Sureserve Group — Well positioned for clean growth strategy

There is a secular growth trend toward improving energy efficiency. On 29 June 2019 the UK government signed legislation that committed it to a legally binding target of net zero carbon emissions by 2050. The Business, Energy and Industrial Strategy Select Committee report of 12 June 2019 set out 25 recommendations for the government to meet the legally binding climate change obligations, highlighting that buildings contribute to 19% of the UK’s carbon emissions, of which 77% comes from homes. It also highlighted that the Clean Growth Strategy set a target to upgrade as many houses to the Energy Performance Certificate (EPC) Band C by 2035, and for all fuel poor households and as many rented homes as possible to achieve EPC Band C by 2030. At the time the paper was published only 30% of the UK’s houses met the EPC Band C rating.

The government’s response on 30 October 2019 disagreed on some of the findings, but agreed that a significant increase in deployment rates would be required to deliver the transition to net zero. The 2019 Conservative Party election manifesto included the following pledges:

The legislation on many aspects of Sureserve’s work in compliance, heating and insulation is gaining political priority and getting tighter, leading to increased demand and revenue opportunities. The key investment attraction of Sureserve is that it is in a position to capitalise on these policy initiatives:

How the drive to improve energy efficiency is carried out is a key issue in the short term. Both the ECO 3 and smart meter roll-out have had issues (see page 9). While the long-term direction is for growth in both areas, successful implementation of policies may lead to near-term bumps in the road.

Sureserve operates through two divisions: Compliance and Energy Services. For the first time the group provided a more detailed revenue breakdown of these two divisions in the 2019 segmental reporting note (see Exhibits 1 and 2).

In Compliance the workload is in planned and responsive maintenance along with installation and repair services, in the areas of gas, fire and electrical, water and air hygiene and lifts. The company supplies these services mainly in social housing markets and on public building assets, as well as on some industrial and commercial properties.

The principal subsidiaries and brands in this division are as follows:

Sureserve Energy Services delivers energy efficiency projects, driven mainly by government programmes, and is now involved increasingly with the smart meter roll-out programme. It operates under two main brands:

The main driver of demand is regulations that require, in many cases, annual inspection, servicing and certification of equipment, which applies in particular to gas boilers but also to other areas. The Gas Safety Regulations 1998 impose a duty on the users of gas systems to be responsible for the annual servicing and inspection of all burning equipment and appliances.

In the UK, gas safety certificates can only be issued by a Gas Safe registered engineer who will carry out a series of tests and a visual and functional inspection. The annual boiler service also provides an opportunity for additional revenue via boiler replacement, where needed.

Sureserve has focused its business on areas of high population density, which allows for revenue optimisation as travel times are relatively short and aborted visits can be more easily replaced than in widespread geographies.

Customers will usually have several items that are covered by regulations, on the same premises, so there is an opportunity for cross-selling. The Compliance operations can be split into gas and building for analysis purposes, as shown below.

We estimate that the addressable market for Sureserve’s Compliance services have a current annual value of up to £2bn. Gas comprises around £1.5bn, split broadly 50/50 between the annual servicing of boilers and the safety certification, which is needed annually for each boiler. The other market areas are lifts, water, electricity and fire, and are worth around £0.5bn in total, but these areas are growing swiftly, especially fire following the Grenfell disaster.

The clients for these services are the owners of dwellings, who usually also operate them, such as local authorities and other quasi-public sector organisations as well as registered providers. The customers/service users are the tenants of the buildings. Sureserve works on a mixed basis, sometimes directly for the client (tier one) and sometimes as a subcontractor (tier two), especially on larger contracts.

The procurement process usually involves a formal tendering period and the appointment of one or a small number of suppliers either for a fixed term or framework contract, involving several suppliers, that might last up to 10 years. There are methods that can provide a workaround for the formal tendering process and these may be used to speed up the process and make it cheaper for all parties.

Sureserve’s competitors vary by region and the supply side is fragmented in most areas of compliance. Some competitors choose to trade only in a particular region and provide a broad service offering, whereas Sureserve, through its branded local operators, focuses on being a specialist. The main competitors in compliance are local operators, working mostly on a regional basis.

The division’s gas compliance business competes in London and the South East with a number of national players, including PH Jones, Mitie and Mears, and a number of local players, including T. Brown Group, Robert Heath Heating, BSW Heating and Smith & Byford. The division’s fire compliance business competes in London and the South East with Rentokil Initial and BBC Fire & Security. Other competitors include Protec Fire & Security, ADT and Chubb. In air and water, the business competes nationally and in local markets with Clearwater Technology, Aqua-Air Hygiene, Assured Water Treatment, Dantek Environmental Services and SMS Environmental.

The group’s competitive advantage in the compliance services market is based on its extensive service capability, its wide base of technically qualified and skilled staff and an established service quality record in the relevant compliance areas. In addition, there is only a limited number of companies that can provide the same range of compliance services, on the same integrated basis.

