Intelligent Energy Holdings — Update 23 November 2016

Intelligent Energy develops and manufactures PEM (proton exchange membrane) fuel cells that exhibit industry leading power densities. This makes them particularly suitable for applications where size and weight must be kept to a minimum. This includes lightweight vehicles such as motorcycles, drones, smartphones, laptops and lower output distributed power generation systems. The technology is now commercially available having been proven during field deployments in telecoms towers and demonstrated to work in devices as varied as Suzuki’s Bergman motorbike, a London taxicab, a 1m diameter UAV (unmanned aerial vehicle) and a grid-independent phone charger that was launched in Apple stores in calendar Q414.

Until 2013 IEH focused on the automotive sector. It depended on funding from programmes with industry partners or with government backing, supplemented by a one-off licence fee from Suzuki for £45m. In order to reduce the reliance on the automotive sector, where volume revenues were dependent on the eventual roll-out of refuelling infrastructure, management diversified into the distributed power generation and consumer electronics sectors. This was good in principle, but fuel cell roll-out in the distribution power generation sector was delayed because the time taken to secure approvals related to the launch customer affected funding. In addition, the B2C launch of the company’s own hand-held charger product did not deliver the expected commercial traction. Incoming CEO Martin Bloom has recently refined the diversification strategy so it is now focused on sales of commercially ready B2B products. In the process he has reduced cash burn significantly. Our model estimates that, following the issue of convertible loan notes and subscription in June 2016, the group has sufficient funds to support activities under the new strategy throughout FY17, but may need additional finance in FY18, depending on the rate and nature of sales growth.

Our analysis indicates that IEH is trading on prospective (FY17e) EV/sales multiples that are towards the lower end of the range for its peers (1.9x vs 0.5-6.4x). This suggests potential for share re-rating if the revised strategy delivers meaningful product sales. We note the possible dilutive impact of the convertible loan notes issued in June 2016 (£30.0m convertible at 8p/share at any time up to 17 May 2019).

As the fuel cell stacks and associated system hardware have already been proven in active deployments, there is relatively little technical risk. However, IEH has yet to prove that the recently restructured and strengthened commercial team is able to identify demand and win orders for significant volumes of products. There are already several competitors offering PEM technology for telecom towers, which is the most immediate market. Penetration of the UAV and consumer electronic device markets depends on OEM commitment, which is outside IEH’s control and would be adversely affected by the development of higher-capacity rechargeable batteries. The production line at Loughborough has not been used for more than prototype production so far.

Intelligent Energy (IEH) designs and develops power-dense hydrogen fuel cell technologies intended for lower-cost, mass-market applications. Following the appointment of Martin Bloom as CEO in June 2016 and an extensive restructuring, the core UK business is now focused on air cooled fuel cell commercial opportunities with a power requirement of sub 1W to 20kW. The emphasis is on applications that are ready for commercial deployment. These include distributed power generation for “always-on” infrastructure and range extenders for drones. IEH continues to work on funded development programmes with the potential to deliver additional commercial products in the medium term. These include a longstanding programme with Suzuki and one with an emerging smartphone OEM to develop compact embedded energy packs. Although management has suspended further work on evaporatively cooled technology, the group retains a significant number of patents and other IP relating to this, which may be monetised in future. Management is evaluating options for the group’s India telecom tower power management activity.

IEH listed on the London Stock Exchange in July 2014, raising £55m (gross) at 340p/share. In June 2016, the group secured £27.2m net funding through the issue of convertible loan notes at a conversion price of 8p/share and a subscription for shares, also at 8p/share.

The group currently employs 136 people, excluding around 60 in the Indian power management operation. The main operating site is in Loughborough with ancillary presence in London, France, India, Japan, Singapore and the US. The fuel cells are currently manufactured on a pilot production line in Loughborough. There is a similar production line at the 50/50 JV with Suzuki, which is currently being used by IEH’s Japanese partner.

