Good Energy Group PLC: Hampole Procurement Investment Strategies - Case Study Example

Good Energy Group PLC: Critical Assessment of Investment Strategies Table of Contents 1. Introduction 1 2. Evaluating GEG’s Public Flotation 2 2.1 Advantages & Disadvantages of Listing on the Alternative Investment Market 2 2.2 Analysis of IPO Valuation 4 3. Analysis of Hampole Wind Farm Capital Asset Investment 11 3.1 The Conceptual Foundation of Capital Assets 11 3.2 Capital Asset Investment Models 12 4. Recommendations & Conclusion 16 References 7 1. Introduction This report presents an in-depth analysis of strategic financing and investment moves by Good Energy Group plc (hereafter, GEG) involving the listing of an Initial Public Offering (IPO) on the London Alternative Investment Market (AIM), in part to fund the acquisition of an onshore wind farm facility, which was completed in January 2013. The report focuses on four key factors in two broad areas, the valuation and relative advantages or disadvantages of public flotation, and the effectiveness of methodologies for assessing and managing a capital asset investment, in this case, the Hampole wind farm. Key topics include: Benefits, disadvantages, and the prospects of success of listing a public flotation on the AIM. Available models and methodologies for the pricing of initial public offerings. Capital asset investment models that could be used by GEG in the case of the Hampole wind farm, and Known differences between “theory and practise” in capital asset investment strategies. The report concludes with an overall assessment of GEG’s financing and investment strategy, and offers a few recommendations, as a guide to future initiatives, for alternative actions that might have had better results for GEG’s recently-realized objectives. 2. Evaluating GEG’s Public Flotation In July 2012 GEG presented an IPO on London’s AIM, with a significant objective of raising the capital needed to acquire the Hampole wind farm. In the following sections, the advantages and disadvantages of an AIM IPO are assessed, along with factors that impact the valuation of the IPO. 2.1 Advantages & Disadvantages of Listing on the Alternative Investment Market There are, of course, a number of well-known general advantages to a market listing, and some advantages that are particular to the AIM. In the case of GEG, the switch to the better-known over-the-counter market from the PLUS market in July 2012 was an advantage in terms of raising the company’s profile and as a result, its marketability to investors (Killick, 2008). This is illustrated by the remarkable performance of GEG’s shares between July 30 and October 15, 2012, during which time the share price gained a remarkable 84.4%, mainly at the expense of the shares of other companies in its peer group, who collectively saw an average 6.5% decline in the same period. The AIM in particular also has the advantages of lighter regulatory requirements and lower initial and ongoing costs for accounting and compliance, a balance of regulation and freedom for listing companies that, at least from the perspective of analysts and investors in the US, whose own over-the-counter markets have declined significantly in the face of competition from the AIM, is considered close to optimal (Killick, 2008; Mendoza, 2008, pp. 261, 263). General disadvantages of listing on any market are the potential loss of control of the company, and increased accounting and compliance costs, although as has been pointed out, these are not as great on the AIM as they are with other markets (Killick, 2008). GEG did not put itself at risk of loss of control with its IPO, as the £3.4 million raised only represents about 30.7% of the company’s total equity at year-end 2012. Furthermore, under UK’s amended Enterprise Investment Scheme (EIS) and Venture Capital Trust (VCT) scheme, single venture-capital investors are capped at £1 million, making it less likely that an institutional investor would be able to gain a significant amount of management control over the company (“A Guide to AIM UK Tax Benefits”, 2012, pp. 2, 12). Another disadvantage of the AIM listing is that under the EIS, even though GEG qualifies under the ceilings placed on the size of the business, and continues to do so with its acquisition of the Hampole wind farm, it does not qualify as a tax-relief investment for investors. This is due to the provision that excepts trade in feed-in-tariff (FIT) electricity generation for firms whose shares are issued after March 2011 but who do not commence electricity generation until after April 2012. With the acquisition of the Hampole wind farm, from which GEG obviously did not generate electricity before that deadline, GEG is thus an ineligible investment under the general principle that an invalid part of an investment renders the remainder invalid as well. This also removes GEG from investor eligibility for tax relief from losses