over the years; 2) we expected the US business to generate A$20m+ negative cash flow in FY19, with a large impact on the group’s cash flow; and 3) the May 2018 downgrade to the US business outlook resulted in the share price underperforming significantly. Second, ERM Power acquired Out Performers, which specialises in industrial energy productivity for large energy consumers, for A$12m (up to A$16m including earn-out). The acquisition will be immediately EPS accretive (we calculate a <5% positive impact on FY19 EPS on a full-year basis) and implies an FY18 P/E of 9.9x (7.5x excluding earn-out), a large discount to ERM Power’s c 14x FY19e P/E.

Our increased forecasts reflect M&A accretion

We have raised our forecasts for FY19-21 underlying net income from continuing operations by 6%, to reflect earnings accretion from the acquisition of Out Performers and cash inflow from the sale of the US business. The statutory net income (including discontinued operations) increases more, reflecting the removal of the losses from the US business (previously accounted as asset held for sale).

Valuation: More room for share price recovery

The share price has recovered c 20% since the lows in July following the recent announcements. However, the shares continue to trade on undemanding valuation multiples with c 14x FY19 P/E reducing to c 9x in FY21. The dividend yield is also attractive at 4.9% in FY19e/20e. Excluding energy solutions (currently loss-making and generating negative cash flow), our base case valuation increases marginally to A$2.4/share (from A$2.3/share) to reflect lower net debt as a result of the cash inflow from disposals. Including a valuation for the energy solutions business would increase the SOTP valuation to A$3.0/share (vs $2.9/share before). The cash inflow from the sale of the US business could add to growth projects and/or shareholders’ remuneration - we expect an update on this at H119 (February 2019).

Refocusing on core Australian business

Over the last few months, ERM Power has announced two transactions that refocus its activities on the core Australian business. ERM Power has exited the US market and acquired Out Performers in Australia.

Acquisition of Out Performers consistent with ERM Power’s strategy and is immediately EPS accretive

ERM Power has acquired Out Performers, which specialises in industrial energy productivity for large energy consumers, for A$12m debt-free (plus an earn-out over two years of up to A$4m). The acquisition strengthens the outlook for Energy Solutions, which is the division where we see the strongest growth potential.

Out Performers reported FY18 PBT of A$2.3m and we expect the acquisition will be immediately earnings accretive (equivalent to <5% positive impact on FY19 EPS on a full-year basis). On our calculations and using a 30% tax rate, the acquisition implies an FY18 P/E of 9.9x (7.5x excluding earn-out), at a large discount to ERM Power’s c 14x FY19 P/E, based on our forecasts.

Sale of US business removes large negative contribution to bottom line and cash flow

On 15 October ERM Power announced the sale of the US business, Source Power & Gas, to Direct Energy Business (owned by Centrica) for US$27m (A$38m). The sale is expected to complete by 30 November 2018. Net after-tax cash proceeds will be around US$23m (A$32m) from the sale after termination and transaction costs. ERM Power will book a loss of c A$8.5m to reflect the US business’ operating results to completion and wind-down and transition costs to June 2019.

We view the sale very positively as 1) ERM Power has struggled to improve the financial performance of this business over the past few years and unitary margins have reduced significantly; 2) we expected the US business to generate A$20m+ negative cash flow with a similar negative impact on group net income in FY19; and 3) the May 2018 downgrade in outlook resulted in a significant drop in the share price.

Balance sheet headroom increases post US disposal

ERM Power has previously discussed its capital deployment priorities. The company is currently implementing a A$20m share buyback programme, which will mostly affect FY19 (only A$2.8m shares bought in FY18). In addition, the company has indicated it has A$40m balance sheet headroom for growth projects (including acquisitions), of which only A$12m has been spent so far on the acquisition of Out Performers (A$16m including earn-out). Hence the cash inflow of A$32m from the sale of the US business (equivalent to 8% of ERM Power’s current market capitalisation) could add to growth projects and/or shareholders’ remuneration. We expect an update on this at the interim results in February 2019. At present, we include only the A$20m share buyback programme in our forecasts, so higher capex or improved shareholders’ remuneration would represent upside to our forecasts.

Forecasts changes: Earnings accretion

As set out in Exhibit 1, we have raised our FY19-21 forecasts for underlying net income from continuing operations by 6%, reflecting the earnings accretion from the acquisition of Out Performers and the cash inflow from the sale of the US business. The statutory net income (including discontinued operations) increases substantially, reflecting the removal of the losses from the US business (previously accounted as asset held for sale).

Exhibit 1: Forecasts changes

	New forecasts				Old forecasts (ex-US)				% change
A$m	2018	2019e	2020e	2021e	2018	2019e	2020e	2021e	2018	2019e	2020e	2021e
Revenues	2,047	2,074	2,133	2,164	2,047	2,068	2,124	2,151	0%	0%	0%	1%
EBITDA	98	97	107	117	98	93	103	112	0%	4%	3%	4%
-Electricity retail AUS	72	72	74	73	72	72	74	73	0%	0%	0%	0%
-Power generation	44	40	41	42	44	40	41	42	0%	0%	0%	0%
-Energy solutions	-4	1	8	18	-4	-3	5	13	0%	-132%	79%	36%
-Corporate	-15	-16	-16	-17	-15	-16	-16	-17	0%	0%	0%	0%
EBIT	67	63	72	82	67	61	70	78	0%	4%	4%	4%
PBT	43	39	49	59	43	37	46	56	0%	6%	6%	6%
Underlying net income from continuing ops (ex LGC profits)	30	28	35	42	30	26	33	39	0%	6%	6%	6%
Statutory net income incl. discontinued operations	-81	29	65	42	-81	13	49	40	NA	125%	31%	5%

Source: ERM Power, Edison Investment Research

Valuation: Significant upside

The share price has recovered by c 20% since it fell in July following the announcement of the sale of the US business and supportive FY18 results. However, valuation multiples still appear undemanding compared with Australian small caps, with the stock trading at a P/E of c 14x in FY19 reducing to c 9x in FY21. The dividend yield is also attractive at 4.9% in FY19e/20e.

