1. Will the UK energy supply market consolidate?
The UK energy supply market was quiet until 2012, with between 10 and 15 firms competing. Participants have since tripled to 44 firms (Figure 1). However, most suppliers are small in size with only 12 firms operating more than 400,000 accounts. Dermot Nolan, Ofgem CEO, thinks it is “highly possible that there will be a shakeout of firms in the coming years, and we may have much fewer than 50 suppliers in five years’ time.”[1]
Figure 1: The number of active domestic suppliers by fuel type has tripled since 2011
Source: Ofgem data portal
It makes sense for independent suppliers to consolidate. Some firms might be seeking a way to quickly boost their customer base. Others might be hoping to achieve greater economies of scale. The recent decisions by European utilities, like ESB[2] and Engie,[3] to enter the UK market shows that there are a number of willing buyers circling energy suppliers.
A number of willing sellers are also lined up. Flow Energy recently announced that “the Board received a number of approaches expressing interest in its Flow Energy business… As a result, the Board has concluded that the disposal of Flow Energy is something that it should actively pursue.”[4] Ovo Energy sold 15% of equity to Mayfair Equity Partners in August 2015[5] and First Utility shelved original IPO plans in favour of a potential equity sale.[6]
There has also been one unwilling seller, GB Energy, who experienced financial distress in November 2016.[7] Given the wholesale price volatility in recent months and the aggressive pricing of a number of new entrants, it is highly possible that more unwilling sellers are uncovered in 2017.
2. What is a fair transaction price to pay for an energy supply business?
Given that buyers and sellers of energy supply businesses already exist, the next obstacle is finding an agreeable price for a transaction. There are three main approaches to valuing a business, which we look at in more detail for energy supply firms:
- income – estimating future cash flows of a business and discounting them back to today’s present value;
- market – identifying comparable market transactions to infer a reasonable range of market price for a business; and
- cost – estimating the replacement cost to re-construct a business from scratch.
Income
The income approach requires that cash flows are forecasted and then discounted back at a cost of capital which reflects the business’ risk profile. This is a discounted cash flow (DCF) approach which provides today’s value of the future business.
Customer account growth and EBIT margin are the key variables when forecasting cash flows of an energy supply business. Growth has been quick for Independents (i.e. non ‘Big 6 companies), but will it continue?
At an industry level, the current churn statistics are encouraging for continued growth of the Independents. Figure 2 shows that for any customer who switched supplier, 35 to 55% of these have switched to an Independent supplier rather than a Big 6 supplier. If this rate continues then the market shares of Independents will increase from 16% to in excess of 30% over the medium to long run. Recent analyst estimates suggest this level might be achieved by 2020 (see Figure 3)
Figure 2: The proportion of customers switching to Independents has ranged between 35 and 55% since 2014
Source: Ofgem data portal
Figure 3: Jefferies forecast of UK energy supply market shares
Source: Jefferies forecasts, 22 Sep 2016
Growth has also been impressive at a company level. The historic growth of accounts for Independent suppliers is in Figure 4. Growth is greatest for suppliers below the obligation threshold of 250,000 customers with a median rate of 90% per year. Account growth beyond the threshold for 250,000 to 500,000 customers is still impressive with a median rate of 64%.
The rate slows as a firm gets larger, but historical evidence indicates robust growth rates of 12 to 31% per year. Alongside the positive churn rates towards Independent suppliers (Figure 2), suggests that Independent suppliers could maintain similar growth rates until the end of the decade.
Figure 4: The annual growth rate of Independent companies, split by size, between 2012 and 2016
Source: Cornwall market share data
Note: There are 7 growth rate data points when customer accounts exceed 500k customer accounts and 46 data points below 500k.
The second key area for cash flow forecasting is the profit margin that energy suppliers earn. The EBIT margin for the Big 6 over the last 5 years averaged 2.9% and in 2015, ranged from -6.8% to 7.0%. Businesses operate at very low margins which are subject to significant volatility between companies.