Until 2013, the group generated all of its revenues from joint development agreements and technology licensing arrangements with major car manufacturers. However, since licence fees are inherently lumpy in nature and volume adoption of fuel cells in vehicles is not expected to occur until the end of the decade, management at that time decided to take control of its own destiny by diversifying into the distributed power and generation and consumer electronics sectors. In both of these markets, having a power-dense fuel cell technology is a valuable differentiator. The recently revised strategy instigated by incoming CEO Martin Bloom refines this approach by focusing on applications where the group can deliver commercial product quickly. The programme to reduce cash burn and ultimately take the group to profitability is based on three key points:

Collectively, these actions have reduced the number of staff (excluding the power management team in India) from 355 in September 2015 to 136 currently. Adjusted EBITDA losses have been cut from c £3.5m/month to c £1.1m/month.

Martin Bloom became interim CEO in June 2016, having previously served as a non-executive director since 2012. Martin has almost 40 years of experience in strategic partnering, technology commercialisation and business strategy. He has built businesses in the US, Europe and China. As chairman of ReneSola, a position he held between September 2006 and March 2016, he helped the company list on AIM and the New York Stock Exchange, steering it through rapid growth to become a $1.5bn+ turnover company in just a few years. He has been chairman of the board of directors of MayAir Group, an AIM-listed Malaysian air purification company, since May 2015, continues as a non-executive director of ReneSola and was a non-executive director of Starcom, an AIM-listed asset tracking company between January 2013 and October 2015. His position became permanent in November 2016.

A fuel cell combines hydrogen fuel with oxygen in the air to produce water, electrical energy and heat energy. IEH develops proton exchange membrane (PEM) fuel cells. These are robust, operate at temperatures below 100°C, are capable of delivering the highest power density and are suitable for a range of outputs between a few watts and hundreds of kilowatts. PEM technology is therefore suitable for consumer electronics devices, drones, portable power generation equipment and motorcycles where, helpfully for IEH, customers are prepared to pay a premium for compactness. By contrast, power density is less important for buses and trucks and household or utility-scale power generation.

The key problem in designing fuel cells is the removal of the heat energy produced during the reaction of hydrogen and oxygen. If the heat is not removed the platinum catalyst clumps together and becomes less effective, the membrane degrades and production of electricity becomes less efficient. In air-cooled systems, the heat is removed by the air flowing through the stack. This contrasts with the more complex evaporatively cooled systems where the heat is removed by the water generated from the reaction between hydrogen fuel and oxygen. In both technologies, the flow of fuel and coolant is controlled in real time using proprietary algorithms that enable IEH to achieve higher power densities than competitive devices. The core technology is configurable into a wide range of power outputs by adjusting the number of cells in each stack and combining individual stacks in parallel. As one underlying design is suitable for multiple markets, the group not only optimises its return on the design investment, but will also potentially achieve economies of scale faster, accelerating adoption of fuel cell technology.

The air-cooled systems are available in 1W to 20kW formats ranging from portable devices to diesel generator replacement applications, motorcycles and small cars and range extenders for larger cars. Management notes that the stacks offer a power density that is significantly superior to the competition with regards to both kW/kg and kW/litre. The development work on drones involving the substitution of lighter materials in the stack has resulted in lightweight variants of both the low and higher power systems that output two to three time as much power per kilogram as the standard stacks.

IEH has always developed its technology with a view to eventually creating a product that would have a total cost of ownership (including fuel costs) comparable to conventional power sources at volume. It has therefore focused on low part count design and on materials that are amenable to high-volume automated manufacture. Importantly, while competitors typically use graphite for the flow field plates, IEH uses stainless steel. This material was originally chosen because it is resistant to corrosion, so the resultant stacks are more reliable than graphite based ones. In addition it can readily be formed into the advanced architectures required for heat removal using standard automotive production techniques such as sheet metal pressing. These techniques are very scalable, giving a rapid route to cost-effective volume manufacturing. IEH has already set up a ready-to-scale, semi-automated production facility at Loughborough. This is replicated in Japan at the manufacturing JV formed with Suzuki in 2013.

The commercial offer is underpinned by an extensive IP portfolio of more than 1,000 granted or pending patents. These relate to the fuel cell power technologies, the components surrounding the fuel cell stack, and the control technology for the stack and how it is manufactured.

