RBC Analysts - Top Pick $23 targetFollowing information is cut from RBC report on SIF.un
Hilights:
Zero long term debt.
$1.7 Billion market cap
89% pay out ratio dropping to 65% in 2 years
November 8, 2005 Energy Savings Income Fund
(TSX: SIF.UN)
Top Pick
Above Average Risk
Mkt Price:$16.63 Price Target:$23.00
52-Wk High:$21.52 52-Wk Low:$15.02 Units O/S (MM):105.1 Mkt Cap (MM):$1,750 Net Debt (MM):$0 EV (MM):$1,750 Net Debt/EV:0% Net Debt/05 EBITDA:0.0
Distributions/Unit (Paid):$0.84 $0.90 $0.94
Payout Ratio (AFFO) 05/89% 06/83% 07/ 65%
Investment Opinion
• Q2/06 Below Our Forecasts –Energy Savings reported Q2/06 seasonally adjusted gross margin of $39.3 million, below our forecast of $48.5 million. Significantly higher-than-forecast electricity gross additions (45,000 RCEs compared to our forecast 25,200 RCEs) was more than offset by: higher-than-forecast attrition in the Canadian natural gas division, a reduction of 64,000 electricity RCEs done at the start of Q2/05 for customers not-expected to renew (not in our forecasts) and $2.2 million of other costs not included in our forecasts.
• Further Expansion – Energy Savings has started marketing in New York state with its "dual fuel" offering (natural gas and electricity); expanded natural gas marketing in Illinois (now in North Shore Energy territory); and now test marketing in the Ontario residential electricity market.
• Federal Government Announcements Impacting Distribution Policy –Energy Savings announced that any increase in monthly distributions would be delayed pending clarification from the Canadian Federal Government regarding the income trust sector. As a result, our fiscal year 2006 distribution forecast goes from $0.93 /unit to $0.90 /unit (83% payout ratio) and our fiscal 2007 distribution forecast goes from $1.15 /unit to $0.94 /unit (65% payout ratio). We note that the 65% payout ratio is below our forecast long-term payout ratio of 75%.
• Does High Natural Gas Prices Impact Growth? – Based on our analysis (see Exhibits 4 and 5), it appears that periods of rising natural gas prices has not had a negative impact on Energy Savings’ growth rate.
• Unit Price Decline Overdone - Energy Savings’ unit price has declined 21.3% (compared to 10% for the income trust sector) since September 19, 2005. We believe Energy Savings has one of the best growth prospects in the income trust universe and that the unit price decline is overdone. We believe Energy Savings is attractively valued at current levels.
• Valuation – We are maintaining our 12-month target of $23.00 /unit, Top Pick, Above Average Risk rating.
The primary reasons for the lower AFFO were:
• Lower Gross Margin – Due to factors noted above. This represented $0.09 /unit of the $0.16 /unit variance; and
• Higher Renewal Commissions – The higher-than-forecast attrition resulted in higher than forecast renewal commissions; this represented the remaining $0.07 /unit of the $0.16 /variance. We note that the attrition and reduction of the First Source electricity RCEs has two impacts: lower gross margin cash flow and increased renewal commission costs. We included the 64,000 electricity RCE reduction as attrition for which Energy Savings would need to replace these customers and the associated commissions would be deducted when calculated AFFO.
• Increased Seasonality – We note that in some provinces/states, SIF receives cash flows from the local distribution companies ("LDCs") evenly throughout the year (Ontario, B.C., Québec and Manitoba); however, there are some provinces/states where SIF receives cash flows from the LDCs only when the customer consumes the natural gas (Alberta, Illinois and New York). This difference in the timing of cash flows received by SIF creates some seasonality in the business. To the extent that Alberta, Illinois and New York RCEs comprise a greater proportion of the overall RCE base, this would likely result in cash flows concentrated in Q3 and Q4 (October to March), and higher customer margins will be reflected.
Timing Differences Creates Lags in Receipt of Cash Flows
We remind our readers that when Energy Savings signs up a new customer, it expenses the fixed commission paid to the sales person at the time of the contract approval, even though the cash flows from that customer are not received by Energy Savings until a later date (2-6 months), due to time required by the local distribution companies to enroll new customers and in some locations to also flow the commodity, bill the customer and remit the first payment to Energy Savings .
Very Strong Electricity Growth Offset By Higher One-Time Attrition
In Exhibit 3 below, we show that while Q2/06 gross additions of 57,000 RCEs in the natural gas division was in line with our forecast, attrition of 38,000 RCEs was nearly double our forecast of 20,000 RCEs. Higher attrition was in part driven by company-initiated terminations in the U.S. for non-paying customers. Energy Savings has stepped up its customer review process in the U.S. We have increased our FY 2006 attrition forecasts for the natural gas segment from 92,500 to 123,000 (15% annual attrition). Longer-term, we are forecasting annual attrition of 10% for the Canadian natural gas division and 15% (up from 10%) for the U.S. natural gas division.
Q2/06 electricity gross additions of 45,000 RCEs was nearly double our forecast of 25,200 RCEs. Normalized attrition of 9,000 RCEs was in line with our forecast of 10,100 RCEs. However, as noted above, at the start of Q2/06, Energy Savings reduced its opening electricity RCEs by 64,000 reflecting the number of First Source customers not expected to renew.
Continued Strong Organic Growth
Since September 1998, Energy Savings has grown its customer base by a compounded annual growth rate of 81%.
Unit Pricing
Energy Savings’ unit price has declined 21.3% (compared to 10% for the income trust sector) since September 19, 2005, the day that the Federal Government announced that it was halting issuing advance tax rulings for income trusts. Based on our estimates, it appears as though the market is factoring a corporate income tax rate of 30 – 35%, compared to the Business Trust average of 23%. For more details, please see our Morning Comment on October 24, 2005, "Taxing Business Trusts: A Closer Look". We believe Energy Savings has one of the best growth prospects in the income trust universe and that the decline in the unit price is overdone. We believe Energy Savings is attractively valued at current levels.
Valuation
We are maintaining our 12-month target of $23.00 /unit, Top Pick, Above Average Risk rating. We value Energy Savings using an average of four methods (Discounted Cash Flows, EV / Free EBITDA, Dividend Growth Model and Target Yield).