A heat pump provider with a bargain share price

Eneraqua Technologies (ETP:168p) is a provider of heating and hot water heat pump systems. The group also delivers water efficiency upgrades for utilities and commercial clients such as hotels and care homes. Decarbonisation is a megatrend as new building and emissions regulations are making inefficient and older heating systems redundant.

In the UK, heat pumps have been a particular focus of the UK government in its move to reduce CO2 emissions by 78 per cent by 2035 and cut the country’s exposure to international fossil fuel markets. Eneraqua is well placed to take advantage of the forecast 41 per cent compound annual growth rate (CAGR) in heat pump installations over the next five years as it offers solutions based on its patented Control HL2024 family of products, which improve the performance of heating and water systems, thus saving customers money. The technology also reduces water wastage and improves end-user experience by reducing the fluctuations in flow rates that occur in systems. In public and private commercial buildings, Control Flow HL2024 helps reduce water and carbon emissions, thus contributing to decarbonisation programmes.

The structural growth in the market and the potential for Eneraqua to deliver strong earnings growth were key bull points when the group listed its shares, at 277p, on London’s junior market in November 2021. At the time, Eneraqua raised £12mn to make a couple of smart bolt-on acquisitions and provide working capital to accelerate its expansion. It didn’t disappoint in the 12 months to 31 January 2023, delivering record revenue of £55.1mn, boosting gross margin from 40.3 to 41.9 per cent, and earning a 20 per cent operating profit margin.

The revenue growth was driven by repeat customer orders, new client wins, geographic expansion and entering new markets. It also reflected how clients are re-prioritising their budgets due to the high inflation seen towards the end of 2022 which led them to focus on heating systems that had or were about to break down.

Changing contract mix to dampen margin

Although no contracts were cancelled, there was a movement in project mix with some smaller, higher-margin projects moving into the 2022-23 financial year and larger, lower-margin projects now expected to fall into the current financial year. As a result, new joint house broker Liberum Capital, expects Eneraqua to deliver £89mn of revenue in the current financial year, a hefty 61 per cent above the 2022-23 result. Around £80.8mn of the £130mnn record order book should be delivered to provide 90 per cent revenue visibility on Liberum’s forecasts.

However, the larger contracts are less profitable and the group gross margin is forecast to contract by a third to 28.2 per cent this year. The projected gross profit of £25.1mn is still expected to be £2mn higher than in the financial year just ended, but that is not enough to cover the incremental £4.3mn increase in administration costs required to deliver on the higher sales. This largely explains why both group operating profit and pre-tax profit are expected to fall almost a third to £7.2mn and £6.8mn, respectively, in the 12 months to 31 January 2024. The forecast decline in earnings per share (EPS) is even more accentuated, down from 25.7p to 15.3p, due to an increase in the group’s underlying corporation tax rate from 14.3 to 25 per cent.

True, the directors are guiding for a ‘more normal mix of projects in the year to January 2025, hence why Liberum expect both operating profit and pre-tax profit to rebound by 26 per cent to £9.1mn and £8.6mn, respectively, outpacing the anticipated 14 per cent growth in revenue to £102mn. However, pre-tax profit margin will still only be in high single-digits or half the level in the 2022-23 financial year.

Share price plunge

The contraction in margins and the resulting impact on profit are the key reasons why Eneraqua’s share price plunged 35 per cent to 168p following today’s results, down from a high of 389p in early March 2023 and well below the 277p listing price in November 2021. To put the reversal in earnings expectations into perspective, former joint house broker FinnCap had been predicting current-year pre-tax profit of £12.5mn and EPS of 28.8p in mid-March 2023, so the subsequent fall in the share price is mirroring the change in earnings expectations.

That said, investors have overreacted given that the shares now trade on price/earnings (PE) ratios of 11 (2023-24) and 8.9 (2024-25), modest ratings for a group that is still exposed to a fast-growing market and one that the UK government is committed to developing, as I highlighted when I analysed the investment case earlier this year. Hold.

Please note that I will now be on annual leave until Thursday, 8 June 2023.