7.9% Div Yield, 15% EBITDA Growth, FCF to EV of 16%
Spark Energy (SPKE) delivers electricity and natural gas to its customer base which includes residential and commercial customers across 19 different states in the US. With significant room for organic growth and the company's strategy of acquisitions over the last few years, we believe Spark Energy should continue growing well in the medium term. We estimate 2020 adjusted EBITDA growth of 15.2% YoY. This growth, coupled with a compelling dividend yield of 7.9% and 2020 FCF to EV of 15.8%, we believe, offers investors with an attractive risk reward scenario. At current prices, Spark Energy is available at an inexpensive 2020/2021 P/E of 4.8x/4.5x and EV/EBITDA of 4.7x/4.5x. Our EV numbers take in to account the Class B shares outstanding.
We value the company on a 5.5x EV/EBITDA multiple, using our 2021 EBITDA estimate. Through this, we arrive at a target price of $12.00, which represents a 31% upside from current levels. This target price is with a one year view and still implies very inexpensive valuation metrics of 6.0% dividend yield and 13.1% 2021 FCF to EV. If Spark Energy demonstrates robust growth over the next few quarters, we believe the stock can touch $15.00, which implies a 6.5x EV/EBITDA multiple on our current 2021 estimates, a dividend yield of 4.8% and 2021 FCF to EV of 11.1%.
Inexpensive Valuations
Spark Energy is trading at relatively inexpensive valuations despite the stock price remaining flat YTD. On P/E valuations, Spark Energy trades at 4.8x and 4.5x for 2020/2021 respectively. With EBITDA being a better representative of financial performance, we also look at the EV/EBITDA valuation of the company. On an EV/EBITDA basis, Spark Energy trades at 2020/2021 valuations of 4.7/4.5x respectively. Importantly, however, dividend yield for the company looks very attractive at 7.9% and we expect this to sustain over the medium term. The company also generates steady free cash flows with 2018/2019 FCF to EV of 11.9%/18.2%. For 2020 and 2021, we estimate FCF to EV of 15.8%/15.9%. In our model, our forecasts don't include any effect of mark to market accounting changes on Spark Energy's derivative instruments and therefore are not strictly comparable with reported historical numbers.
Scope for Organic Growth
Spark Energy's business reach spans across 19 states and 94 utility territories across the US. New England and the Mid Atlantic are the company's largest geographical markets accounting for 35% of Spark Energy's residential customer equivalents [RCE]. The Midwest and Southwest are the other 2 markets the company operates in and these make up the balance 14% and 16% of RCE's. The company's management has highlighted that significant room for organic growth exists in both natural gas and electricity. In natural gas, there are 36mm RCE's within which only 19% of eligible customers have made a competitive supplier choice and Spark Energy's share is less than 1%. In electricity too, a similar situation holds. Of the 139mm RCE's, 37% have made a competitive supplier choice and Spark Energy's share is again less than a percent. This indicates enough potential room for Spark Energy to grow its customer base.
Source: Investor Presentation
Margin Improvement Driven by Business Mix Changes
Currently, residential customers account for 61% of the mix for Spark Energy, with commercial customers comprising the rest. Typically, residential customers have higher margins for the company as compared to commercial customers. Since 2019, with the number of commercial customers decreasing, the mix has shifted more towards residential, leading to higher margins for Spark Energy, despite falling customer numbers. This is demonstrated in both 2019 and 2Q20 financials where EBTIDA margin improved to 11.4% [7.1% in 2018] and 18.5% [7.4% in 2Q19] respectively, despite revenues falling by 19.0% YoY and 27.7% respectively. With focus continuing on residential customers, we expect margin improvements to sustain in the short-term. Spark Energy is also focusing on high value customers to improve cash flow diversification and stability.
