Utilities have long been considered a safe haven in the stock market. Utility stocks generally pay out generous dividends, have predictable revenues, and the business is somewhat recession proof (people usually keep paying their hydro bill if they possibly can). These qualities and the reputation as a safe haven has led to the sector appreciating a lot, with many believing utilities could be overvalued.
Enercare Inc. (ECI) offers the best qualities of the utility sector, with the added benefits of growth and being undervalued right now.
Enercare describes their business as such:
Enercare is a leading provider of water heaters, water treatment, furnaces, air conditioners and other HVAC rental products, plumbing services, protection plans and related services.
The company rents or sells all of the above, and in addition provides sub-metering units, which allow multi-tenant buildings to determine how much water, electricity, or gas a particular unit is using. Enercare also provides servicing to all of their products.
While maybe not a utility by the strictest definitions of the term, I’d include Enercare as one due to the “necessary” nature of their products and services.
You’ll notice quite a bit going on with the stock price for what is supposed to be a boring business. For the sake of brevity I’ll focus on the two most recent developments.
First, the big run up in price since the start of 2017. The fourth quarter of 2016 saw record revenue and EBITDA. This shouldn’t have been a surprise since everyone knew the Service Experts acquisition would be accretive. Nevertheless the stock still rose in anticipation and on the news of the 2016 results.
The surprise catalyst however was the acquisition of Reliance Home Energy Comfort by Victor Li and Cheung Kong Property Holdings. Reliance was a competitor in selling, renting, and servicing water heaters and HVAC units in Ontario. The interesting thing is the multiple that Li paid. TD made estimates of both the enterprise value and EBITDA of Reliance, and calculated the takeover was priced at 12.7-13.7x EV/EBITDA. The market got one more reference point of how Enercare should be valued, with TD predicting it would take $29-$32 to acquire Enercare.
Now the big drop. Q1 2017 looks bad. While revenue almost doubled, EBITDA decreased, and SG&A expenses increased 10% over the previous quarter. Let’s look a bit closer at those Q1 numbers.
EBITDA was lower, mostly due to the increased expenses and Service Experts contributing a EBITDA loss. Everybody knew Service Experts was a seasonal business, so the EBITDA number shouldn’t have been too much of a surprise.
The increase in expenses is concerning, but some of it can be explained. $2 million of the SG&A increase was because the stock price increased, which increased the cost of stock based compensation. Ultimately that is good for shareholders. I believe SG&A is temporarily elevated as Service Experts rolls out their rental program, but with the roll out expected to be completed by the end of 2018, these costs will likely remain this high for the next two years.
2016 was a record year, and in spite of the increased costs I expect 2017 will be another one.
In 2017, I expect SG&A expenses to remain elevated, $344 million compared to $266 million in 2016. This is the only material change to the expenses I feel safe predicting. In 2016 the Service Experts acquistion was closed on May 11, so the expenses must also be extrapolated to a full quarter this year. To be simple, doubling the Service Experts expenses for Q2 would add another $95 million. Expenses for the year should come out to about $962 million in 2017.
Revenue will depend a lot on the type of weather we get. This summer seems much cooler than last year and this means growth should be slower as there is less demand for air conditioners, and less wear and tear also leading to less demand for new units. The weather makes revenue a bit harder to predict, but I’ll give it a shot as well.
I’ll estimate contracted revenue increases 10% for the next three quarters (after increasing 13% in Q1) to $636 million for the full year.
Investment income should come in around $1 million using Q1 as a run rate. It is the sales and services revenue that is really variable. With a cooler summer, and Enercare focusing on increasing rentals over sales, I’ll predict sales and service revenues drop for Enercare Home Services, from $28.6 million to $25 million. Sub-metering sales and service revenue almost doubled in Q1, but I’ll assume that for the full year these revenues only increase to $5 million, a 35% increase.
That leaves the Service Experts division. In Q1 Service Experts contributed $116 million in sales and service revenue.
In Q2 2016, Service Experts contributed $100 million in just half the quarter. At the time that was considered beyond expectations due to a very hot summer in the US. So I’m going take off 10% to account for a cooler year this year, then double it to account for a full quarter, and predict Service Experts contributes $180 million sales and service revenue in Q2. The rest of the year we’ll predict Service Experts revenue is flat year over year. Seeing as Service Experts increased sales (including rentals) 8% in Q1, this should be conservative.
Adding all of these numbers, we get total revenue of $1.25 billion, an increase of 26%, and EBITDA of $284 million (up 6.7%).
Barring any large acquisitions, Enercare should end the year with approximately $20 million in cash, while adding ~$50 million in debt (estimated as the cash shortfall after capex of $180 million and dividends). Shares outstanding will likely increase to about 113 million, as DRIP participation is around 30%, and stock is issued as compensation.
At 12x EV/EBITDA, fair value at the end of 2017 is $20.72. Appreciating to this price as well as collecting the dividend will give investors a return of 8.8% in six months. Not great, but this is a growing company with a great business model and high yield. In a market looking more and more like it is overvalued, I’ll take a growing utility trading at a slight discount to fair value.
I’ll estimate that expenses increase slightly in 2018, increasing by about $15 million. SG&A expenses should not need to increase more than they already have. Management has stated they are confident they will realize synergies with the Service Experts acquisition which will save $0.05 to $0.08 per share (between ~$5 million and ~$9 million), but I’ll err on the side of caution and say other expenses creep up to keep the total marginally higher.
Assuming contracted revenue increases 10% again, and a warmer year as well as organic growth boosts Service Experts sales and service revenue to 2016 levels, 2018 revenue should be around $1.336 billion and EBITDA $359 million. With the growth Service Experts has shown so far, and the anticipated increased uptake of rentals in the US market, I expect this prediction could be low. If debt increases another $5o million, and shares outstanding end 2018 at 130 million, trading at 12x EV/EBITDA Enercare will be $24.50. Throw in the dividend (which I’m predicting will be raised to $1), and you have a return of over 23%, in addition to the 9% return you get this year.
Enercare yields 5%, and is growing at a very high rate for a utility. I don’t think the market truly appreciates the sub-metering story, and is completely discounting any more adoption of rentals in the US. Even being what I think is conservative, Enercare is undervalued . With the bearish sentiment that has set in since Q1 earnings, I think the stock will jump a lot on a positive Q2 release. At the very least, the company is fairly valued with a good record of growing earnings and the dividend. In this market, I’ll take that every time.
Disclosure: Long ECI