Eneraqua Technologies (LON: ETP)

Eneraqua Technologies (LON: ENQ), referred to as Eneraqua for the remainder of this writeup, is a high return on capital business that focuses on the “E” portion of ESG. Per p. 2 of its 2022 Annual Report on why the business exists, “We drive cleaner, greener living. Supporting efficient energy and water usage through innovation and expertise.” Through Fiscal Year (FY) 2022 and FY 2023, the business generated revenues of £36.1 million and £55 million which were year-over-year (YoY) increases of 148% and 54% respectively. Eneraqua is headquartered in the mean streets of London, England.

Eneraqua went public less than two years ago but popped up on my radar because of its high returns on capital which I discuss further in the Valuation section of this writeup. I’m gonna tell you right now that its returns on incremental invested capital have been outstanding. The markets it operates in also offer long-term growth potential. Let’s dive in.

History

Eneraqua was founded in 2012 by Mitesh Dhanak who still serves as the CEO. It originally started out as a consultancy and has since grown into two divisions: Energy and Water.

Shown below is Slide 6 from the FY 2022 Presentation which provides a comprehensive history of the business much better than I could. You can find a link to the presentation here.

CEO

As mentioned above, Mitesh Dhanak has served as the CEO since inception. Per Eneraqua’s website, his previous experience includes being the Director of Strategy at Carillion Energy Services and Eaga plc where he worked from 2006 – 2011. He also holds an MBA from Imperial College Business School as well as an ACCA Diploma in Finance.

CEO Compensation

Mr. Dhanak’s compensation is comprised of a base salary, annual bonus, and long-term incentive plan (LTIP).

His base salary for FY 2023 was £285,000 which was unchanged from the previous year.

Per the Remuneration Committee report on p. 65 of the FY 2022 Annual Report, linked here, his annual bonus is “is capped at 100 per cent of base salary, based on a sliding scale of financial, operational, strategic and ESG-based performance measures.”

I found a note on p. 68 of the same report regarding his annual bonus for FY 2022 which stated, “Annual bonus awards to the Executive Directors were based on the Committee’s assessment of the CEO and CFO’s performance for FY22 based on targets set prior to Admission on AIM, which were paid post year end. For FY23, the Committee has introduced a market consistent bonus structure and, while targets are considered to be commercially sensitive, full details of the targets will be disclosed retrospectively.” This was pretty vague, and I was unable to find any other information about what specific metrics or hurdle rates were used to grant his annual bonus.

Regarding his LTIP on p. 65 of the FY 2022 Annual Report, “LTIP awards are expected to be granted during FY23 over shares equal to 100 per cent of salary for the CEO and CFO. Performance targets will be agreed in due course.”

The LTIP was divided into two segments, each based on total shareholder return (TSR) metrics which each equated to a 50% weighting towards the overall bonus. Regarding the first segment of the LTIP awards on p. 69 of the FY 2022 Annual Report, “50 per cent of awards: 25 per cent of this part of awards will vest for absolute TSR of 5 per cent a year, increasing pro-rata to 100 per cent of this part of awards for absolute TSR of 15 per cent a year or above over the three years from AIM Admission.”

Regarding the second 50% portion of the LTIP awards, “50 per cent of awards: 25 per cent of this part of awards will vest for median TSR increasing pro-rata to 100 per cent of this part of awards vesting for upper quartile TSR as measured against the AIM companies ranked 101 to 300 by market capitalisation over the three years from AIM admission.”

I don’t think the first TSR metric was bad, but a 5% TSR hurdle per year isn’t exactly a stretch target even if it’s only 12.5% (50% x 25%) of the total LTIP awards. I think awarding the full 50% for the 15% TSR target was just fine.

The second TSR metric was a little eyebrow raising though. It seemed entirely arbitrary that the Remuneration Committee compared its TSR performance to 200 others on the AIM exchange. I was unable to find any other information as to why this was the case.

What Does Eneraqua Do?

If you recall from above, Eneraqua aims to reduce its clients carbon footprint and/or water usage, but what does that mean? Let’s take a peek behind the curtain.

One thing to be aware of before moving forward is that Eneraqua only works on commercial projects and applications. I want to be clear that it does not work on individual homes or small businesses.

Energy

Eneraqua’s Energy division operates under the name Cenergist Energy. Per the CEO’s statement on p. 20 of the FY 2022 Annual Report, “In Energy, we focus on clients with end-of-life gas, oil or electric heating and hot water systems. We provide turnkey retrofit district or communal heating systems based either on high-efficiency gas or ground/air source heat pump solutions and are at the centre of a number of development programmes across the UK, upgrading buildings and helping Local Authorities achieve their Net Zero and decarbonisation goals.”

