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Peasgood Preaches Patience on Geothermals
Source: Brian Sylvester of The Energy Report (8/31/10)
Wellington West Analyst Sean Peasgood covers the geothermal, plasma gasification and "Smart Grid" subsectors of the alternative energy (AE) market. He believes there's room to make some dough in each of them but believes investors may need to be patient as these growing markets gain traction. Sean reveals some names to help you earn your reward in this exclusive interview with The Energy Report.
Sean Peasgood: I've been covering the technology and clean-technology sectors with Wellington West now for about 10 months. Before this, I was with a bank-owned dealer for about four years covering the technology sectors as an associate analyst. I now cover the alternative energy space, focusing on geothermal, plasma gasification and the Smart Grid markets.
TER: Could you give us an overview of those alternative energy subsectors and their respective outlooks?
SP: Let's start with geothermal. While the stocks in this sector have been relatively weak over the last few quarters, we have a positive long-term view on the space. It takes significant capital and time for these projects to come online. I believe that early stage investors will benefit as projects generate significant free cash flow in the future. Eventually, they will look more like utilities and less like exploration companies. Investors who get in today will benefit from capital gains in the short term as projects come online and then from dividend-yielding equities in the future.
Given the baseload nature of geothermal, we believe utilities are more interested in signing attractive power purchase agreements (PPAs) than relying on more intermittent sources of renewable power, such as wind and solar.
We also cover the Smart Grid market, which is essentially the deployment of Internet protocol (IP)-based communication networks across the existing power grid. The goal is to increase efficiency, enhance control and provide visibility across the grid for utilities. The lack of infrastructure and maintenance upgrades over the last several decades, along with increasing demand for power, have reduced the reliability and quality of power not only in the U.S. but around the world. This problem is only being exacerbated as the world looks to add renewable energy sources to the grid. While some of these upgrades have already begun, we believe this deployment will take place over the next 5–10 years. This should translate into strong revenue and earnings growth for a variety of IP communications-infrastructure companies both wireless and wired.
Finally, as I stated, we cover the plasma-gasification market, which is an emerging alternative technology being used in waste-to-energy projects, as well as producing cellulosic ethanol. Plasma gasification reduces emissions and produces a synthetic gas that can be used to generate power. In cellulosic ethanol production, this synthetic gas is fermented and converted to ethanol. There are a number of projects getting underway in North America, and we're seeing interest for this technology in India and China, as well.
TER: Given the speculative nature of these alternative energy plays, what type of investor should be looking at this sector?
SP: I think investors should look to balance their traditional energy exposure by adding newer alternative energy companies to their portfolios. In many cases, these new technologies are just emerging; so, while they have more risk than more traditional energy plays, when they begin to gain traction, investors could be handsomely rewarded. That said, there are ways investors can reduce this risk exposure. For example, investing in early stage geothermal companies is, obviously, more risky than investing in some of the larger players that have a portfolio of projects and stronger balance sheets. We believe risk-averse investors should look to the larger players in the market to gain exposure to these growing markets.
Investors in the geothermal market need to have a multiyear time horizon, as development can take several years. As these companies bring projects online, I expect the share prices to continue to increase as a reflection of lower exploration and development risk. Then, as they start generating stable free cash flow, they will trade more like utilities and, eventually, provide dividends.
TER: What's the timeframe on that?
SP: Generally, projects take about three to four years to develop. Depending on who you're looking at in the space, most companies that we cover—I'm talking about Magma Energy Corp. (TSX:MXY) and Ram Power Corp. (TSX:RPG)—have a portfolio of projects that will come online over the next few years, leading to a steady increase in megawatts (MW) online. Ram, in particular, has a 32 MW project in Nicaragua that will come online in the second quarter of 2011, which will immediately provide them with an increase in their top and bottom lines. Two quarters later, they're going to bring an additional 32 MWs online, meaning the company will be generating 72 MWs in total by the end of 2011.
Companies have been developing things in sequence. So you're going to see multiple projects coming online every year, which will be positive for the stocks and help fund future growth.
TER: In looking at your research, some of the price targets in your recent reports are a bit more aggressive; but some targets you set earlier this year were rather conservative. For example, in a report on RuggedCom Inc. (TSX:RCM) dated May 28, 2010, your target price was a mere 21% above the existing price. Using that as an example, are your conservative targets more indicative of your approach or sector weakness?
