Energy One: a fast grower in the Australian electricity market.

This is an example of the kind of research I do when I’m investigating an idea. Right now I’m looking at foreign micro-cap stocks for ideas. Here is one I found. It seemed like a good value, but didn’t meet my level of risk tolerance due to its reliance on a few high-value contracts and some temporary work that is boosting results. I have gotten burned too many times on small companies receiving a few big contracts that later dry up, leaving a much less profitable business behind.

Energy One (ASX:EOL)

Market cap: $5.80 mm AUD

Cash: $1.73 mm AUD

No debt, total provisions of $180,000

Enterprise Value: $3.89 mm AUD

Overview of Business

Energy One  provides software and services to wholesale electricity, gas, and carbon trading markets in Australia.

The business model is based on selling one software system to a customer at a time, then upselling to further systems as the relationship develops. To further these plans, the company plans to make acquisitions of complementary businesses, so it can continue to bundle software packages into its product suite. This results in operating leverage, because the same staff can be used for maintenance of the old package and installation of the new package, resulting in higher profit margins.

In the early part of 2014, Energy One secured two major contracts with Australian energy utilities, Alinta Energy, and one other unnamed entity. Alinta has already purchased the entire Wholesale Energy Trading Suite.

The other utility purchased the Energy One Trading platform in July of 2014. So these revenues were not recognized until the half ended December 31,2014.

Finally, a third utility company has expressed interest in upgrading its systems from a previous version of Energy One’s software to a newer one in the near future. Currently, it is trialing this new version, so there are no guarantees, but a new contract would probably allow for continued profitability for at least another year or so.

Much of Energy One’s  revenue may have been derived from one-time revenues occurring on installation of its products at two major customers. From its December 18,2014 release:

“Energy One has been proceeding with the implementation of its products at two major customers and completed the implementation at another. Revenues from these projects will continue to be realized over the remaining installation period and from license fees and on-going support.”

The company receives revenues that are recurring (Licenses, support and maintenance, IT services, ongoing enhancements and engagements), and one-off (labour services for project-based implementations). These project based implementations generally last for 12-24 months from commencement.

Thus, the major projects announced H2 2014 and H1 2015 (calendar year 2014) will reach the closing implementation stages during H1 2016 (calendar year 2015).

Review of Operations

Because of all of its recent work, EOL published really good numbers for the half ended December 2014. The stock quadrupled from $.10 to $.40 on the news. It had the highest revenues for any half-year going back to 2011:

Revenues from Operations

Furthermore, as EOL has grown, it has been able to leverage its employees. It’s employee expense as a % of revenues is down to 58%, from greater than 100% 4 years ago.

Employee Expense

Other, more fixed expenses are coming down as a percentage of revenues too, showing the power of EOL’s business model to leverage fixed expenses. I regard Rental Expense, Accounting Fees, and Insurance Expense as more fixed expenses. These fixed expenses are smaller than employee expenses to begin with however, so leveraging these fixed costs will have a smaller impact on the bottom line.

Rental Expense

Accounting Fees

Insurance

The one expense that is not decreasing as a percentage of revenues is the consulting expense.

Consulting Expense

The uptick in consulting expenses this last half is related to its recent major contracts. The company increased the numbers of both regular employees and consultants to deal with the new work. The outside consultants are mostly helping in software installation at the two major Energy utilities that signed on in 2014. Per the CEO, “As the projects revert to long-term support, these project costs will reduce as a proportion of revenue”.

R+D Tax Incentive

As of the last half-year, ended December 31, 2015, EOL received about 16% of its revenue from a R+D tax incentive. This down from 21% for the year ended June 30, 2014, signaling decreased reliance on government support for profitability.

Still, its tax incentive in H1 2016 was about $380,000, almost equal to its overall profits before income tax of about $390,000. So if these R+D tax incentives are wiped out, then EOL’s profitability could evaporate overnight.