As noted earlier, IEH is focusing on commercial opportunities with a power requirement of up to 20kW, especially those where space is at a premium. Management intends the group to focus more on the sale of fuel cell stacks, rather than complete systems. These stacks can be integrated into complete systems by OEMs who will bear the sales and marketing costs. (This removes one of the key problems with the introduction IEH’s Upp device.) This model appears viable because historically IEH received enquiries from third parties who were interested in this type of business model, but were not pursued at the time because of the preference formerly for the JDA, licensing and royalty route. Short term, IEH will also sell complete power generation systems for telecoms towers. As a working system for this application is already available, sales may be generated relatively quickly. The system will also demonstrate what is possible, helping to seed the market. To start with, IEH intends to manufacture product in house (thus controlling quality and eliminating the other issue associated with the Upp) using existing capacity. As production volumes increase, it is possible that IEH will migrate to a licensing/royalty model, but this is not modelled in our estimates.

Banks, telecommunication tower operators, hospitals, educational and penal establishments and waste water treatment sites are increasingly deploying fuel cells as primary or back-up power. For these applications the economic cost of not having power, estimated by the Lawrence Berkeley National Laboratory in 2009 at $14.4-173.1/kWh for medium and large commercial and industrial facilities, overrides the higher cost of electricity from fuel cells.

Telecom infrastructure operators have historically installed back-up batteries and diesel-fuelled power generators at the tower sites to ensure continuity of signal transmission and thus protect revenues. Continuity of signal transmission is an issue in both the developing and the developed world. In the developing world the grid does not have sufficient capacity, so power outages occur on a daily basis. In India for example, an estimated 70% of the telecom towers are without grid power for more than eight hours per day. In the developed world, tower operators are more concerned about maintaining transmission following the destruction of power lines during the hurricane season or winter storms. Switching to a hybrid battery/fuel cell back-up system potentially offers a more reliable, compact, quiet and emission-free alternative to using diesel generators. The final three factors are particularly important for towers in residential areas. Moreover, since the number of callouts for repair are reduced, switching to fuel cells may also be more cost-effective.

IEH has a proven solution for this application. Seven systems were installed at GTL sites in north-west India between September and November 2015. Three of these sites are completely off-grid and have therefore used the fuel cells as prime power; the others have used the fuel cells heavily as primary power sources. These systems have shown that they are highly reliable in a wide range of climactic conditions and can be deployed in an environment where local site supervisors may be semi-literate. The systems are very compact. One of IEH’s diesel replacement power systems rated up to 6.0kW fits within a 2m high cabinet. Performance data from this multi-site deployment is a powerful sales tool as IEH’s sales team actively seeks opportunities with tower operators in both the developed and developing worlds, concentrating on territories where bottled hydrogen is readily available. Target regions include India (over 400,000 towers), China and Singapore. The GTL portfolio of 27,000 telecoms towers remains a sizable opportunity for the group.

There are several other fuel cell companies already active in this sector (see Exhibit 2). IEH’s experience of operating fuel cells within a power management service offer, together with the relatively compact stack, puts it in a good position.

Replacing diesel power generators with fuel cells is a key element in reducing emission of nitrogen oxides (NOx). This is becoming increasingly important in urban environments. Cities in North America, Europe and Asia have started to clamp down on NOx emissions from vehicles, but the emissions from static diesel generators as back-up power for infrastructure and buildings and as temporary power for construction sites are also significant. This represents a sizable opportunity for the group. So far, there is little evidence of competitor activity in this sector, although Ceres Power has signed a joint development agreement with Honda, which sells an estimated six million generator sets and power appliances annually. IEH’s compact stack looks a good solution for portable genset substitution.

Fuel cells are also beginning to be deployed as part of hybrid renewable energy systems. Wind and solar power are, by their very nature, intermittent sources of power. This causes problems as the proportion of energy in a grid derived from these sources increases. Fuel cells provide an environmentally acceptable way of balancing demand to supply by converting surplus electrical energy to hydrogen gas, which is stored and then used to power fuel cells when wind or sunlight is in short supply. We believe that much of this energy balancing will be at a utility scale, making it more suitable for competitors with higher output power technology (see Exhibit 2), but IEH’s technology may be suitable for smaller-scale, micro-grid deployments.