Excluding energy solutions (currently loss-making and generating negative cash flow) our base case valuation increases marginally to A$2.4/share (from A$2.3/share) to reflect lower net debt as a result of the cash inflow from disposals. Including a valuation for the energy solutions business, which has not reached break-even yet but has strong growth prospects in our view, would increase the SOTP valuation to A$3.0/share (vs $2.9/share previously). We value the various divisions mostly with DCF valuations, with an average WACC of c 11%. Our initiation note, Offering solutions to corporate energy challenges, published on 29 March 2018, includes more detail on our valuation methodology.

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

Exhibit 2: Financial summary

Accounts: IFRS, Year-end: June, A$m	2016	2017	2018	2019e	2020e	2021e
INCOME STATEMENT
Total revenues	2,691	3,127	2,047	2,074	2,133	2,164
Cost of sales	(2,620)	(3,049)	(1,950)	(1,977)	(2,026)	(2,047)
Gross profit	71	78	98	97	107	117
Exceptionals and adjustments	(5)	0	0	0	0	0
Depreciation and amortisation	(25)	(38)	(30)	(34)	(35)	(35)
Reported EBIT	40	41	67	63	72	82
Finance income/(expense)	(23)	(26)	(24)	(24)	(23)	(22)
Other income/(expense)	0	(0)	0	0	0	0
Exceptionals and adjustments	39	36	(34)	2	30	0
Reported PBT	57	51	9	41	79	59
Income tax expense (includes exceptionals)	(22)	(52)	(90)	(12)	(15)	(18)
Reported net income	36	(1)	(81)	29	65	42
Basic average number of shares, m	242	244	244	238	233	233
Basic EPS (A$)	0.15	(0.00)	(0.33)	0.12	0.28	0.18
DPS (A$)	0.120	0.070	0.075	0.080	0.080	0.090
Adjusted EBITDA	71	78	98	97	107	117
Adjusted EBIT	46	41	67	63	72	82
Adjusted PBT	23	15	43	39	49	59
Adjusted EPS	0.08	(0.11)	0.12	0.12	0.15	0.18
Adjusted diluted EPS (A$)	0.08	(0.10)	0.12	0.11	0.14	0.17
BALANCE SHEET
Property, plant and equipment	391	391	393	371	375	380
Goodwill	0	0	0	0	0	0
Intangible assets	79	89	89	89	89	89
Other non-current assets	59	116	116	116	116	116
Total non-current assets	529	597	599	577	580	586
Cash and equivalents	192	245	80	135	178	194
Inventories	22	42	28	28	29	29
Trade and other receivables	331	361	236	239	246	250
Other current assets	164	331	331	331	331	331
Total current assets	709	979	676	734	784	804
Non-current loans and borrowings	184	181	181	181	181	181
Other non-current liabilities	161	287	253	262	262	262
Total non-current liabilities	345	467	434	442	442	442
Trade and other payables	367	464	297	331	339	343
Current loans and borrowings	37	8	8	8	8	8
Other current liabilities	18	70	70	70	70	70
Total current liabilities	422	543	376	410	418	422
Equity attributable to company	471	566	465	458	504	526
Non-controlling interest	0	0	0	0	0	0
CASH FLOW STATEMENT
EBIT	40	41	67	63	72	82
Depreciation and amortisation	16	53	30	34	35	35
Share based payments	0	0	0	0	0	0
Other adjustments	60	69	(119)	0	0	0
Movements in working capital	0	0	(18)	31	1	(0)
Interest paid / received	3	3	4	1	2	3
Income taxes paid	(0)	(14)	(24)	(12)	(15)	(18)
Cash from operations (CFO)	120	152	(59)	117	95	101
Capex	(26)	(40)	(32)	(32)	(37)	(39)
Acquisitions & disposals net	12	26	0	20	(2)	(2)
Other investing activities	(9)	(6)	0	0	0	0
Cash used in investing activities (CFIA)	(24)	(20)	(32)	(12)	(39)	(41)
Net proceeds from issue of shares	0	0	(3)	(17)	0	0
Movements in debt	(22)	(24)	0	0	0	0
Dividends paid	(28)	(23)	(17)	(18)	(19)	(20)
Other financing activities	(27)	(33)	(30)	(15)	5	(25)
Cash from financing activities (CFF)	(76)	(79)	(51)	(50)	(13)	(45)
Currency translation differences and other	0	0	0	0	0	0
Increase/(decrease) in cash and equivalents	20	53	(142)	55	43	16
Currency translation differences and other	0	(1)	(23)	0	0	0
Cash and equivalents at end of period	192	245	80	135	178	194
Net (debt) cash	(29)	56	(109)	(54)	(11)	5
Movement in net (debt) cash over period	(29)	85	(164)	55	43	16

Source: Company data, Edison Investment Research

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London +44 (0)20 3077 5700

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United Kingdom

New York +1 646 653 7026

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Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

295 Madison Avenue, 18th Floor

10017, New York

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

295 Madison Avenue, 18th Floor

10017, New York

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Level 4, Office 1205

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NSW 2000, Australia

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