Per the FY 2022 Investor Presentation, linked here, Cenergist Energy’s projects focus on “heating and hot water solutions for large, multi-occupancy residential buildings and commercial customers.”

There are a couple of things to unpack here for the uninitiated, namely what are these heating systems, why use them in the first place, and why focus on end-of-life systems?

I won’t focus too much on the high-efficiency gas heater design because they are the least efficient and least popular kind of project that Cenergist Energy designs.

If you’d like to learn more about them, what they look like and how they function, then please watch the video below.

I wasn’t too familiar with heat pumps before I started researching Eneraqua, so learning about them was a welcome experience.

So, what is a heat pump? There are two kinds, air source and ground source, but both are designed as systems that take heat from the air or the ground and run it into your home. There are also heat pump systems that can take heat out of your home, but they’re mainly used to provide it.

The description and image below were taken from the U.S. Department of Energy and provides a breakdown of how an air source heat pump works.

“A heat pump's refrigeration system consists of a compressor and two copper or aluminum coils (one indoors and one outside), which have aluminum fins to aid heat transfer. In heating mode, liquid refrigerant in the outside coil removes heat from the air and evaporates into a gas. The indoor coil releases heat from the refrigerant as it condenses back into a liquid. A reversing valve, near the compressor, can change the direction of the refrigerant flow for cooling mode as well as for defrosting the outdoor coil in winter.”

Source for the picture and description: https://www.energy.gov/energysaver/air-source-heat-pumps

Do remember that the Energy division only works on commercial projects, so their heat pumps will be bigger and more numerous than those used for an individual home. I have posted a picture of what a commercial air source heat pump setup looks like below.

Source for picture:

http://www.anglianes.co.uk/

Here is a video that explains how an air source heat pump works if you prefer that to reading:

. Let’s move on to ground source pumps.

The description and image below provide a breakdown of how a ground source heat pump works and were taken from Kensa Heat Pumps. Kensa is the first and only dedicated business in the UK that designs ground source heat pumps. They are Cenergist Energy’s preferred design project and are commonly referred to as “geothermal heat pumps” here in the U.S. of A.

“Heat naturally flows from warmer to cooler places. A ground source heat pump exploits these physics by circulating a cold fluid through ground array pipework in the ground or water. It absorbs low-grade surrounding energy from external heat sources, such as rock, soil, lakes and streams.

The ground source heat pump then compresses and condenses this free energy to a higher temperature, and transfers it to the property’s heating and hot water system.

Having surrendered the absorbed energy from the ground to the heat pump, the fluid continues its circuit back to the submerged pipework to commence the cycle all over again.”

SOURCE: https://www.kensaheatpumps.com/what-is-a-ground-source-heat-pump/

Here is a video from Kensa that explains how a ground source heat pump works if you prefer that to reading:

Like its air source pump projects, Cenergist Energy’s ground source pumps are only designed for commercial projects, so their scale is much larger than one for a home. I have posted a picture of what a commercial ground source heat pump setup looks like below.

Source for the picture: Slide 8 of Eneraqua’s FY 2022 Investor Presentation.

One additional thing to note is that ground source heat pump systems can be designed vertically or horizontally depending on the size, space, and budget for the project. Horizontal systems are typically used for homes or projects with more available space/land while horizontal systems are usually for commercial projects or those with tighter land/space availability.

The land and space restrictions for commercial projects which Cenergist Energy focuses on typically require boreholes to be drilled to fit the system in to place. Per the FY 2022 Annual Report, management claimed that there was a shortage of these services offered in the U.K. which led them to acquire a borehole drilling business.

Per the Chairman’s statement on p. 16 of the same report, “We identified early in the year that there was a growing shortage of drilling rigs and skilled operators to operate them. Large Ground Source Heat Pump projects often require many boreholes to be drilled to a typical depth of 150 meters. Having both the drilling skills and capacity are vital to our growth plans and we therefore acquired Welltherm Drilling Limited which has exactly the skills and resources required.”

So what and who cares? Why use these heating systems in the first place? The answer is that they’re much more efficient than the legacy systems they’re replacing which leads to cost savings over the long term. Per the U.S. Department of Energy paper linked here, “Geothermal systems can reduce energy consumption by approximately 25% to 50% compared to air source heat pump systems. Geothermal heat pumps reach high efficiencies (300%-600%) on the coldest of winter nights.”