IEH’s power-dense technology is an ideal match for unmanned aerial vehicles (UAVs). Fuel cells offer extended flight times and quick refuelling compared with lithium-ion batteries. They are particularly suitable for larger drones with heavier payloads used in commercial applications such as surveying, where the curtailed flight times and prolonged refuelling times seriously affect productivity. Fuel cells are also of interest for military UAVs because of their low noise and thermal signature. IEH developed the ultra-light version of its air cooled technology discussed above specifically for this sector. Demonstration stacks for this application weigh between 1.2-1.4kg and output up to 1.5kW. They are used with miniaturise pressurised hydrogen gas cannisters. The technology was demonstrated at the Consumer Electronics Show (CES ) in Las Vegas in January 2016 and the more specialist InterDrone event, also at Las Vegas, in September 2016.

In January 2016 IEH signed a letter of intent with a major drone manufacturer to jointly develop hydrogen fuel cell powered UAVs, focusing on increasing flight time. Although the exact improvements to flight times will not be known until the production drone is finalised, the expectation is that a fuel cell could more than double or even triple the time a drone could remain airborne. In addition, fuel cells would reduce the downtime significantly as re-fuelling takes a matter of minutes. If successful, the development programme may result in a formal commercial arrangement between IEH and the drone manufacturer for roll-out.

There is currently little competition in this sector. Protonex, which was acquired by Ballard in June 2015, has delivered prototype PEM fuel cell propulsion modules to Insitu, a wholly owned subsidiary of The Boeing Company, for use in its ScanEagle UAV. US government clearance in August 2016 creates a path for commercial export and deployment of the technology in a variety of civilian unmanned vehicle applications. Industry analyst BI Intelligence forecasts market growth from $8bn in 2015 to $12bn in 2021.

Since IEH has a common platform for its air cooled stacks, it continues to offer these to the automotive sector, where it is suitable for either the primary power source for lighter vehicles such as scooters or as a range extender for battery powered automobiles, enabling them to double their range without compromising payload capability. Its activity in this sector is underpinned by a partnership with Suzuki, which commenced in 2007 with a demonstration of the Crosscage concept motorbike. The relationship continues to be good. Additionally, in March 2015 IEH announced that it was to lead a consortium that includes DHL to develop range extenders for light commercial vehicles. We note that the relationship with Suzuki is of help in gaining acceptance in Japan, which is potentially a large market for IEH fuel cells in a range of applications.

The competition in this sector is relatively limited because of the constraints on size and weight. Horizon Fuel Cell Technologies offers systems with a power output that, like IEH’s air cooled offer, is suitable for use as primary power for lightweight vehicles or as range extenders for battery powered vehicles. Ceres Power recently announced a programme with Nissan to develop SOFC (solid oxide fuel cell) powertrains running off biogas for deployment in Latin America. Ballard Power Systems, Hydrogenics, Plug Power and Proton Power Systems are involved with trucks, trams and materials handling equipment. For these applications, high power density is not so important, nor is the availability of extensive hydrogen refuelling infrastructure, as typically these vehicles return to a depot each evening where refuelling devices may be sited.

As smartphones and other mobile devices become more sophisticated they require increasing amounts of power. Battery technology is not keeping up with this. For example a recent review of the iPhone 7 in the Guardian had the tag line “how good can a phone be if the battery doesn't last even a day?” IEH’s miniature fuel stacks, which can be embedded into portable electronic devices, have attracted interest from numerous manufacturers of smartphones and other mobile devices. In November 2015, IEH announced that it had received a letter of intent from an emerging smartphone OEM to create a tailored development and integration programme for a specific smartphone application. In February IEH announced that this relationship had already matured into a Joint development agreement worth £5.25m over 24 months. The development programme builds on Intelligent Energy’s existing prototype smartphone with an embedded fuel cell and may ultimately result in the licensing of Intelligent Energy’s technology. There is little competition in this sector. Neah Power Systems has developed a compact fuel cell that is promoted for use by the military, first responders, consumers and logistics companies to power mobile devices, but the cells do not appear to be small enough to embed within devices.