SP: Generally, I try to weigh the growth opportunities with the risk factors and be as fair as possible. As far as RuggedCom is concerned, I've become more aggressive on it lately given the recent slide in the stock, the company's leading market position and the significant growth opportunity in the market. They are actually benefiting from not only Smart Grid opportunities but also from other industrial ethernet markets like transportation and infrastructure.
For the geothermal space, while we are bullish long term, investors need to understand the risks involved in these projects. There's financing risk, which has recently been improving, and political risk, as government grants can enhance the value of projects and some of the projects are in foreign jurisdictions. As projects advance and get de-risked, then I will become less conservative. But I think at this point, it's fair to provide investors with the full set of risks and that's reflected in my forecasts and price targets.
TER: You've mentioned Smart Grid a few times. Everyone has heard of the grid, but what's a Smart Grid? And why should investors look specifically at this alternative energy subsector?
SP: Essentially, the Smart Grid is the deployment of a communications backbone over the existing power grid—all the way from power generation out through transmission and distribution, and then into the home. Most of the infrastructure out there really hasn't changed in 100 years. What we have now is significantly higher demand for electricity across a decaying grid infrastructure that is becoming less reliable and efficient. The idea of the Smart Grid is to deploy a communications backbone, so utilities have full visibility across that grid.
Over the last few years, there's been a real focus on putting smart meters in homes. Smart meters provide the user with visibility and the ability to switch their habits to use more power at off-peak times and also provide the utility with information about electricity demand patterns. For example, with a smart meter, the utility can charge a little bit more for running your dishwasher during peak times and try to encourage you to run that dishwasher at night. That's the first phase.
But we believe the next phase is the more important part of the Smart Grid, where communication infrastructure is being placed in substations across the grid, so utilities have even greater visibility and control. Right now, if power goes down, the utility has no visibility and must wait until customers contact them to let them know. The Smart Grid provides the opportunity to put a communications network in place, so utilities know if they've just lost a whole block and immediately take action. This should reduce power outages, which negatively impact GDP and are becoming more frequent.
This is where RuggedCom has been focused for about seven years—putting routers and switches and IP-communications equipment into substations. Currently, in most substations, there is no infrastructure to alert utilities, which can result in a fault in the substation. But with this equipment, all of those things can be monitored in real time; and the equipment will make the appropriate adjustments with very little need for human intervention. This full communications backbone is the real solution to providing utilities with the visibility to meet growing demand, increase efficiency and reduce greenhouse gas emissions.
RuggedCom has a strong management team, backed by a number of individuals from General Electric Company (NYSE:GE). I really like this stock (we have a Strong Buy rating on it and $20.50 price target), and I think it's a good way for Canadians to play the Smart Grid. Currently, there aren't many public companies in Canada that are exposed to this space like RuggedCom. The major risk for investors is the potential for lumpy quarters, which can lead to volatility in the share price. To gain a better understanding of the business, investors should look at results on a trailing four-quarter basis, which illustrates the consistency in revenue and earnings growth over the last several years.
TER: What countries are deploying this technology at a rapid rate?
SP: There's been a lot of attention on smart meters in North America and Europe. Substation automation is happening globally; however, the upgrade process has been one or two substations at a time, rather than the mass smart-meter deployments we have seen to date. When utilities upgrade a substation, they'll upgrade all the communications equipment inside at the same time. Given utilities' risk aversion and new technology, the sales cycle for these products can be 12–18 months. To put this in context, last year the market for substation automation-communications infrastructure was roughly $150 million. If you just look at all of the substations in the world and assume that 20% of those have been upgraded, which is probably a conservative view, to upgrade the rest of the substations would be about a $4 billion opportunity.
TER: That's not an overly huge market though.
SP: That's just the substations—just one piece of the overall Smart Grid opportunity. It shows you where the market could go. I mean it's very, very small right now as utilities are really only upgrading a few substations at a time. Could it multiply significantly over time? We believe it will, but it's really going to be about how quickly these utilities adopt this technology across their footprint.
TER: You mentioned Asia earlier. In other sectors like mining, China has changed the way businesses operate. Last year, according to an alternative energy report that came out earlier this week, $34 billion was spent on solar and wind projects in China. What sort of impact is China having on the AE sector?
