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Guest Commentary: Stephens' Justin Courtney on Retail Supplier M&A, Capital Markets

January 24, 2012

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Copyright 2010-12 Energy Choice Matters

The following commentary is provided by Stephens Inc. Investment Banker Justin Courtney on the state of the REP capital markets. All views and opinions expressed herein are solely those of the author

Where does the REP market currently stand, focusing on competition, saturation and capital availability?

Courtney: As existing and new markets continue to restructure, we expect more REP entrants to capture share from the utility incumbents. As a result, the already overcrowded REP market (with more than 200 retailers in the industry - with 116 in Texas alone) will reach a saturation level. Smaller or privately-owned REPs will be competing for a finite amount of capital and resources. Only 7 of the top 50 independent REPs are backed by private equity (mostly minority), and only a handful are affiliated with incumbent utility/power generation companies. Those statistics point to a fragmented, underfunded sector looking for capital. Fortunately, the REP evolution is still in its infancy, with strong upward projections for competitive markets; as a result, REPs continue to attract the attention of strategic and financial investors. Yet, getting deals across the finish line is the challenge.

How has the M&A market for retailers evolved over the past 12 months?

Courtney: The 2011 M&A market was red hot with 18 REP deals closed, which was nearly 40% of the total since 2000. This level of M&A activity was advanced by a confluence of factors, including an insatiable appetite for growth among REP acquirers. Further, less volatility at low relative commodity prices has led to record performance for many REPs. Multiples are up, closing the gap between buyer and seller expectations with 3-5x EBITDA now reaching 4-7x. Lastly, buyers and in particular integrated utilities, are recognizing the unique capabilities of independent REPs and the superior returns on invested capital that REP deals bring. In recent deals, we have seen offers come in from 20 to 30 buyers, including integrated utilities, independent REPs and to a lesser extent private equity.

In discussing EBITDA multiples on recent deals, can you give a few examples?

Courtney: Let's start with Direct's acquisition of First Choice Power, which was announced at $270 million plus working capital. Our estimates have the multiple as high as 6.5x on 2011E EBITDA. Of course, if you put the $270 million, excluding working capital, on their last-twelve-months EBITDA of $58 as published, it comes out to 4.7x. And herein lies the conclusion – deals are getting done where buyers and sellers look at the deal from unique perspectives.

Just Energy's acquisition of Fulcrum is another good example, which was announced at $79.4 million plus an earnout of up to $20 million. Depending on how you treat the earnout, it comes out to roughly 5-6x EBITDA, which fits neatly into the current range.

The $142.5 million Constellation/StarTex deal is an interesting case study. Our estimates have the total proceeds to StarTex's prior owners at closer to $200 million. You can argue a multiple in 4.5-6x range on EBITDA depending on how you look at it.

The high watermark was NRG's acquisition of Energy Plus for $190.0 million. Our estimates had the deal as low as 4x EBITDA after adding back customer acquisition costs, but as high as 8x on trailing EBITDA. Energy Plus had a very desirable affinity marketing model that produced attractive margins and sticky customers. Further, their Northeast footprint was a perfect fit for NRG. The per customer valuation at over $1,000 per speaks to their attractive margins per customer.

The Vectren acquisition by Direct is the most recent gas marketing deal. The 5x EBITDA was market, but the per customer value of $140 appears low on the outset. The limited availability of independent gas marketers, which is an area of interest for many of the pure electric marketers should lead to more transactions on the natural gas side.

The recent acquisition of BlueStar by AEP is another good case study. AEP had been looking to expand their retail presence and found the energy management / consulting approach taken by BlueStar as highly desirable. Our estimates had this deal at close to 5.0x EBITDA and near $250 per RCE. While the RCE value may appear low compared to other deals, it is in line with other C&I deals such as Noble's purchase of Sempra Energy Solutions.

Although M&A is strong, the equity/debt financing environment remains soft. What are the issues surrounding this weakness?

Courtney: The bank debt markets are still relatively strong for asset-based companies, while REPs are asset-light by nature other than working capital. Banks and even private equity/debt investors are slow to understand and accept energy deregulation and the lack of barriers to entry – in short, they express concern about the "more risky" return of capital. If they lend or invest in a power plant, they can sell it if the company defaults. Banks and investors are in no way capable of serving retail customers and winding down a book of business.

Facing U.S. banks' reticence, REPs have historically tapped the European commodity banks. However, the Euro debt crisis has effectively closed those markets. However, creative structuring that may include multiple banks, both in the U.S. and abroad, has proven effective to date.

The reality is that supply deals offer significantly more liquidity for commodity purchases, yet rarely provide growth capital. EDF, BP, Shell, Macquarie and a short list of others all have very compelling and efficient structures for procuring supply. In very few cases do these facilities provide growth capital.

Regarding the capital markets in general, what do you see driving value for REPs?

Courtney: Simply put, REPs need demonstrable evidence of a sustainable competitive advantage. Differentiation is key. Unique brand/reputation, size/scale and geographic footprint will move multiples up but not alone. A portfolio of creditworthy customer term contracts will bring interest, but the value for such customers is driven by how they were acquired.

A proprietary technology application offering demand management in connection with supply could add two or three turns to the multiple paid. Acquisition, billing and customer service technology are desirable. Smart grid technology adoption (automation, smart metering, demand response, dynamic pricing) is also highly valued. Niche marketing (affinity programs, MLM, door-to-door, call center, network marketing, aggregation) is important as the larger REPs look to diversify their books.

We have seen such differentiating qualities attract bidders across the power industry. Companies with defendable growth prospects and "sticky" customer platforms are positioning themselves for sale, exacting attractive EBITDA multiples

Any predictions for 2012?

Courtney: Even though the restructured markets are growing, I can't imagine we'll see the magnitude of deals that we saw in 2011. We do believe a healthy flow of REP transactions (ranging from M&A to capital raises) will come to fruition in 2012. The industry may experience its first REP IPO – ideally at a valuation that will encourage other large independents to follow. We believe that there is an argument to be made around comparing REPs to other energy efficiency companies that consistently trade at double digit EBITDA multiples.

Until macro-economic conditions improve, and the European banking crisis finds resolution, banks will be slow to lend to REPs. Forward-thinking institutions will continue to consider REP financing, but such deals will be based on relationships rather than the financial metrics. In the interim, I do believe private equity will place significant bets on REPs, particularly as technology and new innovative platforms develop in the sector. There is plenty of capital on the sidelines ready to be put to work.

Justin L. Courtney is a senior vice president at Stephens Inc., where he provides M&A, capital raising and supply financing services in the Power and Resource Solutions group. He is responsible for subsector coverage of retail energy, energy efficiency and energy infrastructure.

This article has been prepared solely for informative purposes as of its stated date and is not a solicitation, or an offer, to buy or sell any security. It does not purport to be a complete description of the securities, markets or developments referred to in the material. Information included in the article was obtained from internal and external sources, which we consider reliable, but we have not independently verified such information and do not guarantee that it is accurate or complete. Such information is believed to be accurate on the date of issuance of the article, and all expression of opinion apply on the date of issuance of the article. No subsequent publication or distribution of this article shall mean or imply that any such information or opinion remains current at any time after the stated date of the article. We do not undertake to advice you of any changes in any such information or opinion. Our employees, officers, directors and/or affiliations may from time to time have a long or short position in the securities mentioned an may sell or buy such securities. The author principally responsible for preparation of this article has received compensation that is based upon, among other factors, Stephens Inc.'s investment banking revenues. Additional information available upon request. Stephens Inc. Member NYSE, SIPC

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