what a dog, page-16

My concern about ERM over the past 18 months has been some degree of confusion:

1. Is this a growth story ?
2. Is this a dividend play?
3. Does it need to be a generator of base load power?
4. What were they doing in gas exploration especially as the gas supply is tightly regulated so I could not see the profit and why then do a pilot study and invest in this area?

I think a lot of the above has now been answered -

1. The growth story at the large users end of the market has ended and the other suppliers are competing on price so the margins are under pressure.
2. The SME growth is much smaller than I think we expected and will take time - You would have to spend a lot of money to grab that market and without a retail supply licence they miss a lot that would change over - I for example use a lot of electricity as I run my business from the property on which my home is built - I cannot get supply from ERM even though I use around $8,000 even after solar inputs as the regulator defines my home as residential supply because there is a house on the property notwithstanding that there is a large warehouse and business also on the property - I would have to get 2 connections to separate them. By the way ERM would be over 15% cheaper than my current supplier.
3. I do think SME will become a player but it will take time and only grow back the overall margin rather than grow the business in my opinion.
4. It doesn't need baseload power production. The Sunset power deal will reduce working capital tied up over the next 5 years.
5. The big issue - Its always been my view that a growth company should keep its cash for growth and not pay unfranked dividends. So if this was a growth business how come it got itself into the dividends of 6 c twice a year fully franked - personally I think it was the family nature of its significant shareholder. At that time the share price was also around $2.40 so the dividend was too high but understandable.

Now review the reason for your investment - If its an income stock its yield is normally high if there is a risk to its dividend. Look at SVW ... So we have a growth story that beginning to peak and growth is off the table - NOW. So if its a dividend stock then what is the risk the dividend will be cut?

It has no franking credits a very complicated set of financial accounts. Its business model creates its own issues...

@$1.10 a 12c unfranked dividend is almost 11% yield - I think a fair return for risk is around 5% so the premium is for the risk of it dropping. We lost 3 years dividends today...

Looking at next years numbers it may well not have enough retained income to pay 12c. It will be determined by the strange valuation of its forward contracts. I think you will find that they have sufficient cash to pay it out but actually they may not have retained income... The first half of 2016 saw retained income drop by almost $6 million the back half I expect to be around $9 million - subject to the strange valuation requirement of accountants.

You therefore have to take a much closer look at the business to understand it:

1. Electricity supply is not a growth business - its a sector in transition.
2. Renewables are more viable in Oz because of our exceptionally high electricity prices at retail level. However at large user level the prices are much closer to the rest of the world. Thats why Tesla is bringing its battery wall here as one of the first markets - we pay too much at retail level.
3. ERM is not vulnerable to a decline in usage or competition in retail market but the other players have huge retail users that pay all their costs and provide significant but declining profits.
4. ERM could be a very attractive player offshore if they can replicate their model in the USA. They have to transition from carrying overheads in a single market to spreading them over two with having a much smaller share of the USA market they could still have a business 3 or 4 times the size of its local operations.

Why would I invest here?:

The growth story is over so my premium for growth is over until the USA provides profitable growth - probably only 2018 to 2020 to see that.

I suspect the people looking for capital growth capitulated today - taking their money out of this sector and looking elsewhere for opportunities.

The income investors are still there because its not easy to find a 10% yield but they are , like me , I suspect hanging in because the capital left (Sprice) is just too little to find alternatives.

The interesting play is that the share price is now lower than NAV by a large margin. $269 million vs a NAV of $361 million. Does that make them a takeover target - possibly.

They are due to get the remaining money out of the EGO transaction in August thats around $15 million plus the approximately $8 million from getting out of the shares.

So the business is now clean...

My estimation is that there is around $70 million in cash they may not need. The depreciation is $10 million a half year and they probably only need around $25 million to develop USA. Most of the interest cost is Neerabup - recourse only to assets of Neerabup.

If I was running the show I would use the new Liberty guarantee facility and the Sunset agreement to recover around $100 million of restricted cash over 5 years. They need $25 million to build USA. That leaves around $70 million.

I would drop the dividend to the depreciation - that's say 4.5c per half - 9c per annum on $1.10 - 8 % yield.

I would enter into a share buyback where the share price is around 15% or more as a discount to NAV. Currently over 25%. As my borrowing cost is below the yield I am paying and no franking credits my EPS will improve.

So I am hanging in there - not for the income but the income is my best way of maximizing my return and if USA does grow as they expect then in 3 years we could have two electricity businesses of roughly equal size and we could be generating the returns we did last year but with a much more stable growth factor - the USA. Then there is the take-over target... Price of $1.50 would get me to sell.