DOE Energy Storage Subsidies Are Both Heavenly Grants and Hellish Loans 17 comments
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Much of the buzz in the energy storage sector is focused on DOE administered subsidy programs and what they will mean for investors in smaller public companies. The buzz began when Title XVII of the Energy Policy Act of 2005 ("EPACT") authorized $2 billion in loan guarantees for innovative energy technologies. It ramped up rapidly when the Energy Independence and Security Act of 2007 authorized another $2.5 billion in loan guarantees under the Advanced Technology Vehicles Manufacturing ("ATVM") program. It reached a crescendo when the American Recovery and Reinvestment Act of 2009 ("ARRA") authorized $7 billion in smart grid, battery manufacturing and job training grants. Speculation about who will be first in line when Uncle Sugar arrives at the party with duffle bags full of money is running rampant.
I've had nothing but praise for a plan the DOE developed to administer $4.5 billion in ARRA grants for smart grid projects. My fondest hope is that a comparable plan will be implemented for the other classes of ARRA grants. EPACT and ATVM loans, on the other hand, create an entirely different and, to my way of thinking, dangerous dynamic. I fear that these loans could be a kiss of death for any smaller public companies that are unfortunate enough to survive the application process.
The simple and undeniable truth is that nothing destroys financial statements faster than leveraged investments in depreciable plant and equipment, which is why many tax shelters are based on building and equipment leases. By the time you account for interest accruals on debt and depreciation on hard assets the double hit to earnings is devastating. The problem is compounded by the fact that the lion's share of any positive cash flow ends up flying out the door to cover debt service costs; leaving little or nothing in the till to grow a business and pay for research and development, marketing and corporate overhead. By the time you work your way down to the bottom of the balance sheet, the shareholders' residual interest in total enterprise value becomes almost inconsequential. For proof you don't need to look any further than the latest GM restructuring proposal that will leave 1% for shareholders, 10% for bondholders, 39% for the unions and 50% for the government. It's not pretty, but debt financing never is.
For investors that want to transcend the hype and irrational expectations that frequently accompany government guaranteed loans, I've found that subtracting 10% of the planned debt from the expected annual cash flow works well as a simple and reliable acid test. The net positive cash balance, if any, represents the maximum contribution a leveraged project can make to other corporate activities. Since the 10% figure is based on an assumed 20-year amortization of principal and an assumed annual interest rate of 5%, a higher acid test number may be appropriate.
While debt financing can be a heavy burden for borrowers that are well financed and profitable, it gets almost unbearable when the borrower is a smaller public company. First, the borrower will be required to contribute at least 20% of the project costs from its own resources, and that can be a big stretch for a small company. Second, if the borrower has a weak balance sheet or a history of losses, a lender will usually insist that the borrower obtain enough capital to eliminate the weaknesses and provide a cushion against future losses. In risk averse markets like we have now and can expect for several years, the probability that a highly leveraged smaller public company will be able to negotiate significant unsecured debt is almost non-existent; which means that applicants who get loan approvals will be required to sell substantial equity before the transaction can close.
I have participated in several negotiations between investment bankers and smaller public company clients that needed to raise equity as a closing condition for project financing. The negotiations were always ugly and the per share value offered by the investment bankers was rarely more than a small fraction of the market price of the client's stock. When the table pounding and cursing ended, my clients were stuck with a Hobson's choice of either abandoning their plans or selling stock at a steep discount to the market. Either way, the existing shareholders ended up holding the short straw.
Three of the cool emerging companies I track are pursuing loans under the EPACT and ATVM programs. Beacon Power (BCON) is engaged in advanced due diligence for a $50 million EPACT loan that will be used to build a 20 MW frequency regulation facility. In January of this year Ener1 (HEV) announced that it had applied for a $480 million ATVM loan to expand its existing battery manufacturing facilities and build a new plant. Last month, Valence Technology (VLNC) announced that it had applied for a $608 million ATVM to build a new battery manufacturing plant. Of the three announced applications, Beacon's is the only one that even comes close to having a reliable future revenue stream to pay debt service costs. The other two have business models that are entirely dependent on the commercial acceptance of electric vehicles that third parties plan to introduce to the market at a later date. None of the applicants has a history of operating profits or a tangible net worth that represents more than a fraction of the requested loan amount.
My big question is "What the hell are they going to do if the DOE says yes?"