According to the Australian Taxation Office, a refundable tax credit is issued to eligible entities with revenues less than $20 million AUD, whereas a non-refundable credit is issued to all other eligible entities.

How does one qualify for the Research and Development credit? It actually operates on the honor system, with random verification. From the ATO: ” We assume that you have completed your tax return in good faith… However, even though we may initially accept the claims in your tax return, we can later ask you to provide the records and information you used to complete your tax return.”

So, if EOL has made a mistake in assessing its eligibility for the tax incentive, the ATO could ask for a lot of money to be refunded.

Here are the R+D Tax Incentive Criteria:

  1. Did you incur the amount (or pay the amount if your expenditure is to an associate)?
  2. Is this amount eligible to be claimed under the R&D tax incentive?
  3. Is the amount incurred on R&D activities that are registered with AusIndustry (who act on behalf of Innovation Australia)?
  4. Have you apportioned your expenditure so that you are only claiming amounts to the extent they are incurred on R&D activities?
  5. Do you receive the major benefit from the R&D activities on which you incurred expenditure?
  6. Have you kept, or can you access, sufficient records to support your claims?

To the best of my knowledge, Energy One’s activities do seem to account for the kind of innovation that would qualify for the credits. However, I have no insight into whether the amounts claimed by Energy One are all eligible or not. I will assume the company has properly assessed the amount of the credit, but I will keep an eye on this as a risk to look out for.

Every year, EOL receives the incentives related to the previous year’s R+D activities. For the year ended June 30 2014, it received $720,247, which was the total amount spent on R+D in 2013. This is substantially higher than the $549,432 recognized on the income statement – one of the major reasons that cash flow was higher than net income for FY2014.

The reason for the discrepancy between the income statement and cash flow recognition of the credit relates to portions of the companies R&D that relate to employee expenses and those that relate to capital expenditures. Whereas in the U.S., R+D expenses are included on the income statement, in Australia, these tend to be recognized on the cash flow statement, if the R+D expense is not an employee salary cost. For EOL, $549,432 of its employee costs were related to R+D, so this amount of the credit is recognized on the income statement. However, the total R+D credit is recognized on the cash flow statement, because all R+D costs are included on the cash flow statement.

For fiscal 2015, EOL has already received $709,326, which was exactly equal to what the company stated it would receive in the annual statement from June 30, 2014.

Death and Taxes

Energy One has had an easy time with taxes so far because of a large build up of accrued tax losses. However, this stash of tax assets is about to run out. The amount left as of December 31, 2014 was only $92,790, down from $611,877 on June 30,2014. This means that pretty soon, likely in the next half, EOL will be forced to start paying taxes. And this will certainly decrease profitability and cash flow.

This means we will have to use theoretical after-tax numbers to value Energy One. If Energy One had had to pay taxes in the last half, it would have generated a net income of $273,964 for the six months ended December 31, 2014. This figure is much less tantalizing than the $513,060 it reported, which was boosted by an income tax benefit of $121,683.

For the half ended June 30,2014, it reported a net income before tax of $540,478, which would be $378,334 after Australia’s 30% business tax. Together, this yields a TTM net income after tax of $652,298.

Compared to an enterprise value of $4.274 million, that looks pretty good, giving it an EV/net income of 6.5.

Risks

In the Chairman’s Report, Energy One Chairman Ottmar Weiss mentions that many of Energy One’s customers are operating in “depressed wholesale market conditions”, particularly in the electricity sector. This is worrisome, since the other customer segments, like energy, are not faring particularly well either.

I don’t see much reason for weakness in the domestic electricity market other than the general economic weakness in the Australian economy. This generally depressed state relates to the poor environment for commodities globally. In the meantime, Energy One seems able to grow even in depressed conditions, leaving it in a prime position to benefit if there is an uptick in the general economy.

Ideally, customers would recognize that improved IT systems may lead to decreased costs in the long run, but in a cash crunch, companies usually don’t splurge on big capital expenditures, even if they may be cost-saving measures. So this is definitely a risk to EOL’s business model.

