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MacMurray Whale: Find Energy Catalysts, Find Growth
Source: Brian Sylvester of The Energy Report (8/24/10)
Cormark Securities Analyst MacMurray Whale knows the micro and macro forces at play in a truly global sector and how those forces are affecting companies seeking growth in largely uncharted waters. It's altogether uncommon knowledge but, in this exclusive interview with The Energy Report, Whale provides a heady glimpse at some prospective alternative energy plays with tangible catalysts for growth. He likes some big-cap energy developers paying dividends and some much smaller solar plays with big upside.
MacMurray Whale: In general, I would say about March. But I think that all of the different subsectors have different timelines.
Ten years ago, we would have been talking about fuel cells and hydrogen, and people would have said at that time that we were in the January of that business. But if you asked me about those companies today, I would say we're pretty much exactly where we were 10 years ago. From a technology-development point of view, there have been amazing developments. But from a marketability perspective, while many drivers have improved, there has been almost no improvement in the financial viability of the companies providing the technology. We're closer but, as an investor, you want to see progress in the business model. We've seen very little progress on the business models of some of the tech names in the alternative energy space.
But if you asked: "Where are we in terms of solar power?" I would say it's vastly different now. Ten years ago, a few off-grid early adopters were paying huge prices simply because they needed the power in a remote location. Now, in certain areas of the world, solar photovoltaic power systems are seeing grid parity. From a market development point of view in solar, we're in December in some parts of the world.
If you're talking about wind, you're beyond that year; it's competitive with incumbents in some places. But if you're talking transportation battery technology or natural gas transportation technology, you're probably not even in midyear yet.
TER: What are the catalysts for growth?
MW: I think there are three major ones: finance, regulation and let's call the other "technology development."
In the finance world, the world went through a balance sheet crisis that caused a recession. Now capital is more expensive and less available. We need to see a willingness for lenders to lend and allow the balance sheets to get bigger again. That's the catalyst we're waiting for.
In terms of regulation, new legislation is very important because of the nature of the incumbent technologies that are being challenged by these new technologies. In some cases, you need regulation to force adoption; in some cases, the regulation helps reduce the costs of switching to a newer, riskier technology. The Cap and Trade Bill that made its way through the House but didn't make it through the Senate would have been a huge regulatory catalyst. There was an energy portfolio standard that was also removed. That would have been a significant catalyst because it would have forced the utilities to adopt alternative energy technology.
The last one, technology development, is just all about hitting a particular cost target. You can't just have performance and cost parity with the incumbent technology. The cost and performance must be better than the incumbent technology because of the risk associated with the new technology.
TER: What's going to give financial institutions confidence in this sector?
MW: That's a good question. I think ultimately it is confidence that a particular technology is ready. What I mean by that is not necessarily that it's cheap and not necessarily that it's hugely better performing, but simply that the risk associated with its adoption is in line with the return that it is providing.
And further confidence will be built around an improving global economy. I think the U.S. is still hugely important in investor sentiment. Just the strength of the economic recovery will create more willing investors because they will be feeling more positive and they will put more money to work. And then that bullishness on the economic front will mean higher energy prices, and that will be a major driver. Although I realize that seems a bit of a circular argument.
TER: But what if an investor wants to put some money into alternative energy. What's there to get that investor excited?
MW: We've seen a big shift just in the last 6–12 months. In the power development space, the power developers that aren't cash-flow positive or the ones that are but don't have a dividend are down 25% over the last 12 months. There's a whole other group—the large caps with a yield—that are up 25%–30% over the same period, so there's been a flight to quality. Northland Power Income Fund (TSX:NPI.UN), Innergex Renewable Energy Inc. (TSX:INE) or Algonquin Power and Utilities Corp. (TSX:AQN) are companies that are primarily renewable—wind, hydro and solar—and those companies have been able to raise capital, raise debt, win contracts and build projects. And their share prices have improved.
The share prices of developer companies, such as Plutonic Power Corp. (TSX:PCC) or the really small geothermals, have really been punished, because an investor looks and says, "Well, I can get an 8% return on a Northland Power, which has projects operating with solid contracts and their projects have come in under budget."