in the case of bankruptcy or liquidation of the company (“A Guide to AIM UK Tax Benefits”, 2012, pp. 13-15). While the positive response to the IPO was evidently not affected by these exceptions, they could prove to be somewhat of a disincentive to future investors, one that cannot be avoided. In terms of the prospects for success with the AIM listing, a recent study provides a promising outlook. Average survival – which is defined either as continued listing on AIM or transferring to a higher market such as the London Stock Exchange – for AIM IPOs is 76 months. This figure is actually skewed downward, however, by the study’s inclusion of IPOs made during the “hot markets” of 1999 and 2004, in which the average was only 43 to 46 months; outside those years, the average is 103 months (Espenlaub, Khurshed & Mohamed, 2012, pp. 427-433, 446). Thus, potential disadvantages notwithstanding, GEG’s AIM IPO should provide a measure of long-term funding stability for the company. 2.2 Analysis of IPO Valuation On 30 July 2012, GEG presented an IPO on the AIM of 4,705,882 shares at a price of £0.85 each; the shares, with a value of £0.05 each thus represented £235,144 in new equity and would, if sold at the offer price, meet GEG’s target of raising £4 million in cash. With a revenue target in mind, the valuation of an IPO determines the number of shares that must be issued to meet that target. A classical method for valuing stock prices, or more specifically, determining a market price, is to capitalise the expected return of a share of stock by the continuously variable rate of return ij derived from the equation , where the rate of return for a share of stock of company j in a class of companies k is equal to the capitalisation rate pk plus the debt-to-equity ratio times the spread between the risk and capitalisation rates; the formula assumes the stock is issued by a company with some debt as part of its capital structure (Modigliani & Miller, 1958, p. 271). A couple obvious problems with this approach is that it relies on a couple subjective variables. Risk and capitalisation rates may differ greatly between companies in the same class, and may be based on slightly different fundamentals. Likewise, even though pk is described my Modigliani and Miller as the “appropriate” capitalisation rate, what represents an appropriate rate for an entire class of companies is subject to interpretation; the next-best alternative, an average rate (whether one is looking at risk or capitalisation), may have a large margin of error with respect to the issuing company to which the results of the equation are being applied. A slightly more accurate type of valuation model is the capital asset pricing model, which is generally used to assess the value of portfolios from the investor’s perspective but can be inverted, given a target return, to derive a target price for a stock (Fama & French, 2004). The conventional, most widely-used – and definitely simpler – method of valuation is the use of multiples. A multiple is the ratio of the stock price to a value driver for comparable firms; multiplying that ratio by the same value driver for the issuing firm results in an indicative share price (Liu, Nissim & Thomas, 2002, p. 135). Some examples of value drivers are (Kim & Ritter, 1999, p. 436): Price-to-Earnings (P/E) ratio Price-to-Sales (P/S) ratio Enterprise Value-to-Sales (EVS) ratio Enterprise Value-to-Operating Cash Flow ratio Multiplying an indicative stock price by the corresponding ratio creates the multiple; multiplying that by the same corresponding ratio for the issuing company results in a suggested stock price. Using P/E ratio as an example (from data retrieved from Google Finance), the average P/E ratio at the end of the second quarter of 2012, the nearest time to GEG’s IPO for which uniform data is available, for the four firms in GEG’s peer group (Andes Energia Plc, Helius Energy Plc, Jersey Electricity, and Renewable Energy Generation Ltd.) was 170.3 and the average share price was £95.59, which produces a multiple of 1.782 (ratio = 170.3/95.59). The share price for GEG prior to the IPO was £0.84, and with earnings per share of 12.4p, this produces a P/E ratio of just 6.77. Multiplying that times the 1.782 multiple gives a result of 12.06; solving for P produces 12.06/12.4, or an indicated price of 97.26 p. One problem with this is the share price of Jersey Electricity skews the average upward; the most recent 52-week range for the other three peer firms is still quite large, from £6.05 to £82.00; Jersey Electricity’s 52-week range, however, is £250-£315. So eliminating that one from the average, we arrive at roughly the same average P/E ratio, 170.62, but a more realistic average share price of £35.60, resulting in a multiple of 4.793. This would then result in an indicated price for GEG of £2.62. This is just one example; a robust assessment would, of course, entail examining