One of the long term trends that the managing director mentions as a potential headwind is the growth of domestic solar power. This decreases the need for consumers to tap into the energy grid. However, in my opinion, this risk is far from materializing. Due to the general downturn in oil and gas prices, electricity in Australia is only getting cheaper, reducing the impetus to switch to solar.

Looking Forward

There are two main questions that will determine Energy One’s future:

  1. How much of revenues are made up of license fees and on-going product support? During the installation period, the company receives installation fees, but after this period (i.e. beginning H2 2016) license fees and product support may become the main source of revenues.
  2. At what margins will the company be able to operate on a license fees and product support model? Will they be able to pull comparable profit margins to what they have been making in the past half, when installations were underway?

The CEO stated, “Notwithstanding that the company’s revenue base is still comprised of one-off project incomes (and those projects can be subject to delays and elements outside of the Company’s control), it is our intention and goal to seek to produce a second half performance that is comparable with the profit before income tax achieved in the first half of the year.”

This statement bothers me for two reasons. 1) the CEO referred to the revenue base as comprised of one-off project incomes. Rather than use the wording, “partially comprised”, he simply used “comprised”, which makes me think the breakdown between project implementation revenues and recurring revenues is heavily skewed to the former. This is bad news, because unless the company can sell new systems, it will likely sink back into the red again, under the weight of all the new employees that were hired for implementing these new system installations. Even if the consultants are let go, permanent employee expenses more than doubled over the course of H2 2014 and H1 2015, so if revenues go down to the levels of FY 2013, the company would quickly turn from a net profit to the biggest net loss in its operating history.

I don’t think this scenario is likely, due to the new recurring revenues and the fact that another major utility expressed interest in upgrading, but I think the risk of this scenario is too great to warrant an investment at this time. I am going to have to pass on Energy One until I see a new contract signed, or we get more information about how large the recurring revenue figure will be.

Is the market really falling because of oil?

The consensus view is that the overall stock market is being dragged down by the slide in oil prices. This makes sense – logic dictates that falling oil prices have an immediate negative impact in terms of dragging down the prices of oil-related equities, and a longer term positive impact due to an increase in consumer spending.

The immediate negative component will be larger now than in the 1980’s, because the economy has grown more dependent upon oil companies in the wake of the 2007-09 crisis. Oil companies were partially responsible for the recovery America has shown since – it makes sense that anything that imperils the health of these companies would imperil the recovery as well.

Oil price may have overshot to the downside. This is the consensus view anyway – most market participants expect the oil price to overshoot to the downside, as part of a Saudi Arabian scheme to shake out American shale oil drillers. Market participants also expect that oil will rebound within 18 months to previous levels (circa $100) after many of the weaker, more highly leveraged firms have been pushed into bankruptcy.

If the consensus view is correct, the move is to be short oil companies now, long retail and airlines, hold until a bottom in the oil price, then switch to well-capitalized mid-cap oil companies. These latter companies will be able to survive the downturn, and emerge more profitable than ever when the oil price picks back up. The added bonus of holding these companies is that oil majors, like Exxon, would rather acquire than drill for growth in an environment of oil price instability, so by picking the strongest companies, investors could benefit from an acquisition.

The fact that there is so much consensus on this makes me nervous. However, I have no basis for arguing with it. The real question, then, is whether I should join in. With oil prices in the mid $50’s currently, I can answer with a no. The risk of joining the “short oil, long retail and airlines” play is that a trend so advanced may easily correct, so even if I got the trend right, I could be pushed out with a loss by a sharp correction.

Therefore, I have to wait for the next leg of events to begin to participate. In the meantime, I have to formulate a working hypothesis of what is going on.

One thing is apparent, if the market is really falling because of oil, then the market should stop falling when oil bottoms. However, if oil price were to stabilize at current levels and the market were to continue to decline, it could be a sign of something bigger.