SP: As one of the world's fastest-growing economies, China is going to be an important part of this market for many years to come. Right now, about 90% of China's energy is from nonrenewable sources. The Chinese government wants to get that to 18% by 2020. Electricity demand there is growing significantly, so you know this is going to require significant investment. We're already starting to see that in wind and solar. We believe all of the markets we have spoken about so far should benefit from that region.
TER: What are some companies other than RuggedCom that have significant exposure to China?
SP: One would be Alter NRG Corp. (TSX:NRG; OTCQX:ANRGF), which is in the plasma-gasification market. The company just signed an agreement with Wuhan Kaidi Holding Investment Co. to develop a number of waste energy plants in China. They're going to start with a small demo plant, which is expected to be online in mid-2011. Then they're going to look to develop up to 50 additional plants in the future. Alter NRG is also in discussions with other parties in the region that want to take advantage of the waste-energy market. Currently, most waste sites are still using landfills and incinerators. These Chinese engineering companies are looking to use plasma-gasification technology to eliminate waste and generate electricity.
TER: How does that work?
SP: Plasma gasification is a thermal/chemical process that converts low-value, carbon-based feedstock into a synthetic gas (syngas), which in turn, can be used as a fuel or combusted to generate steam or electricity. Alter's plasma-gasification technology has been recognized for being very flexible, enabling it to handle a variety of feedstocks. This is important as some competitors' gasifiers require the feedstock to be treated or prepared prior to gasification, which can increase project costs.
TER: That technology sounds interesting. Did they develop it?
SP: They bought Westinghouse Plasma Corp. (NYSE:WEST) gasification technology in 2007 for US$29 million. Alter is working with a number of large players to bring projects online over the next several years. For example, Coskata Inc. is developing a large cellulosic ethanol facility that is trialing Alter's technology in their pilot facility. Alter is also working with NRG Energy, Inc. (NYSE:NRG) to retrofit coal-fired plants to use gasification and reduce emissions. While all these projects are still in the early stages, they offer large opportunities. Any one of those, if they come in, would take this company from $1M–$3M/quarter to between $30M and $90M for just one of these projects. I think it's just a matter of time before the company gets one of these large projects across the finish line, which would help prove to investors the large market opportunity for this technology.
TER: What's your target price for Alter?
SP: Given the projects are still largely in the trial phase, we have a Speculative Buy rating on the stock and a price target price of $2.50.
TER: Another statistic in that same report was that investments in geothermal power fell from $2.2 billion in 2008 to $1.5B in 2009. What accounts for that drop, and how should investors interpret that 31% decrease?
SP: I will start by saying we continue to see strong demand and development both here in North America, and all around the world in the geothermal market. There's a lot of development going on in Africa, Indonesia, the Philippines and Australia, to name a few. We continue to see new projects being explored with companies and governments promoting the development of geothermal projects.
I think the drop in 2009 was largely due to the tightening of the credit markets following the credit crisis. These projects need significant amounts of debt financing to get across the finish line. Before the credit market seized up, geothermal companies needed to have 50%–60% of the resource proven out before getting construction financing. This increased to 100% in the height of the crisis. Good news for investors and the market, in general, is that we are beginning to see the credit markets loosen up. On Ram Power's recent conference call, management indicated that one developer in California was able to get debt financing after only having 60% of the resource proven out and the terms on the paper were more attractive by 200 basis points. It's nice to see that those markets are starting to open up, because geothermal is so capital intensive that this was a barrier to development. As long as the credit markets continue to behave, then I would expect those investment numbers to reverse.
TER: What companies are you following in geothermal?
SP: We cover four companies in the space. The two large ones that we cover, Ram Power and Magma, probably get a little more attention given the larger project portfolios and strong balance sheets. The Ram Power management team has significant experience in the space and has a number of people working for them who were formerly with Ormat Technologies Inc. (NYSE:ORA). The Ram team has numerous projects that they're developing right now, which, as I said, are slated to come online in 2011. They also have a number of properties in the U.S. that they're developing and recently announced that they were going to acquire Sierra Geothermal Power Corp. (TSX.V:SRA) to add to those properties, some of which are adjacent to their Clayton Valley project.