But looking at geothermal power developers, where there is much greater upside, investors will ask about the cost to build, and see that it requires a third or half the total capital even before the resource is known. And the investor just says, "Not right now, thanks."
TER: So then how do alternative energy companies attract the money that's going into oil and gas and even mining?
MW: The power companies need to show a really big resource that is undervalued that some good management team can extract value from; whereas the technology developers have to have something proprietary and not difficult to bring to market.
We've seen some crossover on the geothermal side because it has similarities with mining. The valuation on a geothermal stock is akin to a mining company or an oil or gas exploration company, where you quantify the resource and then discount it.
In contrast, U.S. investors are a lot more used to tech investing. It's like Google Inc. (NASDAQ:GOOG) or Microsoft Corp. (NASDAQ:MSFT), you just get a hockey stick of growth and you take a multiple of earnings into the future and then discount it back.
The people running these businesses and we, as analysts, are trying to find the right investor base for a particular business model. Very rarely have I seen an investor who invests using the "hockey stick" approach who will look at, say, renewable power. However, he will look at a renewable tech play. But on the power side, the investor who does the net asset value (NAV) approach will look at the geothermal plays.
These days, it's just easier for the mining and the oil and gas guys to get their head around a resource value. Because when all is said and done, there's a hard asset to backstop valuation.
TER: In a recent Cormark report, you have some impressive target prices on several companies among the power developers. You have projected greater than 100% growth for MagIndustries Corp. (TSX:MAA), Ram Power Corp. (TSX:RPG) and U.S. Geothermal Inc. (TSX:GTH). Can you tell us about each of those companies?
MW: All these names are typically very early stage companies. MagIndustries has a massive potash project in the Republic of Congo. The resource pre-exists Mag and goes back to the 1950s. MagIndustries has spent well over $100 million developing it. It's a carnallite deposit, and they're planning to use solution mining on it. If this project gets built, it's worth at least a couple of dollars a share. However, they need to raise $1.5 billion to fund the project, and they're a tiny company. Clearly, they don't have the balance sheet to do that, so Mag is looking for a partner. We've been waiting for a Chinese developer to commit to providing that money. A couple of weeks ago, Mag management said they're going to sign a project development agreement with the Chinese sometime in late August. That got people excited again.
TER: They are going to invest $1.5 billion in the Congo?
MW: Yes, there is a lot of country risk. The challenge when you do the valuation is that there better be a lot of upside in order to take that risk. Depending on your potash price and your discount rate, you can easily expect $2 upside. You talk to someone else and he says, "Oh, no. Potash prices are going to go higher in a couple of years; this is a $4 stock." The point is the stock is worth way more than $0.20 or where it's trading now.
These things can turn on a dime, but there's a ton of development risk, and that's why we have a "spec buy" on it.
TER: And Ram Power?
MW: Ram is a geothermal power developer. It has huge potential upside because they have a lot of resources that have been identified and some that they're drilling out. Their first plant is up and running in Nicaragua, and they have power projects in Nevada and California. What sets them apart, and this is very important in power development, is their capital resources. They have a very strong balance sheet, and they're developing in areas and in ways that will allow them to meet deadlines for the investment tax credit (ITC) in the U.S. That's hugely important because that allows them to leverage their balance sheet.
When we value power developers we take the cash they have on their balance sheet and assume that it is used just for the equity position in their various projects. Whether it's U.S. Geothermal, Magma Energy Corp. (TSX:MXY) or Ram Power, you can get an idea of how much of their pipeline is funded on an equity basis. Of course, they still have to raise debt, but notably there isn't any more equity dilution to those projects given the balance sheet. That's the principle on which we're rating these stocks. We're able to say, "Forget about the power agreements they have; just look at the cash." That strategy takes them very far along in development because they can leverage that with the investment tax credit.
This approach also allows you to do a multiple; that's the market cap divided by the cash flow the company can generate from their balance sheet when it's deployed. Ram is trading at less than two times on what we call a price-to-adjusted-cash-flow, whereas a lot of the other companies are trading at 4.5, 5, or even as high as 8 times. Northland Power will have no problem funding its pipeline. It's trading at a much higher multiple, but it should because it's a lot less risky.