I have been expecting a serious correction in equity prices for some time, but I have been repeatedly punished for my bearish views. This could be simply a case of wishful thinking. However, there was a sharp correction earlier this year, that I never found a satisfactory explanation for, other than simply “valuation”.

The fact that market participants are starting to take valuation into consideration is dangerous for the market. In an environment of historically low interest rates, we would expect historically high valuations. If participants are starting to question this process, it could begin to unravel. What makes such an unravelling especially dangerous is the fact that the Fed probably has the data it needs to begin to raise interest rates. Market participants placing more importance on valuation considerations, combined with an increase in interest rates, could create a rapid and deep correction, and possibly a bear market.

The only argument I have against this scenario is that there are strong disinflationary forces in the market: 1) the falling oil price and 2) the strong dollar. These may function to keep inflation below the Fed’s target, allowing it to delay the interest rate hike further and further into the future. The market consensus has been that the rate increase would happen in the early part of 2015, however, latest events should push this at least into the latter half of 2015, if not later.

If this is the case, then the bull market ought to be able to sustain itself, and the indexes will emerge from this dip stronger than ever. In fact, after so many small corrections, we might expect valuations to completely detach from reality. We might see former high flyers in the tech space regain their peaks.

On the other hand, if the market continues to slide after oil stabilizes, then the market may be in for a longer term beating, in which high-flyers are pulled down by the market correction.

One thing is for sure: oil cannot stay in free fall forever. Eventually, it will hit a bottom, and at a current price of $56, I think this will happen sooner rather than later. Then we will have our answer to the above question, and I will have a basis for beginning some speculations.

Gazprom

After the massive gas deal between Russia and China, Gazprom looks like it might be an interesting play.

  • We know it will be doing $400 billion of business over the next 40 years.
  • The market has discounted the price of Gazprom over concerns that Europe may stop buying its gas. However, this is an unlikely scenario.
  • The company trades at a P/E of 3. Part of this may be because of distrust of accounting at Russian companies. However, the valuation looks extremely low.
  • Russia’s market as a whole has been discounted because of the invasion of Crimea. This discount may subside as the situation de-escalates.
  • The key risk is the cost of building the pipeline. China will front $25 billion for the deal. However, the excess costs will come out Gazprom’s capital expenditures. These costs will come over the next several years, while the revenues from the deal will not come until 2018. Equity markets are notoriously short-sighted, typically with a time horizon of 18 months. So any gains in the stock may not come until 2016-2017, while in the near term the stock may be weighed down by costs.

Future Speculation Ideas

I have had a lot of trouble finding the time to do more formal posts lately. Thus, my blog will transition to more of a quick notes format. More formal articles will now be distributed to my Seeking Alpha page, and linked here.

1. Healthcare bubble. Healthcare stocks have been going up. All the traditional healthcare (Johnson and Johnson (JNJ)) along with newer biotechs (Pacira pharmaceuticals (PCRX)). Likely going up because Obamacare means more people that were uninsured will now be insured. Thus, theoretically, more care overall will be provided. Trend will likely reverse when electronic medical records are instituted. EMRs will enable rationing of care, thus decreasing healthcare consumption. This is a weak theory, needs refinement.

2. Internet of things bubble. I havent seen public excitement about this yet, but the underlying trend is there. My hypothesis is this is in stage 1 of George Soros’s boom bust model.  Fundamentals look promising. The key four companies are Sierra wireless (SWIR), NMRX, ESYS, and Cisco (CSCO).
The PE ratios aren’t that high. 24 for SWIR, 20 for ESYS, 15 for CSCO. PE ratios typically get to 100 in a bubble. If the internet of things does become a bubble, there could be upside here.

3. Marijuana bubble. This looks promising. Many penny stocks. The only real company I’ve seen is GWPH. Pharmaceutical company making marijuana drugs. This company is up 1000% in the last year. It may be at the top of a bubble, or it may continue. It has been experiencing a little weakness in the past few months. Unsure if this is a test phase or a sign of a “double top”. Possibly watch this for signs that the bubble is about to burst, and then short.