Management has decided to mothball development of the evaporatively cooled (EC) technology as the air-cooled technology is more mature and has more short-term product revenue opportunities. IEH retains an extensive range of patents and other IP relating to the evaporatively cooled technology, which may be monetised at some point. Hyundai, Kia Motors and the partnership groups of General Motors and Honda; Daimler, Ford and Renault-Nissan; and Toyota and BMW are developing their own fuel cell technology; this leaves a significant number of manufacturers that do not appear to have their own technology and must therefore either develop it or else license the technology from either a competitor (thus eroding key performance differentiators) or a third party. As discussed earlier, the third-party options are limited. IEH would reinstate EC activity if there was adequate funding. We treat this as upside to our estimates.

Revenues from power management services (referred to by management as Essential Energy in the report and accounts) rose by £12.9m (18%) to £85.1m. The growth reflects a full year of managing GTL’s portfolio of c 27,000 telecoms towers, an increase in the number of network operators using those towers and £2.5m benefit from exchange rate movements. Unfortunately, since the remuneration was still based on the low-margin interim contract, this rise in revenues did not have a positive impact on profits. Adjusted EBITDA losses from the activity remained at FY15 levels (£2.5m).

Revenues from the provision of engineering services (referred to by management as the Fuel Cell Technology business segment) increased by £0.7m (12%) to £6.7m. Revenues were derived from a mixture of air-cooled joint development and public body funded-related activities, which are inherently variable in nature. There were no revenues attributable to product sales (FY15: £0.1m), although material progress was made on the drone development programme. As product sales ramp up during FY17, these will be included in the Fuel Cell Technology business segment rather than being reported separately. Adjusted EBITDA losses from the Fuel Cell Technology business segment narrowed by £15.0m year-on-year to £31.1m, reflecting the impact of the restructuring programme discussed above.

Group revenues rose by 17% year-on-year, primarily because of the growth in power management revenues. Adjusted group EBITDA losses reduced by £12.8m year-on-year (28%) to £33.4m. EBITDA losses were cut by 9% year-on-year during H116 as a result of reductions in R&D costs, operations and applications engineering expenditure and administrative costs, but still totalled £21.6m. Following the radical restructuring announced in early April and discussed earlier, costs were cut further, resulting in a narrowing of EBITDA losses during H216 to £11.8m. The group exited FY16 with an adjusted EBITDA loss of c £1.1m/month, c £1.6m including cash interest charges and capex.

Reported losses after tax were adversely affected by several non-cash items related to the extensive restructuring programme and widened by £39.9 m to £82.7m. The losses include £26.7m of non-cash related impairments and inventory write-downs, of which £16.9m relates to intangible assets, as well as de-recognition of a £21.9m non-cash accounting entry deferred tax asset. There was also £2.7m in cash restructuring charges.

The balance sheet was strengthened in June by the completion of the issue of convertible loan notes and subscription raising £27.2m net. This gave a cash balance of £20.6m at end September 2016, in line with management guidance.

Our model assumes that funding for specific development programmes during FY17 will be similar to that in FY14 and FY16e. We note three significant programmes contributing to the £8.5m total: the long-term programme with Suzuki; the JDA with the emerging smartphone OEM (£5.25m over 24 months from February 2016); and an assumed programme with a major drone manufacturer.

Our model assumes £5.0m of product sales during FY17, generating 30% gross margin (Ballard’s Fuel Cell Services and Products activities realised 29% gross margin during Q216.) This represents several hundred units, which management notes can be supplied from existing manufacturing capacity. Management has not provided any guidance on average pricing, as stacks for drones are expected to command a premium compared to telecoms back-up power on a per kW basis. Our February note on Ceres Power states a target price of $5,500 for a c 1kW domestic heat and power system based on fuel cells and an average selling price of $2,000 for a diesel generator replacement. Stacks for specialised applications appear to command much higher prices. Ballard has received a $10m order for 33 systems for deployments in buses. Assuming a meaningful proportion of UAV stacks in the mix, our £5.0m revenue target appears feasible. We expect that deliveries will be skewed towards H2, as it will take time for the sales team to progress through the complete cycle.