a number of multiples to produce a broad average or a range within which the IPO share price should fall. The first of two considerations that the company must balance is an accurate valuation, or in other words, whether or not the share price is “fair” for the amount of equity it represents. The analysis done by assessing multiples is intended to produce that accurate valuation, and studies which have the benefit of hindsight have found there are multiples that are clearly more useful than others in this respect. In every case, multiples using forecasts are more accurate than multiples relying on historical data, in particular, price-to-forward P/E (Kim & Ritter, 1999, p. 436; Liu, Nissim & Thomas, 2002, pp. 169-170). The reason for this is exactly what was illustrated in the simple example in the preceding paragraphs – variations in factors amongst firms even in the same sector can be so large, particularly for a sector such as renewable energy where there are many young firms, that inaccuracies can be introduced (Kim & Ritter, 1999, p. 409). Variations can be taken in account, such as making adjustments for different growth rates, different levels of leverage, and profitability, but only to a point; it has been found that the greater the level of complexity in the multiple analysis, the less accurate its predictive ability (Liu, Nissim & Thomas, 2002, p. 170). For this reason, a practise of determining a valuation based on relatively uncomplicated multiples and then adding or subtracting 10 to 20 percent to generally account for variations has become common in many industries (Kim & Ritter, 1999, p. 436). Using the example share prices derived earlier – which, it should be noted, would probably be at least slightly different if the more accurate forward P/E was used – the indicated range of 97p to £2.62 could be extended as far as 78p to £3.14, depending on which direction the 10%-20% adjustment would have to be made based on GEG’s comparative performance and forecasts. The second consideration that must be balanced can be described simply as marketability. Having determined what price reflects the true value of a share with reasonable accuracy, the firm – and more importantly, the share issue’s underwriter – must determine what price will be attractive to investors when the IPO is placed. Let’s assume that the example price above developed from the approximate price-to-P/E multiple, 97p per share, is the accurate valuation. In order to reach the £4 million revenue target, GEG would have to issue 4,123,711 shares in its IPO at this price – perhaps a slightly higher number, if the company wished to cover listing expenses incurred from its underwriters or the AIM with the revenue from the IPO. In a large number of IPOs, however, very high first-day returns – i.e., the increase in the share price as a result of trading activity on the first day it is in the market – of 10 to 15 percent indicate that underpricing is a common practise. The reason these shares are said to be underpriced is that the assumption that markets are largely efficient suggests that the first day price represents the fair value (Purnanandam & Swaminathan, 2004, p. 811). Paradoxically, however, studies have found that undervalued stocks have lower initial gains than overvalued stocks, which is the opposite effect from what an efficient market should produce. On average, high price-to-value IPOs have a first-year growth rate of about 45%, while low price-to-value IPOs grow at a more modest 21% (Purnanandam & Swaminathan, 2004, p. 834). So then why would a company wish to “leave money on the table,” or offer shares at a lower price than they could obtain for them? The biggest reason for this is to avoid dilution. Most companies have a target of the amount of equity they wish to create through an IPO. High price-to-value shares, as the evidence above indicates, have higher demand. Ordinarily high demand is a good thing, but in the case of stocks, issuing more shares to meet the demand would create more new equity, and “dilute” the control of the company by existing shareholders (Hanley, 1993, p. 249). The alternative, then, is to lessen the demand, which is done by underpricing; so long as the lost opportunity cost of underpricing is less than that of issuing more shares, underpricing is a better option. The demand aspect affects underpricing (or overpricing) through the actions of the underwriter, who has an interest in presenting the IPO to the market in the best circumstances. Part of that interest can be met by market timing; in “hot” markets, the firm characteristics matter much less, and IPOs are generally more successful. The positive impact on the firm, however, is short-lived; within the IPO year, firms issuing in hot markets see a significant decline in leverage, but this quickly reverses itself in subsequent years, whereas firms issuing in “cold” or “normal” markets have a much more