Another interesting piece of the text from the same paper (italicized for emphasis), “Geothermal heat pump systems have an average 20+ year life expectancy for the heat pump itself and 25 to 50 years for the underground infrastructure. Additionally, they move between three and five times the energy they consume between a building’s interior space and the ground.”

Why has Cenergist Energy focused on end-of-life projects up to this point? It’s quite simple. These systems need to be replaced so management knows that their customers are forced to spend money to retrofit their existing heating infrastructure. Management cannot bid on end-of-life projects forever and expect to grow the business, but I do think it was a shrewd move to focus on them in the early phases of the company’s history.

Water

Eneraqua’s water division operates under the name Cenergist Water. It only became a material part of the business last year and has a compelling long-term future growth runway, but more on that later in the Tailwinds section.

The lynchpin of the Water division was the acquisition of the HL2024 water efficiency products in June of 2021. What’s the big deal with them though? Why should you care?

The HL2024 products are a series of pressure independent flow controllers. Per the “About” section on its website, linked here, a pressure independent flow controller is “a device that ensures a constant flow rate at all times, regardless of the water pressure or any fluctuations in that pressure. A pressure-reducing valve in a device that protects the system in which it is installed from excessive static pressure to a pre-set value. It is, in other words, a safety measure designed to present excessive static pressure within the system.”

Its value added is the constant flow rate that it permits. By setting the flow rate to a constant amount and temperature, the owner of the home, business, hotel, etc. doesn’t have to worry about fluctuations in their water bill, which also saves them a nice chunk of cash.

Links to the HL2024’s applications in hotels, irrigation, homes and the care sector can be found here: https://hl2024.com/applications/

A link to its product lines can be found here: https://hl2024.com/products/

What’s Unique About Eneraqua?

Its first unique feature is that the Energy division designs, oversees, and manages its projects. It does not engage in the actual building out of these projects which makes it asset light and allows the business to have high returns on capital.

Its second unique feature is that, while Eneraqua is considered an ESG business, it’s mostly focused on the E portion of that acronym, but they do it quietly. You may be thinking that this isn’t important and doesn’t make sense, but Eneraqua is one of the few businesses I’ve come across in this space that doesn’t use their ESG reputation as a status symbol or to virtue signal.

If you read about the business, you won’t see constant wording/phrasing about “saving the planet” or “revolutionary” products. While these are goals that it hopes to achieve in some fashion, Eneraqua just goes about its business quietly and works on saving its customers money through well-designed heat pump systems or its water saving products. For full transparency, I am a sucker for enterprises that aren’t very loud and do things quietly, so I could be overblowing things here.

The third unique factor is multipronged and has to do with its growth potential. The business operates in two huge growth markets, but I will talk about those more in the Tailwinds section of this writeup.

There was a fourth unique factor that I kept coming back to that I couldn’t really answer. I kept wondering how the business differentiated itself from the competition. This question was partially answered by the CFO at the 5:40 mark of the Introduction to Eneraqua Technologies video which is linked here. The corresponding screencap from slide 11 of the FY 2022 Investor Presentation visualizes where Eneraqua fits in against the competition.

Quoting the CFO from the 5:40 mark of video regarding the technology and products it offers, “So, if we start first at the bottom, uh, in terms of the water products, uh, all of those companies listed the likes of, uh, Danfoss, Honeywell, with the exception of NEOPERL are all actually pressure control valves some of which we do actually use in some of our energy systems. NEOPERL is the only control flow device, but as Mitesh says, our product, our HL 2024 product, is the only one that's been independently certified by the European test house KIWA.”

Quoting the CFO from the 6:20 mark of the video regarding the Water division, “If we then look at the Water sector again with the exception of RPS, who are obviously a large plc, and they focus on network infrastructure solutions. The rest of our competitors tend to be smaller companies or charities who focus on installing water saving devices in high consumption households.”

Quoting the CFO from the 6:39 mark of the video regarding the Energy division, “In terms of the Energy sector again, a wide range of competitors typically all contractors from large plcs to regional companies, they again make their focus solely on one solution as an answer to the client's problems, whereas, because we're technology agnostic, we will aim to deliver the best solution for the client and their needs.”

I also decided to reach out to their IR department and got a message back from Alma PR who seems to be running the Investor Relations for Eneraqua at the moment. My questions and answers are shown below.

1. Why should consumers use the HL2024 line of products versus competitors?

Answer: They provide a better performance and user experience and cut your utility bills.  HL2024 is the only product to meet the pressure-independent flow control test by KIWA.  It provides the set output flow with variation of less than 2% across a range of input pressure flows.  For a householder rather than the shower or tap having flows that vary by c10-15%, they get an even flow.  You can see this fact by turning on kitchen tap on full in the evening.  As your neighbours turn on taps, showers etc, you will see the volume of water flowing out change.  HL2024 effectively eliminates this fluctuation to give you a steady flow.