IEH became involved in the provision of power management services with the intention of accelerating the take-up of fuel cells for telecoms tower back-up power. While the premise was sound, delays in initially agreeing long-term contracts, securing regulatory approval and prolonged financing discussions has meant that the relationship has been based on an interim agreement delivering minimal gross margins, rather than progressing to a long-term agreement generating higher margins. We believe that it is unlikely that IEH will continue to provide power management services under this interim agreement for much longer. As discussed above, the relationship is no longer needed as a route to penetrate the telecoms tower sector. If the ongoing discussions with GTL and financial backers are resolved successfully, IEH’s power management activity is expected to become a separate entity in which IEH holds a minority stake. Revenues attributable to the entity will not be consolidated as part of group revenues, and IEH’s share of the potential profits from this business would be recognised separately from group operating profits. If the discussions are not resolved successfully, we expect that this activity, remaining as it does on the interim agreement with minimal gross margins, will be terminated. Our model assumes that the decision will be made one way or the other fairly soon, so we include one quarter of revenues from this activity (£34.0m), no gross profit and £0.25m of indirect costs. This approach treats any potential profits from the formation of a new entity as upside.

We base our cost structure for FY17 on the FY16 exit run rates noted by management of adjusted EBITDA losses of £1.1m/month. This includes funding from ongoing development activities but excludes the Indian power management activity. Overlaying this run rate with £1.5m gross profit from product sales and £0.25m indirect costs in India gives an adjusted EBITDA total loss of £12.0m. Our model shows that the cash raised in June 2016 will be sufficient to support the growth in commercial products expected for FY17. Working capital requirements are only £0.2m because IEH intends to manufacture once orders have been received. The manufacturing capacity is already in place, IEH is not capitalising any R&D and has some stock of materials to hand, reducing cash consumption.

The cash balance is expected to reduce to £4.7m by the year end. Whether additional finance will be required during FY18 depends on how quickly product sales ramp up and the nature of the sales. Management does not expect IEH to be cash-positive by the end of FY17 on a run rate basis. Funding will be required if product sales remain at FY17 levels. It may also be required to support working capital requirements if product sales grow very rapidly. Given the uncertainty regarding the pace and nature of revenues during FY18, we are not issuing any estimates beyond FY17. We will revisit our forecasts when more information is available on product roll-out.

Any multiples-based analysis using listed fuel cell companies is hampered by the fact that there are no consensus estimates for some peers, and none of the peers is expected to be profitable. There is a wide divergence between multiples for companies such as Ceres Power, which has yet to ship commercial product, and FuelCell Energy, which has multiple units in use in the field. Our analysis strips out the revenues attributable to Intelligent Energy’s Power Management activity, as this currently generates minimal gross margin and is not likely to be part of the group for much longer. Having completed that, an examination of the current year EV/Sales multiples shows that IEH is trading towards the lower end of the range. This indicates potential for share re-rating if successful execution of the revised strategy delivers meaningful product sales from FY17 onwards. The level of product sales expected in our FY17 forecast is modest compared with the size of the market opportunity.

We note the potential impact of the convertible loan notes issued in June 2016. This transaction has secured financing through to FY18, but introduces a source of significant potential dilution. If all of these loan notes are converted to shares, it represents 375m new shares compared with 206m currently in issue. Calculating IEH’s EV/sales multiples with 581m shares in issue gives multiples that are towards the upper end of the range for the peers. If all of the convertible notes issued to Meditor are converted and none of the other convertible loan note holders exercise their conversion rights, Meditor would hold a 69.3% stake in the company. The Rule 9 waiver means that it would not have to purchase the remaining shares, but Meditor would end up with a controlling stake. Meditor has indicated that it would not change the strategy of the company in this event.