by Mark Barnett
One of the brightest stars in the Morningstar alternative-energy universe is Ormat Technologies (ORA), the premier developer and operator of high-efficiency geothermal equipment and power plants. Cost overruns at its newest plant, North Brawley, combined with a drop-off in the products business in 2010 drove Ormat's shares well below our fair value estimate. Concerns about the viability of U.S. renewable tax policy, a primary financing vehicle for growth, have kept up the pressure.
But with its recent financing successes and substantial new plant orders, we think the time is right to scoop up shares before results improve in a big way in 2012 and beyond. Ormat's low-cost, environmentally friendly advantage makes it the only independent power producer in Morningstar's coverage universe with an economic moat, and it is currently the only alternative energy company Morningstar covers with a 5-star rating.
Industry-Leading Growth on Tap
Ormat, whose vertically integrated business designs, builds, and operates geothermal power plants, as well as supplies them for third parties, is poised to grow EBITDA and earnings faster than its independent power-producer peers without the volatility that competing fossil-fuel generators experience.
Ormat's low-cost, environmentally friendly and reliable generation gives it a unique competitive advantage in the power generation industry, as geothermal uses the earth's natural heat and no fossil fuels to turn turbines. Without exposure to fossil-fuel commodity costs, emissions liabilities, or weather-related operating variability like solar and wind, utility distributors are willing to pay premium prices to lock in Ormat's generation supply and prefer it where available. And if state and federal environmental regulations remain in place, Ormat's competitive advantage will strengthen.
Ormat's large pipeline of development projects supports the significant growth we forecast at its flagship generation segment. Improved development incentives and financing opportunities should help Ormat bring on line nearly 150 megawatts of new capacity though 2013 and another 150 megawatts between 2014 and 2015. This represents more than 60% capacity growth from our 2010 estimate and offers long-term, contracted profit growth independent of volatile fuel costs.
In addition to Ormat's generation segment growth, we also think the market is undervaluing the growth potential of its products business. Two large deals signed so far in 2011 have boosted its fast-growing backlog. In addition to the growth from its backlog, we think the business could win supply contracts worth as much as an estimated $400 million for a large project in Indonesia and a recently announced project in New Zealand.
Combined, we think Ormat's generation and products businesses will drive 28% annual EBITDA growth through 2015, with big step-ups in 2013 and in 2015, when significant new capacity comes on line. With Ormat's market valuation currently below its slower-growing, commodity-sensitive peers, we think Ormat offers an attractive risk-reward profile.
Cheaper Than Solar, Competitive With Wind
The source of Ormat's economic moat derives partially from its leading position in low-cost geothermal power generation. The graph below shows how geothermal is an economically attractive power generation source, especially relative to solar sources. As the largest pure play and most sophisticated geothermal industry player, Ormat benefits the most from these attractive economics. We note that for purposes of calculating the geothermal LCOE below, we utilized the high end of industry capital cost estimates.
Another competitive advantage for Ormat is its access to financing, typically the biggest challenge for geothermal developers. Most geothermal projects require an initial exploration phase to prove out the resource for development, typically funded by corporate cash. This limits the ability of many smaller players to manage the long development cycle for new geothermal construction. Ormat's size and ability to fund early-stage development from its balance sheet is a huge advantage over smaller competitors. This allows the company to take more chances and explore a larger portfolio of land, increasing the odds of proving a viable resource and securing external financing.
Once a project is viable, U.S. federal tax incentives give geothermal an additional cost advantage over its fossil-fuel competitors. Current tax policy allows renewable energy developers to utilize a production tax credit (PTC), investment tax credit (ITC), or cash grant. Developers like Ormat can pass these tax benefits on to tax-equity investors in return for project financing. While required returns for all renewable tax equity deals have gone up significantly since the financial crisis, meaning lower returns for Ormat, the ITC and cash grants have helped spur major growth in the tax equity market after it contracted in 2008. Accelerated depreciation is also a strong incentive. Standard tax policy offers five-year depreciation for geothermal projects. The 2010 stimulus bill offered 100% first-year depreciation for projects completed in 2011 and 50% first-year depreciation for projects finished in 2012. Federal loan guarantees, which lower debt financing costs, are yet another financing benefit for geothermal projects.
Are Renewables on Washington's Chopping Block?
Investing in renewable energy has certainly been a roller-coaster ride recently. U.S. federal tax incentives and increasingly demanding state renewable energy mandates swelled investor optimism prior to the 2008 financial crisis, boosting growth projections along with share prices. When the crisis hit, financing for all but the largest renewable developers ground to a halt. Some of the biggest players in arranging tax equity deals either went bankrupt, like Lehman Brothers, or played out like the Wells Fargo takeover of Wachovia, where Wells Fargo's tax base was depleted by Wachovia's losses in addition to its own, shrinking its appetite for tax equity. Many renewable energy projects simply fell off the table along with stock prices. Geothermal suffered as much as any, given the longer lead times to bring projects to viability and high up-front construction costs.
Much attention has been focused on the potential for these tax incentives to expire or be axed given Washington's focus on deficit reduction. In addition, some states are reconsidering their fast-approaching renewable energy mandates. Whatever your ideological position, one undeniable fact is that renewable power saw a renewed surge in investment interest with the extension of the ITC and PTC and the creation of the cash grant program. Another is that, like it or not, a majority of Americans polled consistently support government incentives for renewable power, regardless of their views on global warming. Given the tiny slice of the federal pie that currently goes toward these programs, we think incentives for renewable energy are here to stay, and that Ormat is well-positioned to benefit.