Attractive Dividend Yield
Spark Energy offers Class A stockholders a dividend of $0.725 per share which translates to a very attractive yield of 7.9%. In addition to the dividend on its Class A common stock, Spark Energy also paid out a dividend to its Series A preferred stockholders of $8.1mn in 2019. To be able to pay out dividends to Class A common stockholders, the company's subsidiary Spark Holdco is required to make corresponding distributions to Class B common stockholders [the company's non-controlling interest holders]. Management has indicated that it is evaluating all facets of its business, including dividends, given the impact from COVID-19. With a low net debt to equity ratio, improving margins and strong generation of free cash flow, we expect the company to maintain current dividend levels in the medium term, even if there is any short-term cut due to the economic scenario.
Source: Bloomberg Terminal
52.2% EBITDA CAGR over 2014 - 2019
Source: Company Data
Adjusted EBITDA over 2014 - 2019 has shown a CAGR of 52.2%. Correspondingly, Adjusted EBITDA margins have improved from 3.5% in 2014 to 11.4% in 2019. These numbers have been driven by a five-year revenue CAGR 20.4%. EBITDA improvement in the last few quarters has been on the back of a reduction in lower margin commercial customers as well as a lower run-rate of G&A expenses. In 2Q20, customer acquisition costs have dropped sharply from $3.4mn in 2Q19 to $0.2mn in 2Q20 given that certain marketing channels like door to door sales have been halted. This has led to a sharp 1090 bps improvement in EBITDA margins for the quarter.
Looking ahead, as the company resumes its customer acquisition push, we expect these costs to jump, consequently lowering EBITDA margins to more sustainable levels. A resumption in marketing, however, is going to help long-term growth for the company. Net income for Spark Energy is impacted by non-cash mark-to-market variations on its derivative instruments which can create volatility in profitability quarter to quarter depending on commodity pricing. As a result, management believes adjusted EBITDA is a better indicator of the company's financial performance.
Customer Acquisition Strategy
Source: Investor Presentation
To acquire customers, Spark Energy has relied on organic sales methods as well as customer portfolio and business acquisitions. To gain customers organically the company offers competitive pricing, pricing certainty and green products. Spark Energy uses a number of sales channels in its markets to identify and acquire customers. Some of these include door to door marketing, inbound customer care call center, outbound calling, online marketing, direct mail, brokers, consultants, etc.
Source: Investor Presentation
In 2019, the largest channels for the company were telemarketing, door to door sales and web-based sales and their mix was 61% residential and 39% commercial customers. The company also maintains a disciplined approach to recover its customer acquisition costs in a fixed period of time, with a target of 12 months. Along with these organic methods, Spark Energy has concluded 12 acquisitions in the last 5 years across the electricity and natural gas segments.
The company actively evaluates M&A opportunities and seeks to acquire both customer portfolios as well as retail energy companies. Currently, Spark Energy's monthly customer attrition rate stands at 3.5%. COVID-19 has impacted a number of organic sales channels over the last few months, especially door to door marketing, leading to a marked reduction in customer acquisition costs for 2Q20. As the situation improves, we expect marketing activity to pick up, which can help the company boost customer numbers.
Hedging to Manage Commodity Risk
Spark Energy hedges and gets its energy requirements in the form of long-term and short-term contracts, from a number of wholesale energy markets, including physical and financial markets. The company's risk management strategy is designed to hedge most of the forecasted volumes for fixed-price customer contracts and a portion of near term volumes for variable price customers. Management uses both financial and physical products to hedge its fixed-price exposure. Spark Energy has refined its hedging strategy over the last 20 years and has demonstrated the ability to manage commodity price fluctuations in different market conditions, extreme weather and down economies. The company's hedging policy is closely monitored by the CFO and Risk Committee.
Electricity Business has been growing at 31.3% CAGR
Spark Energy's electricity business has grown at a CAGR of 31.3% over 2014 - 2019. The business now accounts for 85% of the company's total revenues. Within this segment, New England is the largest geography making up 40% of RCE's. Gross margins in the electricity business have been improving and are up from 18.5% in 2014 to 23.3% in 2019. Within the electricity segment, fixed priced customer contracts are 78% of total RCE's. Twelve-month trailing unit margins in electricity, as at 2Q20, were $31.16/MWh and management expects this to be in the range of $27.00/MWh - $35.00/MWh in the future.