uniform balance trend between leverage and equity in their capital structure (Alti, 2006, pp. 1708-1709). That is because after the initial enthusiasm of investors wears off, company fundamentals do become important to their assessment of the value of the stock. Companies that are treating IPOs as a form of short-term financing rather than an integrated long-term part of their capital structuring tend to be less robust in their decision-making processes and internal communications systems – having perhaps “rushed” their IPOs to take advantage of market conditions before they were fundamentally ready to do so – and as a result, see a decline in their market value in the years following their IPOs (Champion, 2001, p. 44). A familiar example of this kind of unwise “market timing” is the “dot-com” bubble of the late 1990s. Despite the evidence suggesting that market timing is a poor indicator for the presentation of an IPO, however, it still appears to be a more significant factor than firm life cycle stage in decisions to make a public offering (Ritter & Welch, 2002, pp. 1822-1823). Regardless of the market condition, underpricing also occurs as a result of issue management considerations on the part of the underwriter. Presenting an IPO that earns a strong initial return is an obvious advantage to an underwriter, because it will attract and keep investment clients. Underwriters cannot, however, perfectly predict the value of an issue; this is called ex ante uncertainty, and the greater this uncertainty – in other words, the less information the underwriter has from the issuing company – the greater the degree of underpricing (Beatty & Ritter, 1986, pp. 216-217). There are limits to how much an underwriter can underprice or overprice an issue; if it is underpriced too much, the underwriter stands to lose business from issuing companies, and if issues are overpriced too much, the underwriter will lose investment clients (Beatty & Ritter, 1986, pp. 217, 227). One way to look at this phenomenon is as a form of bargaining between the underwriter and the issuing company. Because underpricing is in effect an indirect cost to the company, the degree to which the company agrees with underpricing represents a form of indirect compensation to the underwriter in exchange for successful market timing (Loughran & Ritter, 2002, p. 435). Nevertheless, companies do try to reduce underpricing by incurring costs in promoting the issue; one finding is that each dollar spent in promotion reduces wealth losses through underwriting by 98 cents (Habib & Ljungqvist, 2001, pp. 435-436). In summary, the valuation of shares based on comparisons with peer-group companies produces a result with a large degree of uncertainty, which becomes even larger the more complex the comparative assessment process is. From both an investor’s and the issuing company’s perspective, an overvalued IPO may actually be less risky in the short-term, because these paradoxically tend to have larger initial gains (Purnanandam & Swaminathan, 2004, p. 836). However, certain factors such as the need to manage demand for the IPO and to encourage good performance from the issue’s underwriter often leads issuing companies to accept some degree of underpricing; they can control the amount of “money left on the table” by offering shares at below their real value by increasing their promotion of them prior to the IPO. 3. Analysis of Hampole Wind Farm Capital Asset Investment 3.1. The Conceptual Foundation of Capital Assets The acquisition of the Hampole wind farm represents an expansion of GEG’s organisational capabilities, and this larger perspective about the value of a capital asset is the key to understanding what constitutes an effective capital asset investment model, and how those models are altered to function effectively in practise. The traditional criteria for choosing an investment are the maximisation of profits and/or the maximisation of firm value; an investment is considered good if it either increases the net profits of the firm’s owners, or increases their equity (Modigliani & Miller, 1958, p. 262). The resource-based view of the firm goes beyond that, however, and holds that competitive advantage (which is tangibly expressed in firm growth in profits or equity value) is largely derived from firm-specific resources and capabilities; this includes not only physical assets, but the manner in which they are acquired and deployed by the firm (Peteraf, 1993; Teece, Pisano & Shuen, 1997). Capabilities are defined specifically as the firm’s ability to apply tangible and intangible resources to perform or improve the performance of its tasks; they are knowledge-based and unique to the firm, and therefore have a social and behavioural aspect to them, and cannot be simply acquired in the marketplace (Amit & Shoemaker, 1993; Teece, Pisano & Shuen, 1997). Thus the capital investment in the Hampole wind farm is not simply an investment in a physical asset, because it is both the asset and the particular deployment of it that determines the return on that investment (Robins, 1992; Peteraf, 1993). Therefore, there are two kinds of uncertainty about any investment; the uncertainly about the asset itself, which is an environmental, external factor, and uncertainty about the firm’s ability to use the asset, which is a purely internal factor (Dixit & Pindyck, 1994). 