The outlook for Sureserve is positive given recent contract wins and the strong position the business has achieved in the gas market and the reputation of the businesses in their areas. Improved cooperation and benchmarking that will be facilitated through a common IT platform will aid margin improvement. Retention of key employees in the gas business has been high. Water remains a very positive area for the company and, based on wins in FY19, should improve further this year. The lift business performed weakly in 2019 and recent measures should enable improvement. The outlook is positive and given the mild winter for the start of FY20, margins of 6.4% in FY19 should be sustainable.

At present, the markets for the energy services operation are driven mainly by government policy and direction. Of the three key areas for the division, energy efficiency, smart metering and the emerging electric vehicle charging points, only the latter is funded by private sources.

In energy efficiency there were many funding schemes, but these are now reduced to three main ones, each of which has a separate funding scheme:

At the time of its flotation the company estimated that its addressable market in Scotland had an annual value of around £1bn and in South East England it was around £1.1bn. Wales was a new market for Sureserve. The value of the programmes will not have grown, in our view, although it has not declined. The need for measures remains high, increased in the last six months by the level of energy prices and the political imperative to reduce greenhouse gases and respond to environmental concerns.

In 2013 the UK government launched an energy efficiency scheme to help reduce carbon emissions and tackle fuel poverty. Over time the scheme has been amended and the latest policy, ECO3, which commenced on 3 December 2018, applies to measures completed from 1 October 2018. The ECO policy is entirely formed from one obligation, the Home Heating Cost Reduction Obligation (HHCRO). Under HHCRO, obligated suppliers must promote measures that improve the ability of low income, fuel poor and vulnerable households to heat their homes. This includes actions that result in heating savings, such as the replacement of a broken heating system or the upgrade of an inefficient heating system.

While the government and local authorities have introduced various schemes over the past 40 years to improve insulation in homes, Eurostat data show that there are 19m homes in the UK with poor levels of energy efficiency, defined as EPC Band C or below (note, there are over 25m homes in the UK). The October 2017 government paper, the Clean Growth Strategy, committed to all fuel poor homes to be upgraded to EPC band C by 2030. Although funding for the objective is vague at present, the intention is clear. That in itself does not create certainty around the funding. However, the 2017 strategy commits to support around £3.6bn of investment to upgrade around a million homes through ECO and to extend support for home energy efficiency improvements until 2028 at the current level of ECO funding. We estimate the annual value of the market in the UK is around £1bn, including all schemes.

The vehicle charging point installation programme is still in its early phase, so a market value is not wholly relevant. The UK government’s commitment to reducing vehicle emissions over the next 20 years is clear. Sureserve is an approved installer for vehicle charging point manufacturers, such as Schneider and Chargemaster.

The area of smart meter installation and maintenance has been around for some time but never quite taken off; that seems to be changing. The Climate Change Act of 2008 called for all UK power meters to be smart by 2019. That target has long since been missed as the practicalities of the technology, affordability and cost effectiveness were not understood fully. It was superseded by later legislation and the 2017 strategy.

The latest government data show that as at 30 September 2019 there were 15.6 million smart meters operating in smart mode and advanced meters in homes and businesses in Great Britain, operated by both large and small energy suppliers. This is a 4.1% increase from the previous quarter.

The programme has been slower than expected due to a number of factors:

The process of meter installation is that the energy supplier is responsible for the works and the billing of the customer. The client for an installer, such as Sureserve, is the energy supplier. The meters historically have been funded by a third party, which seeks to fund assets on a long-term basis as a meter typically lasts 15–20 years before being replaced.

The largest operator of smart meters is British Gas with some 6.8m smart meters installed. Thereafter a long tail exists with Scottish Power, Utilita Energy, E.ON, OVO Energy and SSE each having just over 1m meters when last counted. Npower, EDF and First Utility each have around 0.7m smart meters installed with their customers.

The smart meter segment is now entering a more mature phase. The programme is now more in tune with the normal cycle of meter replacement with the ‘rush’ to install smart as fast as possible having ended. The impending IPO of Calisen, a business formed by the merger of Calvin, a funder of meter assets, and Lowri Beck, an installer, with a value of £1.2bn is indicative of the changes. Smart Metering Systems and Fulcrum Utility Services, both UK quoted, have been down the strategic route of combining meter asset ownership with installation and pulled back. Calvin had greater market longevity in funding meter assets than the others, but it remains to be seen whether the Op Co/Prop Co model is preferred. Sureserve is actively considering the Op Co/Prop Co model.

The supply side for companies that implement energy saving measures, typically using legislation driven schemes, is fragmented.

Everwarm competes with organisations such as BillSaveUK, Dyson Energy Services, A&M Energy Solutions and Domestic & General Heating on energy measures, and on larger, more complex assignments with Engie, Wates Group and Willmott Dixon Group.

As suggested earlier, the competition in smart meters falls into two groups. There are companies that install and maintain only, such as Providor, and those that seek to own assets for the annuity style returns as well as install and maintain revenue, such as Calisen, SMS and Fulcrum. Providor competes with SMS and Fulcrum for installation only work and on new builds with Nexus.