Natural Gas Segment has Remained Steady
The natural gas segment revenues for the company have declined at 3.5% CAGR over 2014 - 2019 and now comprise 15% of total revenues, as at end 2019. The mid-Atlantic is the largest geographical region for this segment and represents 34% of RCE's. As with the electricity segment, gross margins in natural gas too have improved from 30.2% in 2014 to 49.1% in 2019. Fixed price contracts make up a smaller portion of Spark Energy's customer base for natural gas and represent 56% of RCE's. Natural gas unit margins on a twelve-month trailing basis, as of 2Q20, stood at $4.66/MMBtu. Looking ahead, Spark Energy forecasts this to be in the range of $4.35/MMBtu - $4.70/MMBtu.
COVID-19 Impact
Spark Energy has seen some impact on the business from COVID-19, especially in its marketing and sales efforts. The company has suspended its door to door marketing channel which has resulted in a sharp drop in customer acquisition costs for 2Q20. Additionally, the company is reviewing its liquidity situation constantly and streamlining its operations. Moreover, bad debts are being monitored closely. Bad debt expenses for 2Q20 stood at 1.5% against 3.6% in 2Q19 for non-purchase of receivable markets [non-POR]. Since late 2019, Spark Energy had increased collection efforts, ensured timely billing, and credit monitoring for new enrolments in non-POR markets which have led to the current improvement in bad debt expenses.
Preferred Stock
Spark Energy has an authorized repurchase program for Class A preferred shares that allows them to buy back these shares till end 2020. There is no obligation on dollar amount or number of shares related to this repurchase program. The company's preferred stockholders have no voting rights, except in certain limited conditions. Additionally, the preferred stockholders accrue dividends at 8.75% pa. For 2019, preferred stockholders were paid a dividend of $8.1mn.
Source: Investor Presentation
Risks
Volatility in Commodity Pricing
In case of large volatility in commodity pricing, Spark Energy's costs could be impacted despite its hedging policies.
Inability to Improve Customer Numbers
Spark Energy's ability to grow significantly will be dependent on the number of customers it's able to gain. A reduction here will impact revenues and future revenue expectations.
High Customer Acquisition Costs
A sharp jump in customer acquisition costs will impact margins and profitability for Spark Energy.
Spike in Bad Debts
Any spike in bad debts for the company will negatively affect margins and profitability for the company.
Catalysts
Room for Organic Growth
Spark Energy has significant room for organic growth with a large number of customers not having made a choice for competitive energy supply. Additionally, the company uses a number of marketing and sales channels to increase its customer base. An improvement in these numbers, once the short-term impact from COVID-19 subsides, can provide meaningful room for growth.
Attractive Dividend Payout
Spark Energy paid out a dividend of $0.725/share to Class A common stockholders which translates to a very compelling dividend yield of 7.9%.
Improvement in Margins
Management's focus on reducing the run rate for G&A costs as well as the strategy to decrease the number of lower margin commercial customers can provide some tailwind to margins looking ahead.
Conclusion
With significant room for organic growth and the company's strategy of acquisitions over the last few years, we believe Spark Energy should continue growing well in the medium term. This growth, coupled with a compelling dividend yield of 7.9% and 2020 FCF to EV of 15.8%, we believe, offers investors with an attractive risk-reward scenario. We value the company on a 5.5x EV/EBITDA multiple, using our 2021 EBITDA estimate. Through this, we arrive at a target price of $12.00, which represents a 31% upside from current levels. This target price is with a one year view and still implies very inexpensive valuation metrics of 6.0% dividend yield and 13.1% 2021 FCF to EV.
You can download our 10+ page research report: Spark Energy Report. This report has our detailed analysis on Hooker, inclusive of a financial model: IS/BS/CF forecasts, rigorous ratio analysis, DCF valuations and price targets. A preview of the entire report can be seen below:
