What’s ailing Utilitywise Plc?

The shares in Utilitywise Plc (UTW:LSE), a company that helps small businesses find the cheapest energy and water supply contracts and takes a cut from suppliers, have fallen 30% over the last year. Its shares currently trade at a low P/E of 9.4 and EV/EBITA of 8.3. For a company that is growing revenue at 36%, with healthy gross and EBITA margins of 40% and 20% respectively, the stock looks cheap. Quality, which I measure as Return on Invested Capital (ROIC), is not bad at all at 26%. The market it caters to is huge and largely untapped – there are over 4.5m small businesses in the UK and many more in Europe where the company has just started operations. My Discounted Cash Flow valuation for various scenarios comes up with an intrinsic value per share of £2.6 - £2.8, implying a potential 60% to 75% upside on the current price of £1.60 per share.

So why this sell-off? Shouldn’t this stock be a screaming buy?

Two major concerns merit market’s skepticism. The first is to do with revenue recognition and risk of future write-downs, and the second is a lack of moat and increasing competition which seems to be eating into margins and putting the sustainability of growth and returns at risk.

Revenue recognition

Utilitywise earns a significant chunk of its income as commission from energy suppliers; a fair amount of this commission is paid over the life of the contract (typically 5 years) that the end consumer signs with the energy supplier. The commission paid by energy supplier is based on actual energy consumed by the end consumer over the life of the contract. However, the group recognises revenue on the entire contract at the point when the contract goes live; using a fair value method, the group applies a 15% variance discount (for variance in projected consumption) & present values the projected cash flows using a 3% discount rate. There are obvious risks associated with such an approach – a) the end consumers are small businesses and the risk of a default will be high; the 3% discount rate that the company uses is based on the credit rating of the energy suppliers not the small businesses, and b) it cannot be easy to project energy consumption over the life of long contract period with any degree of certainty; any variance in consumption could have a material impact on prior year revenue already booked.

This approach means:

1. A significant chunk of the revenue is sat as trade receivables and accrued revenue on balance sheet and takes a fair amount of time before converting to cash; and,

2. There is constant downward pressure on this prior year revenue both due to variance in projected versus actual consumption and due to risk of default by the end consumer.

The group has already taken significant write-downs against its FY14 and FY13 receivables and accrued income claiming that its initially projected consumption variance was lower than actual. To put this into context, the group in its FY15 accounts wrote off a total of £6.35m of accrued revenue and trade receivables booked in FY14 and FY13 (net of tax). Adjusting the group’s operating profit in FY14 and FY13 for these write-downs would result in operating profit after tax falling by 42% for FY14 and by 52% for FY13. This is significant and throws into question any DCF valuation based on group’s revenue numbers in the accounts (out of the window goes my intrinsic value estimate of £2.6 to £2.8 per share when such uncertainty exists in revenue recognition). Furthermore, the FY15 financial statements say that no adjustments have been made for years prior to FY13, not because none exist, but because it would be difficult to estimate due to lack of information.

Competition, moat, and falling profitability

When a sector offers juicy margins, a large & untapped market, and low barriers to entry (Third party intermediaries are currently unregulated), one can bet top dollar that competition will come. This is evident in the company’s results - operating margins have fallen from a peak of 31% in FY11 to 20% now, and arresting the fall will be difficult. The company also seems to be facing significant difficulty in retaining sales staff – the high staff attrition rates are a clear sign of high competition  in the sector. The company looks to be trying to counter competition by diversifying (it has made some technology acquisitions – i.e., enabling energy consumption tracking, providing energy consulting services etc.) and expanding into new markets (it has recently commenced operations in Europe). It has also recently put new management team in place to counter the challenges. But given the low barriers to entry, it is difficult to see how the current high margins and ROIC can be sustained.

In conclusion

If one were investing simply based on attributes – cheapness (low P/E & low EV/EBITA) & quality (high ROIC) – Utilitywise Plc would be a buy. But as Michael Mauboussin has repeatedly said in his writings circumstances trump attributes when it comes to investing success. To paraphrase a quote of Michael’s – “Sometimes our nostrums work, but more often they fail us. The reason usually boils down to the simple reality that the theories guiding our decisions are based on attributes, not circumstances.”

I highly recommend buying Michael Mauboussin’s two books - More Than You Know and Think Twice; both are great investment in time for a value investor, but I would pass on Utilistywise Plc’s stock for the time being.