Everwarm’s main activity is the improvement of energy efficiency of properties, mainly in social housing. The funding comes mostly from energy suppliers who have obligations to reduce carbon emissions, which can be done effectively by reducing usage, through energy saving measures. Sureserve’s Everwarm operates in Scotland mainly through a 33.3% share in Warmworks along with its JV partners Energy Saving Trust and Changeworks. In Wales, the main JV partner is Energy Saving Trust. Everwarm carries out the division’s work on ECO3 alone. Recent contract wins include:

In addition, Everwarm has been active in winning small contracts in battery storage and electric vehicle charging for clients. These are small scale at present but are providing useful experience and reference sites. The business will require investment to scale up in these new areas and at present smart meters represent the best near-term opportunity from what we observe.

Providor is at the forefront of the efforts to install smart meters throughout the UK. It is one of the few operators capable of managing a national rollout of smart meter installations with some 300 trained installers. The company has made a significant investment in training operatives in this area, much of which was ahead of the pace in the market. It acts as an installer and maintainer of meters.

Introduction and acceptance of SMETS2, the standard for meter communications, is opening up the market. The deadline to install smart meters in 85% of homes has been extended to 2024. This will create a smoother pattern of installation for the 30 provider operatives that should aid effective use of engineering resource as, to date, it has tended to be suboptimal and therefore not generate adequate returns.

Providor recently won a contract with Octopus Energy for smart metering delivery worth up to £9.4m over an initial 18-month term, which was followed by a £1.7m asset management contract with the same customer. The business also won a contract with iSupply that points to a maximum value of £20.6m by the end of 2021 for smart meter installation and asset management. The pace of installations is dependent on the supplier’s ability to get permission for conversion to a smart system from the dwelling/property owner.

For Everwarm the outlook depends on the speed at which ECO3, Warmer Homes Scotland and Arbed can ramp up their spending. All three play firmly into the government’s agenda of climate change and are therefore likely to be improved. But changes in each scheme had an impact on the FY19 outturn. Each of them is expected to be more settled in the near term and volumes will rise in the current financial year.

Providor’s progress seems more assured in the midterm as a realistic timetable is now in place for the roll out of smart meters. The rate of progress depends on the ability of the energy suppliers to convert existing customers. Providor is looking at developing faster in other market segments, such as new build and in installation and asset ownership, but, as yet, we understand that no decision has been made.

There were changes to the management team in 2019. Peter Smith was appointed CFO in July 2019. The departure of COO Michael McMahon in October 2019 for personal reasons was announced, with Executive Chairman Bob Holt assuming Michael’s duties. Biographies of the executive team are on page 12.

The non-executive team also had changes. In March 2019 Christopher Mills, CEO of Harwood Capital, was appointed as a non-executive director. Harwood is the largest single shareholder in Sureserve. Mr Mills acts as a NED at a number of other listed companies, including Augean, EKF Diagnostics, Ten Entertainment Group and MJ Gleeson.

There are two other NEDs. Robert Legget came onto the board in April 2016; he is chair at Progressive Value Management, which specialises in creating value for investors in poorly performing entities with illiquid shareholdings. Derek Zissman was appointed in November 2017, having spent much of his career at KPMG; he is chair of the audit committee and director of several private companies.

With the former Lakehouse Special Incentive Plan not vesting, two new incentives plans, a long-term incentive plan (LTIP) and Special Incentive Award Plan (SIAP) were proposed and approved at the AGM. The two schemes allow Mr Holt the option to acquire 1.9m shares in Sureserve. The SIAP terms effectively create increasing incentives provided the share price of Sureserve is above 40p; the maximum multiplier comes in at a share price of 70p or above.

We would highlight two key areas that would potentially affect our investment case for Sureserve:

In our 19 November 2019 note, we introduced our sum of the parts valuation. The methodology and choice of comparators has not changed. We update our valuation noting the following changes:

Following the divestment of the Construction and Property Services divisions, we have been cautiously optimistic that the more focused operations that are underpinned by strong repeating demand would start to see improving financial results. Having already upgraded our estimates in November 2019, it was extremely encouraging to see the group deliver results ahead of our 2019 estimates, beating divisional revenue (£212m actual vs £205m estimate), EBITA margin, EBITA and overall group EPS (4.4p vs 4.2p) estimates. Net debt also came in lower than the £7.6m previously guided to. As well as the strong operational performance, we liked the robust cash generation, the increase in dividend from 0.25p to 0.5p and that for the second year running the group was carbon neutral.

The group starts FY20 with an order book of £333m. This effectively means that c 72% of FY20 revenues are already committed, c 50% for FY21e and c 25% for FY22e. A mild winter at the start of FY20 provides some comfort that the margin improvement in the gas compliance division seen in 2019 will be maintained. In addition, we expect the group to benefit from:

Management has commented that it is comfortable with the c 10% earnings growth expectations and would expect further progress in paying down debt by the end of FY20 (we currently forecast net debt at £1.4m).