TER: It sounds like Ram's management has a good grasp on things if they're getting things done in time to maximize the tax credits.
MW: That's right, and that speaks to another very important point. I think this separates our coverage on this particular subsector from that of other analysts. Ultimately, geothermal development is power development; it's not mining. You need to know at the beginning what the potential economics are going to be for your project.
Getting a power agreement in place is crucial because it tells you what you're working toward in terms of project costs that would make the project financeable. If you can't finance it, you're not going to build it. The lenders have too many good projects to choose from.
TER: Does Ram have power agreements?
MW: It has a number of power agreements for the Orita Project in Southern California, and the Clayton Valley project in Nevada. They are pursuing this acquisition of Sierra Geothermal Power Corp. (TSX.V:SRA), which is very interesting because Sierra brings projects that are adjacent to Ram's properties, yet they're further advanced. It's interesting because both companies benefit. Sierra doesn't have the capital to develop and doesn't have the power agreement. Yet, it's on a timeline to reach the tax credit deadline. Ram has the power agreement and cash, but can't make the deadline.
By merging the two, not only does Ram have a project that will meet the ITC deadline, but it also has a power agreement for it. To me, that is astute project management and development that goes well beyond drilling. There is still drilling risk, but where these guys have gone the drilling risk is lower. The Salton Sea area in California is very well established, and the question is not getting heat and hot water when you drill. The question is: Are you going to get a good flow rate? Are you going to have a lot of sand in the water? But those issues can be managed financially, depending on when you get the drilling done.
There's a different experience level with management at that firm, which is why we like that company.
TER: And your growth projections for all of these companies are within 12 months?
MW: Yes, and that is because of catalysts. With MagIndustries, if the deal with the Chinese developer were not on the table, we wouldn't have that level of potential upside. With Ram, they have a lot of drilling results that are coming out in the last half of 2010 that should be real catalysts for the stock. This isn't something that should take five years; it has the potential to double quickly.
TER: What are the catalysts for U.S. Geothermal?
MW: U.S. Geothermal remains small, but they have some potential projects and expansion projects that are attractive. They've done a very good job developing what they have. They don't quite have the sort of explosive growth, if you will, that some of the other geothermals have, but I think the quality of management is very high.
A lot of investors in this space are interested in takeover candidates whose capital needs to be cheaper. I think U.S. Geothermal could be a potential takeover target.
I think the projects are being undervalued. I think in the space of a year we could see a re-rating of those projects as they continue to move through development.
TER: On Cormark's "Watch List," Acro Energy Technologies Corp. (TSX.V:ART) and NaiKun Wind Energy Group Inc. (TSX.V:NKW) were up about 20% percent in July. Tell us about those.
MW: Acro is a really interesting story in the solar space; they're one of the biggest integrators of solar systems in California. And they don't have any of the sort of principal risks typical with an alternative energy play. They're not buying and building the solar farms. They are operating at the install level, and they're bringing scale to that.
The way they explain how the business works is not unlike getting your kitchen remodeled. You have a guy going back and forth to Home Depot buying equipment at retail and all the while he's wasting time going back and forth. Acro buys equipment at wholesale, gathers the equipment and sends it to the site. The installer shows up and puts it together without wasting any time; it's an efficient business model. And they're buying electrical contractors who don't know anything about solar. They're teaching them the solar part of the game and bringing them the business.
I think they will break even this quarter, showing traction in their model. They've gone from losing money to break even very quickly and are seeing a lot of demand in California. They made some key acquisitions, all in debt, so the debt on the balance sheet is a little high, but it's a really interesting story.
TER: What's the catalyst with Acro?
MW: I think the catalyst is some kind of acquisition. I think there's enough understanding of their business model and confidence in their ability so that if they found a big enough acquisition, they could find the investors to provide funds to buy it while reconfiguring their balance sheet.
They don't need a lot of cash for their business. They have a partner they get a lot of business from, one of the founders who founded this other company called SunRun. This partner is actually the owner of the systems that sit on the customer's roofs. They're providing the capital.
TER: And Naikun?
