This is from long term investor EGP capital.Microcaps are Hard,...

This is from long term investor EGP capital.
Microcaps are Hard, Part II: -
We will continue last month’s theme of reviewing some of our positions that have not worked out as anticipated at
the time of investment and why we still hold them. This month we will review Locality Planning Energy (LPE). We
wrote about LPE here (.PDF) in December 2018, and the performance of the share price since then has frankly been
abysmal. If we look at the management revenue forecast for FY2019 outlined in that newsletter ($44.2m) and compare
it with what prevailed ($28.5m), we get a sense of why market participants give zero credence to published forecasts
LPE management makes (to be fair, the large shortfall against FY2019 guidance can be partially explained by
extraneous factors, not the least being an unexpected and sharp fall in Queensland electricity prices in the period).
With that said, it is worth reviewing the historic revenue performance of the business:
That is an unequivocally strong, consistent demonstrated revenue trajectory. The primary issue that the company has
had to date however is that operating cost growth (OPEX) has consistently exceeded both management projections
and investor expectations. As such, the jaws of operating leverage have been wired shut by this aggressive cost
growth. The equivalent operating cost graph has been (much) steeper than we had modelled at the time of our original
investment, though appears to be flattening, finally as the graphic on the next page indicates.
EGP Concentrated Value Fund – 31 January 2021 5
The sharp slowdown in the “other expenses” line in FY2021 is the critical reason for thinking that operating leverage
is about to appear in LPE’s results. Last year was the first year the business has managed to show meaningful cost
control and if it can be continued, very real operating leverage should soon appear in the reported results.
Pinpointing the gross profit (GP) for LPE can be tricky as it swings meaningfully from year to year depending on the
outcomes of hedging. If we look through the last two years, $97.8m of revenue and $82m of electricity cost of goods
sold (COGS) indicates the average gross profit (GP) has been about 19.2%. If we extend it to the last three years, GP is
19.9%. The gross margin is however declining as larger scale commercial sales give up some margin for the larger
electricity volumes. Margins for the last couple of years have been higher than they will be in future for two reasons.
Firstly, the business had a higher proportion of revenues from the strata part of the business, as the direct market
component of the business grows, the businesses natural GP level will fall. The business also benefitted from falls in
wholesale electricity prices in the past couple of years, which improves margins as it takes time to pass on these
savings to customers. This has now reversed, and the business will likely have its lowest margin in years this year as
they follow the major retailers in passing through the almost 30% rise in Queensland wholesale electricity prices.
We are modelling a 17-18% underlying GP at maturity (i.e. ignoring hedging effects). As mentioned, margins for
FY2022 will likely be below this as the falls in wholesale prices over the past couple of have reversed, depending on
how quickly management have re-priced customers, margins could be as low as 15% in FY2022.
The company has added $15m and $12m of revenues in the past two years (with declining retail electricity prices
providing a significant headwind) and the last two market updates have indicated ~30% year on year customer growth
has been observed in the first 5 months of FY2022. If the 30% customer growth translates into equivalent revenue
growth, LPE should increase revenue by around $15m in FY2022 to ~$70m.
At the normalised margin we expect of ~17.5% on $70m of revenue would imply more than $12m of GP for FY2022
(if actual margins come in at 15%, this number will temporarily be closer to $10.5m or $11m until price rises are fully
passed through). Total operating costs in FY2021 were $14m but appear to be flattening. This would indicate that if
LPE can maintain the recent restraint in cost growth, the business will not be far away from the breakeven point.
Marginally profitable or almost profitable microcap businesses are a dime a dozen on the ASX though, what makes
LPE more interesting than other marginal microcaps are three key things.
The first is the prospect of the jaws of operating cost (finally) opening. If LPE can continue to add $10-15m of revenues
annually at even only a 17.5% GP margin, that produces an additional $1.8-2.6m of GP annually. If the OPEX cost
growth to service that additional revenue can be kept to $500k per annum for example, that means the business can
add at least $1.3-2.1m of reliable, secure, recurring pre-tax profit annually. Such additional earnings would likely be
valued at a multiple of 10-14x. This implies LPE can potentially add $13-28m per annum of market capitalisation by
EGP Concentrated Value Fund – 31 January 2021 6
simply maintaining their current revenue trajectory with good cost discipline. This compares incredibly favourably to
the current market capitalisation of $12.1m at the 13cps share price at the time of writing. Furthermore, LPE carries
an exceptionally expensive debt burden, the $2.22m financing cost in FY2021 was for total average borrowings of
barely more than $14m throughout the year, these expenses include more than just interest, but given the highly
predictable cashflows, the scale of the business must surely be close to the point where more traditional bank
financing can be obtained, potentially bringing the cost of debt down to a mid-high single digit cost. Even at a 7.5%
financing cost (high for such reliable cashflows) the lower cost of debt would strip more than $1.1m in financing costs
from the cost base annually. For a company with only a $12m market capitalisation on the cusp of profitability, that
potential cost saving is alone worth close to the market capitalisation, the rest of the business is currently effectively
being thrown in for free if they could successfully execute such a refinancing.