Profitability is also volatile over time. Expect EBIT margins during growth phases to be low because retailers discount tariffs to attract customers. For example, Ovo Energy’s EBIT margin averaged -5% from 2011 to 2015[8] and Flow Energy is operating at a -10% EBIT margin. Suppliers hope that customer accounts can grow but indirect costs stay relatively fixed. The resulting economies of scale could drastically improve margins. It is therefore imperative for cash flow forecasts to set margins which are consistent with the growth phase of the business.
Further, a valuation needs to spend sufficient time to fully understand how a business operates, First Utility and Utilita are already achieving 1% and 6% EBIT margins, but are still experiencing robust account growth.[9] The differences in growth and margin expectations between suppliers create markedly different valuations.
Market
The market approach applies the prices paid for similar companies and applies the price to the business being valued. The popular market multiple used for energy supply transactions is price per customer account. Recent transactions have occurred at prices around £250 per customer account:
- Telecom Plus purchase of 770,000 accounts from nPower for £218 million in November 2013, corresponds to a £280/account;[10] and
- Mayfair Equity Partners bought 15% of OVO’s shares for £31million in August 2015, which corresponds to £250/account.[11]
We can crosscheck these multiples using very basic assumptions about the behaviour and margins for a single customer. Assuming an EBIT margin of 2% in the year of customer acquisition and an 8% EBIT margin for a further four years would correspond to a £225/customer value today.[12] However, more conservative assumptions with an acquisition EBIT margin of -2% for one year followed by 3 years at 5%, corresponds to only £86/customer today.
Energy supply businesses operate at very small margins and so valuation is highly sensitive to small percentage point changes. The crosscheck does not include any growth in customer numbers and acts as a ‘floor’ to a valuation.
Cost
Another way to determine a ‘floor’ value is to use a cost approach to value an energy supply business. This estimates the cost to rebuild the business from scratch and was used by the CMA in its recent Energy Market Investigation.
The CMA capitalised supplier’s costs to acquire customers, which included “Customer acquisition costs comprise doorstep/energy advisers’ costs, telesales, commissions payable to brokers or PCWs, sales support, proposition development and other similar costs”.[13] Applying this approach can result in multiples of £50 to £150 per account depending on which costs are included and what the life of the customer.[14]
3. What next?
In conclusion, the income approach is the key tool for any buyer or seller who is valuing an energy supply business, but market and income based approaches form useful cross-checks. Make sure your valuation has:
- a realistic growth rate that decreases with company size and in line with industry dynamics;
- EBIT margins that are consistent with the level achieved by others in a competitive marketplace and with the rate of growth of the company; and
- a number of cross-checks which set cash flows into context.
A number of companies like Flow Energy and First Utility might be the next sellers in the UK market. Buyers must make sure they have their valuation tools ready to price transactions, which might need deployed at short notice to bid with confidence for distressed sellers.
[1] Dermot Nolan, Beesley Lecture, 2016.
[2] ESB to enter UK supply market.
[3] Engie to enter UK household power market.
[4] Flowgroup update, 08 February 2017.
[6] First Utility Eyes Share Sale As IPO Spark Fades
[7] Ofgem appoints Co-operative Energy to take on GB Energy Supply’s customers, 29 November 2016.
[8] Capital IQ data
[9] Capital IQ data. First Utility FY2010 to FY2015 and Utilita FY2014 to FY2016.
[10] Telecom Plus and nPower transaction
[11] Mayfair Equity Partners and Ovo Energy transaction. Assumes 815,000 accounts in Q215 (Cornwall Energy market share data).
[12] Assuming a discount rate of 7.5%, annual tariff cost of £1050, tax rate of 20%.
[13] CMA EMI, Appendix 9.10: Analysis of retail supply profitability – ROCE, Paragraph 67.
[14] In particular, how any discounting of the tariff is included and the customer lifespan.
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