MW: We basically put that down from formal coverage onto our Watch List because after the company's massive wind project in British Columbia didn't win a key contract, it was a challenge to value the company.
But on that Power Developer List is a company called Etrion Corporation (TSX:ETX), which is a solar power developer. They have a lot of private solar development going on in Italy. Despite everyone's concerns over debt and lending in Europe, they're actually doing quite well and getting financing. They've actually closed on agreements recently, and they have a $60 million credit line with Lundin Petroleum Corp. (OMX NASDAQ:LUPE)
TER: And that's because Lundin is also a part owner.
MW: Yes, so Etrion is actually able to develop very rapidly because they don't need to go to the market and get capital. They can draw down that line and then refinance the projects when they get close to up and running. We've learned that European banks love solar because there's a very low risk associated with the resource, but also in performance. There have just been so many megawatt-hours generated all over the world that people have confidence in these systems providing cash flow.
TER: It seems financing is a lot harder to come by for that kind of thing in America. What's the difference in the mindset between people managing European banks and people managing American banks?
MW: It's a very, very good question. We really haven't been able to figure that out. The European banks like the lack of oil exposure and the lack of natural gas exposure but I believe they're a lot more influenced by the governments to support this type of development.
TER: And in the U.S. you also have a strong oil and gas lobby that probably mitigates some of the government funding for alternative energy.
MW: I think you're right. The oil and gas industry enjoys a number of incentives; just the removal of those would change the cost of energy in favor of renewables.
TER: Are there any other companies you would like to talk about today?
MW: Earlier I talked about yield now being important in investors' minds. I think investors are going to continue to look at yield, and it will be the primary focus on the big-cap power developers. Those are going to trade at a premium. The upside is going to be limited, but investors will receive a dividend or distribution. Our top pick is Boralex Inc. (TSX:BLX). There's a catalyst there with their takeover of the Boralex Power Income Fund (TSX:BPT.UN). When those merge, that company will be trading at a much higher multiple.
Boralax is trading at less than five times the combined cash flow of the company, so there's a significant opportunity there, if that's successful. And I think they will be.
On the technology side our top pick is ATS Automation Tooling Systems Inc. (TSX:ATA). They have a solar element to their business, but it's really an industrial products company. It's like a Rockwell Automation Inc. (NYSE:ROK) in the U.S.; it's exposed to GDP growth. Again, a very low multiple with the option value associated with the spinout of its solar division.
Those two, Boralex and ATS, have real catalysts. They're bigger market cap, a bit more liquid, but they're the sort of stand-out values in the two subcategories that we cover.
TER: Do you have some parting thoughts on alternative energy?
MW: I know everybody's been excited about natural gas and natural gas vehicles and Westport Innovations Inc. (TSX:WPT), but I think that story is over. I think it's not as well managed as it should be; and there's a lot of hype around natural gas that will wane in the next 24 months. I think you're better to stick to lithium and battery technology developers and even the integrators like Azure Dynamics Corp. (TSX:AZD), rather than focusing on natural gas in the transportation space.
Solar will come back; those technologies will do better and wind is certainly solid. But if you want something that has that real sex appeal, it's still the batteries and hybrids and the technology suppliers on that front. The name to look at there is Azure. That stock has done well, and I think it will continue to do well.
TER: This has been great, MacMurray. Thanks very much.
MacMurray Whale heads the Power & Alternative Energy equity research team at Cormark Securities Inc., a leading private investment dealer/broker based in Toronto, Canada. The team covers more than 40 publicly listed power developers and technology firms, active in creating, producing and deploying renewable power and other low carbon/environmental technologies. MacMurray has 20 years' experience in technology research and development reaching back to his doctoral work on photovoltaic energy conversion at MIT, and continuing through his research program as an engineering faculty member at the University of Victoria. MacMurray was the recipient of the prestigious "1967" Science and Engineering Postgraduate Scholarship for his work on microscale heat transfer.
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1) Brian Sylvester of The Energy Report conducted this interview. He personally and/or her/his family own the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Acro, Etrion and Ram Power.
3) MacMurray Whale: I personally and/or my family own the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None.