I hope that Beacon will be able to change its pending subsidy application into a request for a combination of ARRA smart grid grants and fill-in EPACT or ARRA loans. They company has been working on its 20 MW frequency regulation project for a long time, it represents an important smart grid technology and it deserves to be installed and thoroughly tested. From what I know about the process, I believe the DOE would be likely to approve a combined grant and loan structure. I'm less optimistic about the chances that Ener1 or Valence will be able to negotiate financially sound alternative proposals. If it can't do so, a rejection of its ATVM loan requests would probably be the best thing for the company's shareholders.
In almost 30 years of practice I have never seen a smaller public company borrow its way to prosperity. The debt financed projects I've been involved in never worked as well in the real world the way they did on paper. The existence of a large secured creditor with a first claim on major assets always complicated negotiations with junior lenders. A highly leveraged capital structure always made negotiations with new equity investors difficult, if not impossible. In every case, existing shareholders who bought a debt-free capital structure, and ultimately found themselves at the bottom of the food chain, felt the lion’s share of the pain. This is not a theoretical issue for me. It's one that has cost me millions of dollars over the years. I've been through the drill more than once and would never go there again.
Disclosure: No position
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This article has 17 comments:
The first step in solving a problem is acknowledging its existence. Criticizing me will not change the fact that the publicly disclosed loan proposals can only crush the stockholders of companies that recieve the mother of all sub-prime loans.
I find Knowsitsurelock's comment very hard to read, but my best parsing of it finds it to be complimentary. You should read it again.
(Maybe I'm wrong - if so please disregard or reprimand me for my poor reading comprehension.)
Beacon is taking a rational approach and consistently raising equity at a price their market will bear. They're also well advanced in the DOE process and I think they probably have a good shot at converting the loan into a combined grant and loan structure. With a consistent cash flow and much lower leverage the project will work much better for them. I would also think that a combination structure would make it far easier to bring in a larger equity investor to increase stability.
The other two are tougher because the cost of building a factory only gets you about half-way to an operating business. By the time you include inventories and receivables, the cost of running a factory is roughly 2X the cost of building the factory.
Many years ago I had the pleasure of watching some close friends build a manufacturing company named Compaq. They started with a modest facility, ran its production to capacity and immediately went back to the market for more equity for more facilities. They kept their debt low and sold stock at every reasonable opportunity. The debt they did carry was mainly revolving credit for inventories and receivables.
CFOs are always delighted when they get a check from a financing transaction because they can always put the money to good use. I have never seen a CFO smile while he wrote a check for dividend, interest or principal payments because he could always think of about a dozen places that needed the money.
I'm very old school when it comes to financing small companies. Do it with equity, do it early and do it often. Don't let your market price run to a number that will scare off new investors. Use debt sparingly until your business is stable enough to justify a solid credit rating and reasonable rate. Take baby steps to prove your ability to manufacture and sell a competitive product and then move on to more aggressive growth after you've shown investors that you know how to make money.
Don Harmon
My sense is that the battery manufacturing grants will have to go out in bigger increments to a smaller number of applicants because even modest sized battery manufacturing plants can run to a couple hundred million dollars.
Without knowing a lot more about your needs and plans, it would be very difficult to offer any advice.
One of the most intriguing opportunities that seems to be coming for smaller companies is the ARPA-E initiative. This is modeled after a long-running DARPA program that is designed to make staged funding available for small companies and in manageable amounts. I'd be happy to talk with you about the options but think direct contact would make more sense. ipo-law.com
Derek, Toronto
Another issue that merits discussion are the industry and investment "conferences" that have become so popular. For attendees they're great sources of information. For presenters, a conference is a PR opportunity, a chance to get your face in front of a crowd, tell your story and hopefully build your contact network. It's an advertising expense, not business news. I'm always wary when companies spend too much time presenting at conferences. It usually indicates an unhealthy focus on talking about a business instead of building a business.
Now "Gass" wants to borrow from Uncle Sugar (like that one) a little less than a half a bil that was, until very recently, more than his market company's cap.
This is a bad pipe dream only getting worse for the American taxpayer.
Maybe, for more Sunday fun, I'll go read Ener1's balance sheet!
www.energy.gov/news200...
This could very well be the mix of ARRA grants and EPACT loans to Beacon of which you write above. We shall see.