Geothermal power generation is becoming a viable solution to the US's and world's reliance on fossil fuels. Ormat Technologies Inc (NYSE: ORA) is best positioned in the geothermal industry. Most renewable resource power generation is still expensive and has disadvantages that still outweigh the benefits, strictly from a business perspective. Geothermal energy comes as one of the very few renewable energies that is not intermittent (running 24/7), does not rely on an underlying resource taking resource price risk out of the equation and is relatively cheap to generate on a kilowatt measure compared to other renewable energies. Geothermal price has come down partly due to increasing natural gas and oil prices during much of this period and, equally important, to newly enacted legislative and regulatory requirements and incentives, such as state renewable portfolio standards and federal tax credits.
- Coal - 4.8 - 5.5 cents/kW-h
- Natural Gas - 3.9 - 4.4 cents/kW-h
- Nuclear - 11.1 - 14.5 cents/kW-h
- Solar - 15 - 30 cents/kW-h
- Hydro - 5.1 - 11.3 cents/kW-h
- Wind - 4.0 - 6.0 cents/kW-h
- Geothermal - 4.5 - 30 cents/kW-h
Ormat Technologies is in the geothermal generating business with 86 intellectual patents and management with over 30 years of geothermal know how. The company is composed of two segments, electricity and product segments. 75% of revenues are through the electricity segment, while the rest is through the product segment. It is very beneficial that 3/4 of Ormat's revenue is from their electricity segment because each power plant has a long term power purchase agreements (NYSEARCA:PPA) with utility companies. These PPAs stretch out over a number of years, locking in customers and giving Ormat a nice income stream into the far future and a narrow moat (competitive edge). The average PPA of the 16 plants extends to 2024.
The product segment has a $241 million backlog, which will mainly be realized in 2013. The company currently generates roughly 580 megawatts of energy. A large upswing is possible to occur if and when the 7 plants under construction go online. The Sarulla project, one of the main plants under construction in Indonesia, is set to produce 330 megawatts which Ormat has a 12.75% ownership in -- an example of what is in store. Pre-plant construction also looks promising, with 32 area prospects composed of 340,000 acres currently in the exploration process. Chile has 336,000 acres set for exploration, and the company has the option to enter in geothermal leases covering an additional 264,000 acres all over the world. The company has an extremely large growth potential, but only if it has the ability to access capital. If a large macroeconomic downturn similar to 2008 repeats, Ormat's growth could be delayed. With that said, Ormat has the advantage of accessing federal grants and tax incentives, so they are somewhat shielded from a recession.
While geothermal energy can be relatively cheaper to produce compared to other energy, geothermal has a large upfront cost in exploration and construction. The US government does provide tax breaks and grants to minimize costs for geothermal companies, however, it is uncertain how long these benefits will last. Cost to transmit energy from remotely located plants also is another cost negative.
Ormat has been successful in generating a good return out of their older plants, upgrading them and constructing newer plants relatively on schedule. The downside of Ormat's rapid growth is that they are highly leveraged with net debt/capital of 49%. If construction slows and successful completion of plants is delayed or the exploration of new geothermal areas does not materialize, Ormat's ability to pay their growing interest expense will become a large problem.
Ormat is largely expanding abroad and is susceptible to foreign government intervention, which might not be as favorable as the US. However, some countries like Japan are welcoming geothermal energy with open arms and aim to add 670 Mega Watts by 2020.
Due to Ormat's heavily leveraged nature, owner's earnings (cash flow from operating activities - capital expenditures) has been negative for the last 7 years which is not something I feel too comfortable with. However, based on a rough estimate of Ormat outputting 850 - 900MW of power by 2015 - 2016 and margins hovering around their current positions, Ormat's current fair market value should be around $25. Ormat would be currently trading for a moderate margin of safety at the current time.
With a narrow moat and potential growth, Ormat is positioned well in the geothermal energy industry. The main unknown going forward is if and when geothermal becomes a common source of energy utility companies are willing to utilize. If problems bringing new plants online persist, then returns on capital will continue to depress, leading investors to run towards the exit.
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