TER: What's the status of that takeover?
SP: Management indicated that they expect the transaction to be completed in the third quarter. They also said they would come back to the market with specific details as to how capital expenditure requirements may change, and how quickly some of those projects at Sierra may advance. It's a nice acquisition for both companies because Sierra was having trouble raising the funds needed to continue development, and Ram has a much stronger balance sheet and the ability to access capital markets to develop those projects. I think the combination of the two is going to be positive.
TER: What are Ram's catalysts for growth?
SP: I think the catalyst is that Ram has done exactly what they said they were going to do. Their projects are all advancing on time and on budget. The share price has been weak recently, but really the whole sector has shown some weakness.
My view is that, as we get closer to the Nicaraguan project coming online in 2011, investors will be able to better understand the cash flow from these projects. While it's capital intensive upfront, investors who get in early are going to benefit as these projects come online. But, from an investor's perspective, getting in front of that, and then having the second project come online later that year, are two big catalysts for the company.
TER: But these geothermal projects in development are in Nicaragua. Do you consider Nicaragua a safe jurisdiction?
SP: Well, obviously, there's some political risk; but, from what I understand, the government is very supportive of the development and the country needs access to reliable power. Ram has a PPA in place and management has been operating in the region for some time. I don't see this as a major risk, but investors should always stay tuned into political issues where these geothermal projects are located (as things can change over time).
TER: What's your target on Ram?
SP: We rate Ram Power a Buy with a $4.50 price target.
TER: What are some other geothermal companies you're following?
SP: I also cover Magma Energy, which is similar to Ram in that it has a strong management team, healthy balance sheet and is also helping to consolidate the industry. Right now, the focus at Magma is what's going on in Iceland. They had a 46% stake in HS Orka—an Icelandic company that generates about 175 MWs annually. They recently made a bid to increase their stake to 98%. However, over the last few months the Icelandic government, spurred on by some high-profile people in Iceland, has become more concerned with foreign investment. They are now reviewing that acquisition by Magma. There has been some uncertainty in the stock over the last month or so given these developments. The company has stated it's going to move forward with that acquisition and recently announced they had closed an additional tranche, taking them to 84%. We continue to believe this transaction will be successful; however, investors do need to weigh this political risk.
TER: You mentioned Magma's management. That company is headed by Ross Beaty, who made a name for himself in mining and, more specifically, as chairman of Pan American Silver Corp. (TSX:PAA; NASDAQ:PAAS). Could you comment on Magma's management?
SP: Obviously, Ross is very well respected and has done a great job of creating value for investors in the mining space. I think investors expect that to continue in the geothermal space. Coming from the mining industry, the company is familiar with exploration activity, working in different regions of the world and working with different governments. I think those are all synergies as far as moving from mining into geothermal.
Ross has done well to attract talent from across the industry and now has a strong management team behind him, as well. And that's another aspect of this Iceland acquisition—he is adding significant human capital that he'll be able to leverage across other projects they are developing. The stock has been weak, but I think it offers investors an opportunity to get into a company with proven management, a very attractive basket of assets and a strong balance sheet that should allow them to develop those assets. If this Iceland ordeal can blow over, we believe the stock should recover nicely. We rate Magma a Buy and have a $2.40 price target.
TER: Do you have some final thoughts on the sector?
SP: Investors in the geothermal space are going to have to be patient while projects come online. That said, the rewards for early stage investors are likely to be higher than for those who wait until the companies are spitting out strong cash flow. At this point, a new set of income-seeking investors will likely look to take advantage of utility-like stocks that will generate stable free cash flow and are likely to produce dividends.
The other question is: Will large utilities step in and potentially buy these companies in order to meet their renewable targets? We believe that utilities are unlikely to take on exploration risk today; however, as projects come online, we believe these companies could be strong acquisition targets.
Sean Peasgood is an equity analyst at Wellington West Capital Markets, covering the clean-technology sector. Before joining Wellington West, Peasgood worked in the equity research department of a bank-owned dealer covering the technology space as an associate analyst for four years. Sean has a HS.Bc. from McMaster University and an MBA from Saint Mary's.
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1) Brian Sylvester of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report or The Gold Report: Ram Power.
3) Sean Peasgood: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family are paid by the following companies mentioned in this interview: None.