3.2 Capital Asset Investment Models There are a small number of investment appraisal models that are considered standard practise, and among these, the discounted cash flow (DCF) methodologies of Net Present Value (NPV) and Internal Rate of Return (IRR) are considered superior to accounting rate of return (ARR) and payback methodologies (Busby & Pitts, 1997, p. 169). The latter are less costly and time-consuming, however, and are still commonly used, although the better techniques are becoming increasingly adopted (Sangster, 1993, p. 309). Considering GEG’s Hampole wind farm acquisition in terms of the NPV technique, the following information is available: The acquisition cost, or capital outlay (CO), is £3 million. GEG has a cash flow of £25.03 per MW from its own electricity generation. The Hampole wind farm is projected to produce 24,000 MW annually. The discount rate is not known, but different discount rates can be applied – although this method is not guaranteed to accurately represent all risks – to cover a variety of scenarios (Yang & Blyth, 2007). 6% can be used to represent a low-risk scenario, and 12% can be used to represent a high-risk scenario. As development of the site is expected in 2013, the cash flow from Hampole is assumed to be 0 for the first year, and then according to the 2012 cash flow factor for succeeding years. This is another area of uncertainty, because the future fluctuation of electricity prices and generation costs is not yet provided, and in reality may be difficult to forecast. According to the equation for NPV,  where t is the year, Ct is the cash flow for the corresponding year t, r is the discount rate, and CO is the capital outlay (Dayananda, Irons, Harrison, Herbohn & Rowland, 2002), for a low-risk scenario covering three years the NPV of the Hampole wind farm is: And for a high-risk scenario the NPV is: Meaning that within the low-risk/high-risk parameters, GEG would recover its initial capital outlay for the Hampole wind farm within six to seven years, provided the unknown variable risks could be quantified within the discount rate and if other factors, such as cash flow, did not change significantly. This is a simple example, but it is enough to illustrate the main criticism of DCF techniques, that they tend to be static, and do not effectively account for the variability of basic factors, nor easily allow for real options, flexibility in investments such as scaling up the investment, shrinking it, or changing its timeframe (Busby & Pitts, 1997, p. 170). DCF techniques also seek to express risk in a unified factor, which is not always possible to accurately generate, since a proper risk analysis process involves several steps that include some judgment, such as the selection of risk factors and the assigning of weights to them (Savvides, 1994, p. 3). Perhaps the reason DCF techniques and NPV in particular are still widely favoured is because of the impact of ex ante uncertainty on the success of investments. Firms have been found to have a tendency to take a portfolio view of investments, rather than focusing on them individually; GEG is typical in this respect, having numerous capital asset investment plans in a variety of directions. Assessing investments in a broad way has two noticeable effects: First, it simplifies risk by spreading it out amongst a number of investments, and second, it actually encourages a somewhat higher level of risk-taking amongst managers, since a single high-risk investment has a lesser variable input when considered as part of a portfolio (Shapira, 1994). And despite the apparent practical shortcomings of DCF techniques, there is evidence that they do produce reasonably good results; if certain assumptions – such as the accurate representation of risk in discount rates – are made, NPV has been found to predict firm market value within a reasonably reliable 10% margin (Kaplan & Ruback, 1985, pp. 1091-1092). Nevertheless, there are some improvements that can be applied to capital asset investment assessments. One change in practise, suggested by Alkaraan and Northcott (2006), is to align DCF techniques with types of investments where the analysis is most effective; research has shown that while companies exercise due diligence in applying multiple techniques (although still favouring less-complex methods), the choice of methodology is independent of the type of investment being considered. Likewise, risk analysis, other than relatively simple techniques like