Small Caps | Apr 03 2017
Success with its strategy has meant power retailer and generator, ERM Power, is able to upgrade guidance for FY17 and provide a better-than-expected outlook for FY18.
-Reduced competitive pressure as wholesale electricity prices rise
-Benefit from in-the-money contracts and hedge book
-Brokers envisage long-term value if pricing and offtakes align
By Eva Brocklehurst
Power retailer and generator, ERM Power ((EPW)), has pulled off a win in the complex and volatile electricity market. The company has revised its FY17 gross margin outlook to $3.50/megawatt hour from $3.00/MWh and provided FY18 guidance of $3.50/MWh.
This FY18 guidance compares with Macquarie's original estimate of $2.70/MWh. The broker finds predicting the company's retail business challenging, as visibility is low and a function of the company's hedge book. In just one month, following first half guidance, there has been a positive swing of around $9m pre-tax. As load contracts are already written, the primary variable is the cost of supply.
The broker suspects the company has obtained a benefit of being long power over the Queensland summer and that it covered some of the Callide C coal-fired power station hedge when one of the participants went into administration, but with the hedge actually not being closed out. Macquarie estimates the gain could be as much as $4-5m.
The other driver of the improved guidance, the broker suspects, is likely to be the hedge book, which has performed favourably relative to customer demand and market volatility. What is less clear is how the guidance affects later years, which will be a function of contracting.
Over the medium term, Macquarie's forecast remains at the lower end of the company's annualised $2.60-4.00/MWh gross margin range. The upside offset will emerge if the capital intensity of the business diminishes. All up, Macquarie finds enough positives to upgrade to Neutral from Underperform. The broker calculates a minimal premium is being paid for the stock.
Citi also upgrades, to Buy/High Risk from Sell/High Risk. The broker believes the guidance upgrade is because of reduced competitive pressure in the commercial and industrial (C&I) market as wholesale electricity prices rose, while volatile prices created opportunities within the hedge book, with the company coming out ahead.
The exit from administration of a party to the Callide C joint venture means ERM obtains cheap wholesale purchase contracts, struck before the recent run-up in electricity prices, versus much higher current costs. The broker believes the company's strategy has paid off, with high electricity prices and state government support continuing to move renewables projects forward.
That said, Citi cautions that this is not always the case and cost blow-outs are experienced every once in a while, but at this point in time the risk is well factored in at current share prices.
Morgans agrees that ERM's prior outlook would have presumed, prudently, that the electricity hedge contracts from Callide C with the counter-party in administration would cease. As this appears not to be the case, the broker expects the company to be significantly in the money as a result of the substantial increase in forward electricity hedge prices.
Hamilton
The 57MW Hamilton solar project has reached final investment decision and Citi suspects this could add 15% per annum to free cash flow once it operates. If the company can sign a further 250MW of offtake, as planned, for five years, this could add a further $0.25 per share to the broker's valuation.
Value
Citi envisages long-term value in the stock and further upside risk, if pricing and timing on renewable offtakes align with expectations for the delivery of US margin/volumes that are ahead of the broker's conservative estimates.
Citi lifts FY17 operating earnings (EBITDA) estimates by 13% by linking to the company's updated Australian gross margin guidance. The broker rates the stock high risk to reflect its low interest cover because of off-balance sheet finance that supports the retail business.
While this finance can be supported by earnings, there are risks to valuation from retail competition, commercial electricity demand and wholesale electricity prices. Also, if the company can no longer pay a third party to provide security to electricity market operators in the US this could materially increase the capital required by the business.
Morgans believes there is potential upside surprise to the dividend and the solid dividend yield may be enticing for some income investors. Nevertheless, uncertainty surrounds a number of key value drivers such as the sustainability of the gross margin, the maturity of the Australian C&I book and growth in the US retail initiative. If a track record of delivering earnings growth is developed and there are further positive earnings surprises Morgans expects a share price to respond positively.
History
ERM Power operates in three business segments: electricity sales, power assets, and other energy solutions. Historically, the business is Australian but in 2015 the company entered the US retail electricity market by acquiring Source Power & Gas in Texas.
There is one Buy rating (Citi) and two Hold ratings on FNArena's database. The consensus target is $1.30, suggesting 1.2% upside to the last share price. Targets range from $1.20 to $1.46. The dividend yield on FY17 forecasts is 6.4% and on FY18 forecasts 6.2%.
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