By eliminating these fluctuations, trials have found HL2024 reduces water consumption by up to 26%.  At same time the even flow is better for heating systems that supply hot water.  Trials by Crawley Council and Liverpool University found residents saved an average of £360 a year in energy and water bills.

Side note: KIWA is a well-known and respected testing, inspection, and certification business in Europe. Per its homesite and Wikipedia page,” Kiwa participates in the safety analysis of many new European and international technologies, as well as the drafting of safety standards for numerous devices and components. Kiwa provides safety-related certification, testing, inspection, auditing, advising and training services to a wide range of clients, including manufacturers, policymakers, regulators, service companies and consumers.”

To be clear, KIWA is not affiliated with, nor does it speak for the EU or any member country, but it’s seal of approval on the HL2024 line of products is encouraging.

2. Who are your competitors in this space and what's their value proposition versus what HL2024 offers?

Answer: Our main competitors rely on NEOPERL flow restrictors.  These are much cheaper than HL2024 but do not have the same level of performance.  Unlike them, HL2024 is supplied with a full 5-year warranty.

3. What makes HL2024 stand out as a pressure independent flow controller?

Answer: It is the only pressure independent flow controller to meet the KIWA performance standard.

4. Are these products mainly used in non-industrial settings?

Answer: They are used mainly in domestic settings at present but other products are in development for the agritech sector for example.

Valuation

Revenue

Eneraqua’s revenue growth since 2019 is shown in the screencap below. That data were taken from TIKR.

Its revenues have increased from a paltry £7.61 million in FY 2019 to £36.18 million last fiscal year which was a CAGR of 47.66%. Per its FY 2023 Update, linked here, the business generated £55 million in revenue which bumps the CAGR up to over 48%. While the actual figures are still small, the growth in revenues over the years has been nothing short of impressive and exactly what I want to see as a potential investor in the business.

The business currently trades at 2.6x FY 2022 revenue given its current market cap of ~£95 million.

Capital Structure

Eneraqua’s balance sheet is shown in the two screencaps below with the first one showing the asset side and the second showing the liabilities and equity side. The data were taken from TIKR.

One line item that increased notably was Accounts Receivable. I don’t have a good explanation as to why this happened other than the business doing a lot of project-based work which may result in payments coming in infrequently. There was no additional insight provided other than a note on p. 99 of the FY 2022 Annual Report that stated, “All trade receivables fall within their due date. Accordingly, no provisions have been made.”

It also makes sense when you take a step back and think that accounts receivable would naturally increase as revenues increase. I don’t think it warrants a full red flag, but it’s something to keep an eye on. Let’s shimmy on over to other side of the balance sheet.

Nothing too concerning here on the liabilities and equity side.

One thing to be aware of is that the business didn’t have any long-term debt as of FY 2022, but it did secure a loan facility £6 million of it during the first half of FY 2023 per its HY 2023 Presentation which is linked here. It has a four-year term and the interest rate is 3.45% above the Bank of England’s base rate. Even with the debt, leverage is low and not concerning at this point.

Free Cash Flow

Shown below are my calculations for Eneraqua’s real free cash flow since 2019.

I debated on even doing these calculations as I only had four years’ worth of data, but I decided to go through with it. Its real free cash flow has been kind of all over the place and not as consistent as I’d like. Again, it’s only been four years though. I don’t think that is quite enough time to issue judgement either way about its long-term free cash flow generation prospects.

Returns on Invested Capital (ROIC)

My calculations for Eneraqua’s returns on invested capital (ROIC) since FY 2019 are shown in the screencap below.

Its ROIC since 2019 have been good and exceeded my base rate of 15% over the last three with FY 2022 being the best twelve-month period by far.

Like its free cash flow, I don’t think four years of performance is enough data to weigh the probabilities on how the business will perform in the future, but it seems to be doing well so far.

Returns on Incremental Invested Capital (ROIIC)

My calculations for Eneraqua’s ROIIC since 2019 are shown in the screencap below.

Side note: Eneraqua started paying a dividend of £0.01 per share in September of 2022 which isn’t included above.

My calculation for Eneraqua’s ROIIC from FY 2021 through FY 2022 is shown below.

By my calculations, the business has been compounding its value by 71% - 74% between 2019 and 2022. The growth slowed a bit between ’21 and ’22, but still came in at 63%. Both are staggering figures.

