Stock in Focus: Is Utilitywise worth the risk?

Does limiting your investment to companies with high StockRanks mean you miss out on some profitable buying opportunities?

The answer to this is almost certainly yes. But I think it’s the wrong question.

The right question is whether the StockRank system can help you avoid bad investments. After all, you don’t need to invest in every good stock. It’s often much more profitable to simply avoid investing in bad stocks.

Utilitywise is a case in point. Is it an attractive investment at current levels? There are strong arguments on both sides, but a StockRank of just 30 suggests it may not be.

In this week’s column, I’m going to take a look at why Utilitywise scores comparatively poorly against Stockopedia’s StockRanks.

I’ll also look at the arguments in favour of this company. After all, with top fund manager Neil Woodford on the shareholder register holding a 26% stake, Utilitywise must have something in its favour.

What’s the big deal?

The controversy starts with the Utilitywise business model. The firm essentially acts as a bulk-buying middleman for business customers. It claims to be able to offer customers cheaper rates for utilities than if they go direct to the big energy and telecoms firms.

According to the firm’s website, it manages over 20TWh of power for more than 27,000 businesses across the UK. Utilitywise makes money by receiving commission payments from energy and water utilities, in return for providing them with new customers.

These commission payments have historically been generous enough for Utilitywise to generate operating margins of more than 20%. This gives rise to an obvious question. With such high profit margins, will the energy suppliers one day decide that they are paying companies such as Utilitywise too much for each new customer?

We don’t know. But in my opinion, there are several potential risks here:

• Utilitywise salespeople might find themselves in a position where they have to choose between maximising commission payments and maximising customer savings;
• Regulatory changes could result in a dramatic fall in commission payments;
• Utility companies might decide to spend more on marketing in-house and reduce payments to middlemen like Utilitywise.

All of these risks could one day result in a dramatic fall in the profitability of Utilitywise’s business model.

Is it cheap?

Does Utilitywise’s valuation reflect investor uncertainty about the firm’s long-term profitability? A ValueRank of 54 suggests not.

Although the trailing P/E of 13 and dividend yield of 2.5% are not outrageously expensive, they don’t scream value either.

The firm’s other ValueRank components are even less appealing. A price/book ratio of 3.3 is perhaps to be expected for an asset-light firm, but last year’s negative free cash flow and a price/sales ratio of 2.2 suggest to me that the firm’s revenues are already valued quite highly.

What about quality?

A QualityRank of 45 is probably not what you’d expect of a firm with consistently high profit margins and low debt levels.

However, it’s here that the potential problems start. The quality of Utilitywise’s earnings is hotly debated because the company appears to be very slow at converting accounting profits into cash flow.

Investors’ concerns revolve around the accrued revenue and trade and other receivables lines of Utilitywise’s balance sheet. These represent commission payments earned but not yet received by the company following new customer signups or contract extensions.

Last year, the firm’s pre-tax profit was £14.1m. Accrued revenue and trade and other receivables rose by £14.8m. This suggests that Utilitywise did not convert any of last year’s profits into cash.

This is very aggressive accounting, in my view. Accrued revenue is listed as a non-current asset, meaning that it is not expected to be received for more than one year. Despite this, Utilitywise recognises this revenue in its income statement each year.

The good news is that because Utilitywise’s customers are the big utilities, it’s very unlikely that any will default on their contractual commission payments to the firm. We’re not looking at a Quindell situation here, although commission payments can be reduced if end-users default or use less energy than expected.

It’s interesting and impressive to see that these risks are picked up by Stockopedia’s algorithms and reflected in Utilitywise’s QualityRank:

The low Piotroski F-Score of 3/9 is the biggest red flag and is the main reason why Utilitywise qualifies for the James Montier ‘Unholy Trinity’ short-selling screen.

Here’s how the F-score breaks down:

Utilitywise is not generating cash, and profits are much higher than cash flow. The firm’s operating cash flow was actually negative last year, pushing the firm into net debt for the first time.

Profit margins have been falling. A lack of free cash flow means the company’s ability to service current liabilities is deteriorating. The current ratio fell from 1.65 to 1.25 last year. That’s barely adequate, in my view.

However, there are some signs that things could be improving.

A turning point?

At the time of writing, Utilitywise has a MomentumRank of just 15.

Price momentum is poor and earnings forecasts have been downgraded steadily since April. I don’t think Utilitywise is a momentum buy.

However, alongside the firm’s recent results was a second announcement, which could be significant. Utilitywise has renegotiated its contract with one energy supplier to bring forward commission payments on contract extensions.

The renegotiated contract terms are being applied to historic commissions, too, and the new deal resulted in the firm recently receiving a £3.6m cash payment. Utilitywise says that it is hoping to modify its contract terms with other utility suppliers too. If so, the firm’s cash flow profile could improve dramatically.

In turn, this would reduce accrued revenue and improve the quality of the firm’s profits.

This could well justify a modest re-rating of the group’s share price and could be one reason why Neil Woodford’s fund owns a 26% stake in Utilitywise. Mr Woodford has publicly stated that he is confident the firm’s numbers are okay.

If you believe this version of the story then Utilitywise could be a buy. The shares trade on a 2015 forecast P/E of just 9.5 and offer a 3.6% forecast yield, backed by four years of consistent dividend growth.

Personally, I’m not keen. Utilitywise could be a profitable buy, but there are other equally attractive stocks that don’t carry such risks. I’d rather invest elsewhere.