Secondly, one thing we feel management have failed to properly articulate to the market is the substantial investment
in growth the current cost base contains. The single greatest thing management could do to help prospective investors
value the company more accurately would be to explicitly break out “growth OPEX” in their investor presentations.
The sales team required to deliver the ~$15m per annum of revenue growth is large, and we estimate costs upwards
of $1m per annum with base salaries and inducements being paid to the sales team. Furthermore, the team required
to service the onboarding of all these new customers is also larger than it would be if the business were to stop
growing and operate on a lean, “steady state” basis. If management were to decide to stop growing and to cut the
staffing back to the leanest possible level that could service the existing customer set, I would hazard there at least
another $1m of employee costs that could be removed. The P&L with $2m removed is a very different looking one
but given the importance of scale to the business model, it would be a mistake for the long-term value creation of the
business for management to take this austerity approach to running the business. With that said, the >$6m per annum
of employee costs, alongside $2.2m of IT costs feels far too large for the level of complexity of the business at the
current scale should have. If the business could run find a way to make the current staffing/IT cost base hold steady
for a couple of years whilst maintain the revenue trajectory, the shareholder value accretion would be enormous.
The final point is the value of the existing LPE revenue base to an acquirer. Although the business might be only close
to breakeven, or at best marginally profitable at the current scale in the current structure as an ASX listed microcap,
the same revenue base plugged into a more mature entity produces a very different level of profitability. As an
example, before being sold by Amaysim to AGL, the Click Energy business had a GP of $73.3m and had operating
expenses of $44.7m, or 61% of GP (one can only assume that AGL expected to improve that ratio too through better
scale and efficiency). This would imply that the ~$13m GP run rate LPE currently produces would create $5.1m of
prospective pre-tax profit to an acquirer of similar operational efficiency (costs 61% of revenue) to Amaysim’s Click
Energy business. Given the long-duration contracted nature of much of the LPE revenue base, to an acquirer, it would
be much more valuable than the Click Energy business was, where the weighted average contracted tenure was less
than 1-year whereas we understand the weighted average tenure for LPE customers exceeds 5 years.
An acquirer should be able to comfortably justify a 14x pre-tax profit multiple, particularly if they expected to be more
efficient than the 61% cost ratio in the Click Energy example. Such a multiple implies a ~$70m enterprise valuation
(EV). If we subtract the ~$15m of debt the business carries from this figure, the $55m remaining compares very
favourably to the current $12m market capitalisation. This valuation allows nothing for the optionality of the various
other businesses LPE operate, the shared solar, virtual power plant and carbon-neutral central hot water all provide
optionality above the primary electricity business valuation.
With such significant value-accretion on offer to a corporate acquirer of LPE, if LPE management don’t turn the
company to profitable account before too long, there is a non-trivial risk that someone larger somehow gains control
of the company and does the job for them without the full value being captured by the shareholders who have
provided the capital and support for the business to get to where it has.
As to the question why we still hold LPE despite the poor performance of the share price, and the notable historic
failure of management to deliver on their promises? The answer is simply that we cannot be sellers in a situation
where under a variety of relatively plausible situations that upside measured in multiples of the current valuation can
be observed.
EGP Concentrated Value Fund – 31 January 2021 7
Furthermore, we are of the view the world is entering an extended period of meaningfully higher energy prices. The
term “Greenflation” has started to enter the lexicon of folk who have spent the past decade or more insisting the
transition to green energy would presage lower global energy prices. This speech by ECB member Isabel Schnabel
outlines the burgeoning view that to transition to a greener energy future, energy prices will remain elevated for an
extended period. This is exacerbated by the fact ESG investors are restricting the flow of capital available to invest in
even very prospective non-renewable energy projects, as such the trend of diminishing supply meeting still growing
demand can only result in higher energy prices.
Such an environment will provide a significant tailwind to businesses such as LPE that simply clip a margin from the
selling of energy. If you were going to make $100 margin selling energy and then the prevailing price is suddenly 30%
higher, without any additional cost, you are now making $130 margin (once you successfully pass through the price
rises). Given the already very strong revenue growth LPE is experiencing, such a tailwind would further improve the
operating leverage.
The biggest risk to LPE is in funding their obligations to the Australian Energy Market Operator (AEMO). The business
must post cash to AEMO based on the forecast load for the direct market customers. For a more bankable business,
they could rely on their banking relationship to give a bank guarantee for this amount, but LPE’s relative immaturity
as a business means they must post cash to AEMO. Many millions of cash are tied up in funding this obligation and
unless the refinancing mentioned earlier is successfully executed, there could be a requirement for further capital
that the equity market will be reluctant to fund.
Thankfully, LPE’s embedded network customers (approximately 26,000 customers), are fully hedged through fixed
price load following forward purchase contracts with Shell Energy. These do not require AEMO credit support.
To ensure the significant equity upside is realised, management needs to act aggressively on two fronts. First, cost
control must be prioritised, the equity will not be re-rated until market participants can see managements
determination to make the business self-funding. Secondly, the refinancing must be prioritised and must ensure there
is a viable way to finance any continued growth on the direct market business. Absent this, direct market business
must be eschewed in favour of less capital hungry embedded network customer growth.