I rechecked my calculations after I saw the value compounding rate outputs just to make sure I was right which is why I did the second calculation for FY 2021 – 2022. The outputs indicate two additional things. The first is that Eneraqua should be putting every dollar back into the business because its ROIIC is outstanding. It has started a dividend policy for whatever reason though. British businesses seem almost obsessed with issuing them.

The second indication is that there is a massive spread between my calculations and how its stock price has performed since it went public. Said stock price has only increased by 3.6% in total since the business IPOd in November of 2021.

Risks

I think this is a long way off, but I can envision a world where both divisions become successful, which leads to another problem. At some point they may need to separate, or one may need to be sold/spun off because they are entirely different from one another. It may not be the most efficient use of management’s time to try and run both businesses via one central team or office. Maybe they’ll be able to figure out a way to decentralize and push responsibility down to each division, but that remains to be seen. Doing that is also a lot harder than it sounds.

I have to imagine that competition is going to increase in the future. Its high returns on capital almost guarantee it, but we’ll have to see how the business fends off the challengers. Only time will tell how this will work out, but I don’t think enough time has gone by for me to weigh the probabilities either way.

Revenues for now will be lumpy because the Energy division is so much bigger than Water and its work is project based. I don’t think of this as a risk necessarily, but investors seem to have been conditioned to almost linear growth in revenues and profits over the last 10 years or so due to the rise of subscription-based business models. As a rebuttal to this, I’ll quote Buffett where he said, “We prefer a lumpy 15% return to a smooth 12% return.”

The business promotes its KIWA approval and seems to almost rely on it. While it is impressive that their HL2024 product is the only pressure independent flow controller to meet the KIWA performance standard, I’m sure its competitors have noticed and are gunning for its approval as well. The business cannot rest on its laurels here and must constantly introduce new products to the market.

At the 10:45 mark of the Introduction to Eneraqua video, linked here, the CEO talks about the Energy business winning more than 50% of the tenders that it bids for. He then lists why it wins at such a high rate with the reasons being because of its pricing, quality, relationships, quality, and track record. The risk here isn’t the winning, it’s the win rate. I have a hard time believing that the business will keep winning 50+% of the projects it bids on going forward, especially as the size and competition for them increases.

Heat pump projects are expensive to install. Individual heat pump projects for single homes routinely run into the tens of thousands of dollars. The commercial projects are often in the millions. There just isn’t a cheaper way to install them.

Heat pump projects are a system and like any system, they must be designed well or they won’t work. It is imperative that Eneraqua maintains and improves its engineering prowess in its Energy division.

Tailwinds

I don’t know where you stand on climate change or global warming, but a lot of governments are beyond thinking about it and are moving towards making changes in energy and water conservation policy. These policies are both growing and here to stay. They’re facts of life at this point.

ESG policies, like the ones described above, are growing and here to stay. They will doubt help Eneraqua with its image and mission going forward.

The business did a great job of showcasing its growth drivers better than I could in slides 7 and 8 of its HY 2023 Investor Presentation which is linked above.

These slides speak for themselves. In total, these growth markets present massive tailwinds for the business. Obviously, they’re the best-case scenarios, but Eneraqua only needs to capture a fraction of them to be successful going forward.

The growth driver slides mostly included statistics for the U.K., but what about international growth? I ran a search for the “size of the global heat pump market” and “size of the water conservation market” and the results yielded varying answers. While the answers were different, there was no doubt that each market is massive.  At minimum, both markets are already in the tens of billions of dollars and are projected to grow by at least mid- to high single digit percentages for the foreseeable future. One only needs to look at Google search results linked above to see what I’m talking about. I know they’re basic but click on any of the results and tell me if you disagree with my general point about the size of each market. Each one provides a huge growth runway for Eneraqua.

Conclusion

Do I see myself investing in Eneraqua? I could and it’s certainly enticing. Its financial performance has been astonishing since 2019 and it certainly has a large growth runway. However, I’m not thrilled with its incentives and I’m just not certain about how it will grow in the future given that its Water division is so new. I think it’s best to pass on it at this point, but certainly track its progress as time goes on. I’m eagerly awaiting its FY 2023 Annual Report and Investor Presentation which will be posted in June.

Thanks again as always for reading. If you liked this writeup, please feel free to share it and subscribe!

Please reach out to me at possiblevalueresearch@gmail.com, @PossibleValue on Twitter and @Heshy on MicroCapClub with any comments, concerns or questions. Lastly, don’t forget to tell someone that you love them.

*** Remember that this isn’t investing advice. Consult a trusted financial or investment advisor before making any kind of investment decision. ***

Disclosure: I do not own stock in Eneraqua.