By George Mack
Source: Streetwise The Energy Report
Renewable energy stocks have not been the darlings of Wall Street, but that's just the angle Senior Vice President for Research John McIlveen of Jacob Securities is playing for his institutional investor clientele. He sees renewables as the classic unloved value sector that could pay off big for investors over the next decade. In this exclusive interview with The Energy Report, John shares his best ideas, including some that could offer surprise upside given the right set of deals, power purchasing agreements and joint ventures.
Companies Mentioned: Alterra Power Corp. - BIOX Corp. - Etrion Corporation - Nevada Geothermal Power Inc. - Ormat Technologies Inc. - Ram Power Corp. - Run of River Power Inc. - U.S. Geothermal Inc. - Western Wind Energy Corp.
The Energy Report: After the earthquake and tsunami in Japan on March 11, we saw a spike in alternative and renewable energy shares. But that was short-lived. Even before the situation stabilized and radiation contained, shares of these securities began to weaken again. What's it going to take to get investors into these renewable energy stocks?
John Mcllveen: First off, the rapid rise in renewable stocks was really due to momentum players as opposed to players taking a long-term position. So they were strictly in it for the quick turnaround. What we really need to see is some long-term positions taken. What would that take? We need more success stories among the junior renewables. We have had too many dropped balls on execution, projects over budget or past their timelines or not delivering the amount of power as advertised. And we need more consistent government policy. Policy keeps changing and money hates uncertainty. Rather than these expiry dates or constantly changing tariff rates, we need a policy that can stay consistent for a long period.
TER: Are you referring to policy in the U.S. and Canada?
JM: It's pretty much worldwide. Even in Europe, where they've had these policies for many more years, they still keep changing the rules.
TER: It's a combination of fundamentals such as going over budget and problems with projects, but also government policy. Does one of those weigh more heavily on renewable stocks than the others?
JM: Government policy definitely creates more volatility in the market than the success rate of the project companies. When project companies not executing well fall out of favor, it tends to be for a longer term. In contrast, changes in government policy can cause rapid movements of capital in and out of the sector.
TER: When we last spoke, you talked about an approximate breaking point where if oil reached roughly $150/barrel (bbl.), alternative and renewable power sources might become more attractive. How is that looking today?
JM: The price of oil only impacts renewable power prices in areas where power is generated by oil. This includes much of the developing world where oil-fired power is costing well over $200/megawatt hour (MWh). That's about three times the normal North American rate. So those countries, the Caribbean or Latin America for example, are certainly pushing toward renewable power because just about any form of renewable, except perhaps solar, is costing less than $200/MWh.
TER: In the renewable sector, do you have a favorite source of energy from an investor point of view?
JM: Geothermal. It is the only 24/7 renewable. You cannot close a coal plant and use wind or solar. Those two are too intermittent. Geothermal runs 24 hours a day, 365 days a year; however, geothermal carries high drilling risk, and we need to improve our targeting technology to reduce the risk of dry holes. So it carries more risk but is the only 24/7 renewable that can support base-load power.
TER: So it's comparable to nuclear or coal?
TER: In capacity?
JM: Comparable in capacity and competitive in cost.
TER: We know how important diversification is in owning securities. But, how important is it for investors to be diversified among the various power source stocks?
JM: You'd want to be diversified by geography as opposed to technology. With wind, run-of-river and solar, weather can have a large impact. And, if you're a single-geography company, you'll feel that impact much more heavily. So you should be diversified across geographies. For example, in British Columbia they're having a record hydrology year due to a record thickness in the ice pack over the winter. The ice pack starts melting in May and freezes in December. During that time they're going to have record run-of-river power generation. That may not be the case on the East Coast where we've seen poor hydrology.
TER: Are institutional investors beginning to look at these renewable plays more seriously and not just as a curiosity?
JM: They're looking at that now. I don't think it's a matter of a curiosity. It's still, "What kind of return can I get from this investment?" They are focused on the companies that generate free cash flow so that if one has poor results from one site, it will have enough other sites that can compensate. Or if it's a project company in geothermal and it drills a dry hole, does it have enough cash flow that it can absorb that loss without having to raise equity?
TER: Can we talk about some of your best ideas for investors?
