The recent investor day confirmed the opportunities we see for ERM Power from an evolving energy market, which we expect will create medium-term growth potential especially for the Energy Solutions business. In the meantime, investors will benefit from strong forecasted cash flow generation, with total free cash flow over the period FY19–21 equivalent to c 40% of the current market cap. We expect this to be allocated in a balanced way between shareholders’ remuneration and growth capex.
The investor day presentation focused on the impact of the structural growth trends on ERM Power’s activities, including the development of Energy Solutions and the opportunities for power generation activities as a result of the energy transition. We maintain our view that the Energy Solutions business has the potential to develop to a sizeable business, with the mid-case of our sensitivity analysis suggesting the business can generate c 20% of group EBITDA in the medium term. In addition, we believe the high flexibility of ERM Power’s generation assets is likely to benefit from increasing price volatility and increasing volumes.
In our view, a key attractiveness is the strong cash flow generation. Over the three years FY19–21 we estimate ERM will generate total free cash flow (FCF) equivalent to c 40% of the current market cap. We expect this cash flow will be used in a balanced way for shareholder remuneration and growth initiatives. We estimate total dividends and share buyback over FY19–21 equivalent to 21% of the current market cap (assuming a special dividend in FY20 and growth in ordinary dividends thereafter). ERM Power will report FY result at the end of August; we will mainly focus on the guidance for Energy Solutions and Retail as well as an update on capital allocation. Our forecasts are broadly aligned with Refinitiv consensus for FY19 (our EBITDA is 1% higher), while we see c 10% upside to consensus EBITDA for FY20–21 as we factor in growth in Energy Solutions and Electricity Retail.
Despite the recent share price recovery (+17% ytd), the valuation is attractive with the stock trading at undemanding earnings multiples (c 13–11x P/E in FY20–21, excluding a one-off contribution from the LGC sale) and robust cash flow generation with FCF yield of 14% a year on average in FY19–21. The dividend yield is 6.5% in FY19–20 (including the special dividend, 4.9% based on ordinary dividend only). Our SOTP valuation of A$2.4/share (A$2.8/share including a valuation for Energy Solutions) and our forecasts are unchanged.