Let’s talk about an extremely risky microcap energy equity, Spark Equity, and a unique potential value opportunity in the insurance business–Brighthouse Financial, the spinoff of Metlife.
By Kris Rosemann
Spark Energy
Spark Energy (SPKE) operates as an independent retail energy services firm, providing an alternate choice for natural gas and electricity delivery in certain competitive markets. The company purchases energy from wholesale energy providers and delivers the energy to local regulated utilities for distribution via their existing infrastructure.
Such an operating model exposes it to material commodity price risk, as its profitability is dependent on its ability to identify attractive markets in which to compete, as well as the price it pays for energy from wholesale providers. This operating model also excludes it from earning a regulated rate of return like traditional regulated utilities. We’re not fond of this middle-man type business model, and it appears as though the market agrees–a large percentage of Spark Energy’s float is currently shorted.
Spark Energy has done well in growing its customer base via acquisitions, but the competitive, unregulated side of energy generation and delivery has been littered with tales of caution over the past few decades. In fact, a common theme found throughout many large public utility dividend cuts in recent history is outsize exposure to unregulated power sales and delivery, “Shocking?!?! Utility Dividends Aren’t Always Safe.”
Further muddying the investment thesis for Spark Energy is its status as a “controlled company” under the rules of NASDAQ. Spark Energy owns a ~39% economic interest and is the sole managing member in Spark HoldCo, its operating company, but NuDevco Retail and Retailco retain a 61% economic interest in HoldCo, resulting in a significant level of net income being attributable to these non-controlling interests, as well as material distributions to these non-controlling interests each quarter.
It is worth noting that Spark Energy’s founder W. Keith Maxwell III is the sole owner of Retailco. In 2015, Mr. Maxwell formed National Gas & Electric for the purpose of purchasing retail energy companies and customer books that could be resold to Spark Energy. Mr. Maxwell is a director and non-executive Chairman of Spark Energy’s board, as well as CEO of NuDevco, Retailco, Retailco Services, and National Gas & Electric (all of which are affiliated with Spark). He beneficially owns 100% of Spark Energy’s Class B common stock in addition to nearly 11% of its Class A common stock, the combination of which amounts to roughly two-thirds of combined voting power. As a result, we would expect dividends paid to Class A shareholders and non-controlling interests (Class B owners) to be protected to a degree.
In short, Spark Energy suffers from far too material of a shortfall in corporate governance, an extremely competitive operating environment, and significant commodity price risk for us to consider the company an interesting investment consideration. The firm may very well continue to grow as a result of acquisitions, but such growth does little to increase confidence in its business model, as it remains sensitive to changes in regulatory environments without enjoying the benefits of collecting a regulated rate of return on a regulated rate base.
Brighthouse Financial
Brighthouse Financial (BHF) is a holding company that was spun out of MetLife’s (MET) former ‘Retail’ segment. The separation was completed August 4, 2017, and the firm offers a range of individual annuities and life insurance products. MetLife retains a 19%+ ownership interest in the company.
On a high level, we’re not too fond of the insurance business model, as underwriting profits can quickly be eroded by exogenous events (such as the example of the recent hurricanes in the US), and returns on premiums (“float”) are still based on investments that are tied to market activity. An investor, for example, may instead prefer to identify his or her own investments that meet his/her circumstances and criteria than rely on an insurer’s investment committee for such diligence. Please read our full opinion of the structure of the Insurance industry, which we view as largely commoditized, meaning that its products are largely undifferentiated or can be replicated by rivals quicky, at the following link:
Moody’s assigns Brighthouse a credit rating of Baa3 with an outlook of stable as a result of its solid asset quality and a modest level of exposure to high-risk assets. Brighthouse aims to hold cash and liquid assets of at least 2 times annual fixed charges over time, and management has a focus on cash generation and operating earnings. It expects to deliver cash flow conversion of 50%-70%+ of operating earnings by 2020, mid-to-high single digit annual operating EPS growth, and a stable operating ROE of ~9% over time.
As of the end of the second quarter of 2017, Brighthouse’s net tangible book value per share was ~$83, suggesting shares offer an interesting discount given that they are trading at levels in the upper $50s. Though a key portion of an insurer’s income is generated from its investment portfolio, and these returns are largely out of the firm’s control, Brighthouse’s discount to book value, generally solid credit rating, and growth-oriented ambitions make for an interesting consideration within the insurance industry.
We’ll be monitoring the company’s interest-rate risk and ability to generate economic value in excess of its cost of capital (its ROE target) closely in coming periods. If it can sustainably generate a comfortably-positive ROE-less-COE spread, the company’s discount to net tangible book value may be completely undeserved. If it can’t, then the market may be right in haircutting its book value.