4. Russia speculation. Russia’s stock market has been down because of the Ukrainian tensions. There is a fear that Europe will stop buying gas from Russia. However they have no alternatives. There is some LNG from Qatar, but not enough. It would be extremely inefficient to get LNG from Australia. US is not providing LNG until next year. Therefore, Europe will not stop buying Russian gas. Russian market is trading at a P/E ratio of 6. Some of that is because Russian accounting is very bad. But it is probably too low, and will recover in 12-18 months, if Russia does not annex any other countries.

5. China speculation. Chinese market has been depressed because authorities are trying to pop the real estate bubble there. There is a large banking system that is not accounted for on balance sheets (I.e. Companies issuing IOU letters of credit, etc) and there is fear that this informal system will collapse. This may happen. There is real risk. However, eventually markets will recover. China still has a long term expected growth rate of 6-7% or so, more than double the US growth rate. It is currently at a P/E of 10, while the US is at a P/E of 18-19. The perception of China may get better towards the end of the year, because China is predicted to overtake the United States as the largest economy in the world by 2015. The trick with this play is to find the bottom of the downturn, and to pick the stocks that will benefit most from a recovery from the dip.

Your Brain Isn’t Made for Trading

“Our brains are hard-wired to get us into investing trouble; humans are pattern-seeking animals . . . .Our brains are designed to perceive trends even where they might not exist. After an event occurs just two or three times in a row . . . the anterior cingulate and nucleus accumbens automatically anticipate that it will happen again. If it does repeat . . . dopamine is released . . . .Thus, if a stock goes up a few times in a row, you can reflexively expect it to keep going up . . . .Brain chemistry changes as the stock rises, giving . . . a “natural high.” You effectively become addicted to your own predictions.”

http://www.zerohedge.com/news/2013-12-13/penny-stock-traders-diary-our-brains-are-hard-wired-get-us-investing-trouble

Cyprus talks mean the worst may be over for Turkey

Turkey’s stock market has been in a downward spiral as Prime Minister Erdogan looks more and more like a dictator than an elected official. This has alerted me to a possible situation where the worst possible outcome is priced in to the market, and the downside is limited compared to the upside.

A possible catalyst for a rebound in the Turkish market may come on the back of reunification talks with Cyprus. Officials from Cyprus and Turkey would need to cooperate to build a natural gas pipeline to Europe, which would be a huge boon for the region. If reunification does occur, it would provide a boost in the form of increased natural gas exports.

Both countries have an incentive to find a solution. And Western countries have an incentive as well, because European countries need the gas, and United States energy companies are involved in its exploration. Because all parties have a stake in the matter, there is a good chance the deal could go through. If it does, I believe the Turkish stock market could rebound.

Thus I have begun a small speculation in TUR, the Ishares Msci Turkey Investible Market Index. If the deal actually goes through, I may increase the size of this position. However, I want to keep it small in the meantime on the possibility that the situation with Prime Minister Erdogan could further deteriorate.

Thoughts from Victor Sperandeo

After a large bull movement like the one we have just had, the odds for further price appreciation decrease. However, that does not mean that one immediately needs to sell – investors need only become increasingly more critical of positive news, and more watchful for negative news.

In the words of Victor Sperandeo:

“…the median extent for an intermediate swing in the Dow during a bull market is 20 percent. This doesn’t mean that when the market is up 20 percent, it’s going to top; sometimes it will top earlier, sometimes later. However, what it does mean is that when the market is up more than 20 percent, the odds for further appreciation begin to decline significantly. Thus, if the market has been up more than 20 percent and you begin to see other evidence of a possible top, it’s important to pay close attention to that information. ”

– The New Market Wizards, Schwager, 1992

After a 30% up year for the S&P 500, this market move is growing old. Though there are no immediate signs that the move will end, going forward into 2014, investors will need to be cautious and wary of signs of a top.