sensitivity analysis, is still considered more an exercise in judgment rather than empirical analysis (Alkaraan & Northcott, 2006). Examples of changes in methodology that could give more accurate results by improving risk and option analyses are the use of the Capital Asset Pricing Model or Markov chain analysis. These methods provide much more precise factor inputs but still allow for some flexibility, and in this way they help to counteract the phenomenon of hysteresis, in which uncertainty encourages managers to inefficiently lower their risk tolerances (Busby & Pitts, 1997, p. 172; Carmichael, 2011, pp. 127, 129-130). The output of a Markov chain analysis, for example, is a factor of “feasibility” of an investment; whether the feasibility is above or below a selected threshold determines the action taken towards the investment. And it can provide a quantitative basis for defining common “rules of thumb” used by managers in decisions on investments or options, such as basing the length of separate phase-in stages on the degree of uncertainty about the investment, or setting target returns in relation to the degree of flexibility (in terms of scope or timing) in the investment (Busby & Pitts, 1997, pp. 180-181). One of the best ideas to improve the analysis of capital asset investments in the energy sector specifically is the modification of NPV presented by Yang and Blyth (2007). Because of the continuously fluctuating nature of both energy and carbon prices, the cash flow of a project is a stochastic function of these two inputs, as in: Where Co is equal to the capital outlay or unit construction costs, and Pc and Pe are the carbon and energy prices, respectively, with the expression  representing cash flow (Yang & Blyth, 2007, p. 20). This formula, which better takes into account variables particular to GEG’s sector, still helpfully provides a single factor as a result that can be incorporated into judgment-based, qualitative assessments of capital investments. 4. Recommendations & Conclusion It is clear from the outcome of GEG’s IPO that the stock was significantly undervalued. It gained at a rate completely outstripping the market, and did so, at least initially, at the expense of its competitors. This suggests that GEG did indeed leave a great deal of money “on the table,” which is perhaps regrettable in light of CEO Davenport’s statement that progress on all the company’s various generation initiatives probably will not completely progress and will be subject to reduction upon further more detailed analysis later in the year. While that is certainly a prudently cautious position for any CEO to take, the scope of “rolling back” plans later on might not be so great if the IPO had been issued at a price more closely representing the actual share value; while the IPO was successful, the P/V gap is something the company should examine much more closely in any future stock offerings. In terms of the capital asset investment in the Hampole wind farm, the outcome of that remains to be seen. There are, however, good reasons for the company to be optimistic about the investment’s likely performance. As has been explained, a capital investment is fundamentally an investment in firm capabilities, in two different respects – the expansion of those capabilities, on the one hand, and the application of existing capabilities to the successfully deployment of the resources obtained through investment. In both these respects, GEG has a solid advantage; with the company already being quite experienced at productively operating wind generation with the Delabole facility, Hampole merely represents an expansion of GEG’s proven capabilities. This advantage, in fact, might also partly explain the large P/V gap in the company’s IPO, particularly in view of the fact that competing companies generally declined in proportion, or nearly so, to GEG’s gain. Since the IPO occurred at a time when the market would not be described as particularly “hot”, trading considerations were likely less important to early investors than company characteristics; if the opposite were true, a gain for all the stocks in GEG’s peer group would be expected. In summation, the two main recommendations for GEG are relatively simple ones: First, moderate the degree of stock undervaluation, perhaps through increased pre-issue promotion, since it is apparent ex ante uncertainty about the company’s performance was much greater than it should have been. Second, depending on the outcomes realised from the Hampole acquisition, consider more robust investment assessment methods such as the modified NPV method presented by Yang and Blyth (2007). References “A Guide to AIM UK Tax Benefits” (2012) London Stock Exchange plc and Baker Tilly, October 2012. http://www.londonstockexchange.com/companies-and-advisors/aim/publications/documents/a-guide-to-aim-tax-benefits.pdf. 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