JM: Among my stocks, my two top picks are Ormat Technologies Inc. (NYSE:ORA) and Western Wind Energy Corp. (TSX.V:WND). Ormat is a geothermal leader with over 500 megawatts (MW) and generating $75M (million) in free cash flow. In geothermal terms that means you can expand by 75 MW per year without raising new equity, although, that's probably faster than Ormat can actually drill. The stock is near $17, which is near its 52-week low, and some recent positive announcements have not been priced into the stock. Our one-year price target is $34.
Western Wind is an early stage developer, but it is about to turn free cash flow positive. It will bring 130 MW of wind online this year. That should generate free cash flow of $8M in 2012, which will be enough to start developing the next site. It can then expand with internally generated cash. The stock is at $1.37 and our one-year price target is $2.35.
A higher risk option is Ram Power Corp. (TSX:RPG). Ram has not executed well at its Nicaraguan geothermal site and had to dilute itself severely to cover $70M in cost overruns. The project looks like it is back on track now. However, that's still not certain. That is where the high-risk component comes in. If it's successful, the Nicaraguan project should generate free cash of $15M in 2013 and $25M in 2014. The stock is at $0.37, which is also near its 52-week low, and our one-year price target is $0.74.
TER: You are very positive on Ormat. Back in June the company won a $350M loan guarantee from the U.S. Department of Energy. Is that one of the reasons that you raised your target price from $31.50 to $34?
JM: It is, but that's a smaller component.
TER: Is the catalyst the turbine sales?
JM: That would be the main catalyst. The second catalyst would be Ormat's North Brawley Power Plant. This plant has been operating at about half its capacity, which means it is operating at a loss. It is the only one of over 20 plants that Ormat has that is not operating at capacity. I believe this situation will be fixed over the next few quarters, so we will see an improvement on the power generation side as well.
TER: I couldn't help but note that Western Wind shares have behaved much better than most of the renewable energy companies, and it's held on to its gains from the summer and fall of last year.
JM: The market understands now that Western Wind is executing well and will come online with these 130 MW this year. They've done it without issuing significant amounts of equity, and they have taken those investment tax credit (ITC) cash grants and arranged a bridge loan against those grants, avoiding having to issue equity.
TER: The big advantage for investors is that they haven't been diluted.
TER: You mentioned that Ram Power is a more speculative play for investors. Your implied return based on your target price is something like 50% or 60% from current levels.
JM: Right. All of them are around the 60% range.
TER: You spoke about its execution problems, but Ram has reported exceptional results on the rework of one of its wells, the SJ12-2 in Nicaragua. The well flow tested at 20 MW, and the lender's agent was on hand to verify this. Why hasn't the stock behaved a little bit better?
JM: The lender's representative, GeothermEx, was on hand, but that doesn't mean that it certified the megawatts. A certification by GeothermEx would be a strong Buy signal. Ram will have a large movement upon such an announcement. The idea is not to certify just a single well, but to run the whole well field at the same time and look at the total megawatts. This is needed to release up to $160M in construction debt financing because sometimes when you drill a geothermal well it can cannibalize another well. GeothermEx is running the whole field at the same time and measuring the results now.
TER: Ram also announced a revised power purchasing agreement (PPA) with Northern California Power Agency for the Geysers Geothermal Field Project. Better price?
JM: Yes. Ram got a slightly better price and a little bit better deal on some other terms there. The signed PPA is a positive achievement that will signal the lenders to begin their due diligence to determine what construction loans they might give against the project. I'm hoping for an agreement with nearby Calpine Corp. (NYSE: CPN) to take the steam from the existing four wells and pipe it over to Calpine's plant. That way Ram would avoid building a plant altogether, save a lot of money and earn cash flow from that site two years sooner.
TER: Was there another geothermal that you like?
JM: I like U.S. Geothermal Inc. (TSX:GTH; NYSE:HTM). It has been pulled down unfairly with all the others. U.S. Geothermal hasn't had any miscues. It's been plodding, and it's taken quite some time, but it is bringing a number of megawatts online this year. I expect it to be free cash flow neutral in 2012 and then positive in 2013. So it's a case of the baby being thrown out with the bathwater. It's been executing quite well.
TER: It's down to a $55M market cap, and it's really borderline with respect to the size of mutual fund that can buy the shares, isn't it?
JM: Yes, $100M in market cap is a real cutoff in terms of what funds will participate in that size of company.
I have a $1.35 price target on Alterra Power Corp. (TSX:AXY), and the stock is in the $0.70 range. So you would think that would be enough for it to be a Buy. However, included in my forecast are three events that I need confirmed before I can move that one to a Buy. I need a resolution on their negotiations with Nordural in Iceland. This will allow the company to have a higher tariff on the 80 MW expansion of its plant in Iceland. I'd also like to see a joint venture partner announced and see what the terms of the deal are for the project in Chile. And, of lesser importance, I would like to see the company collect the ITC cash grant, probably $6-$7M, on the Soda Lake site in Nevada.
The only geothermal we haven't mentioned is Nevada Geothermal Power Inc. (TSX.V:NGP; OTCBB:NGLPF). The company has had trouble with its flagship site, the Faulkner 1 Power Plant. It's designed to operate at 45 MW net, but it can't seem to get higher than 35 MW due to the injection program. You have to pump brine back into the ground as fast as you take it out and the company hasn't been able to achieve enough injection capacity to match what it can produce. In effect, you have to lower the plant's output, otherwise you're just draining the system and suffering a high resource decline rate. I don't think Nevada Geothermal is going to see any cash flow benefit out of that particular site. That means their fortune really is dependent on a joint venture with Ormat at Crump Geyser. Ormat is drilling there now.
TER: Ormat's market cap is close to $1 billion. Do you see Nevada being a takeover target here?
JM: Historically, Ormat hasn't bought a collection of assets and certainly not a public company. It is pretty site specific and very careful about what it does. Management probably prefers the joint venture route because they can go one at a time and firm up the resource in their own way before deciding whether to spend a lot of money on it.
TER: You mentioned run-of-river power. You follow one company?
JM: I have a Hold on Run of River Power Inc. (TSX.V:ROR). Its market cap is down around $10M now. It can't really raise equity either. It does have a PPA for a 25 MW project, and it's looking for a joint venture partner. It isn’t going to be able to put much cash into the project so it is going to end up with a minority interest, probably as low as 10%. It hasn't won many PPAs. It has bid on much larger projects than the one it has, but has not gotten them across the finish line. I think its prospects right now are limited.
TER: And you follow one Swiss solar company, Etrion Corporation (TSX:ETX).
JM: It's Swiss-headquartered, but its assets are all in Italy. It's grown quite rapidly. It's got 47 MW generating now, and it'll be at almost 60 MW by the end of the year. It is strongly backed by the Lundin Family (The Lundin Group of Companies), which has provided €60M in bridge loans to construct all these solar plants. However, tariffs are falling in Italy now. Even so, incentives in Italy are still higher than in Germany—probably the highest in the world or near to it. But with the tariffs dropping, it means you have to get a lower price for construction costs.
TER: You're following a biodiesel.
JM: Yes, BIOX Corp. (TSX:BX). The biofuels market right now is driven by the mandatory content requirements in the U.S., a billion gallon requirement in the market. This will escalate slowly, but right now biodiesel still costs more than regular diesel. In order to get rapid adoption, you need to get the price below that. I don't think that is possible with the technologies I know of today, which is why we need the mandate. Right now the price of biodiesel is in the $5.60/gallon range. We need to see it at about $6.40/gallon for the industry to be profitable. That's the key metric to watch.
TER: Do you think of your universe of coverage as a value sector right now?
JM: Looking at the group as a whole, most of them are near their 52-week lows and have been bouncing off that a little bit. So, from a chart perspective, it looks like many of them are beginning to form a value bottom. When that happens, a little bit of good news can go a long way in the price of the stock.
TER: John, this has been so interesting. Thank you.
JM: Thank you, too.
Jacob Securities Senior Vice President for Research John McIlveen has been with the firm five years and has a total of 26 years experience in special-situations research and merchant banking. In 2004, he became Canada's first sell-side analyst to focus solely on renewable energy research and consistently has been ranked a top performer by Bloomberg on accuracy of estimates and returns. He is currently treasurer of the Canadian Geothermal Energy Association and a published academic with 15 papers, including his and coauthor Alan Rugman's 1985 best Canadian book-nominated Megafirms: Strategies for Canada's Multinationals