John McIlveen: Alt Energy Is Still at Value Levels
Source: George Mack of The Energy Report 02/22/2011
Alternative energy is a catchall axiom referring to any source of power generation and use that can replace fossil fuels, including nuclear, solar, wind and geothermal. Humankind will by necessity adopt renewable energy sources but, like all disruptive ideas, acceptance is preceded by doubt and hesitation, resolution of which comes only after systemic shocks like shortages and rising prices. Jacob Securities Research Director John McIlveen staked out this new economic sector to become one of the first North American analysts to specialize in renewable energy stocks. He believes these industries—particularly geothermal, solar and wind—could present unusual publicly traded opportunities for investors seeking truly unique diversification and significant capital appreciation. John spoke with The Energy Report in this exclusive interview to explain his focus and offer several ideas to round out growth-oriented portfolios.
The Energy Report: On June 15, 2010, you wrote that you believed the chances for U.S. passage of climate legislation were improving. Of course, that would be bullish for renewable energy around the globe. But now the political climate in the U.S. has seen an ideological shift with the leadership change in U.S. House of Representatives. Do you think climate change legislation will occur in the U.S.?
John McIlveen: Well, last summer it looked like the Gulf oil spill had played into the Democrats' hands and improved their position in both the House and Senate. However, voters preferred spending cuts and tax-cut extensions instead because the economy and jobs were on their minds. In a better economy, I believe the environment would have been the voters' priority. So, cap and trade and/or a clean-energy standard are likely off the table until the economy improves. There is room for a deal here, however, because with the current makeup of Congress, the Senate can block any restrictions the House would like to put on the EPA—and the House can block any clean-energy standard that comes out of the Senate. So, there's a possible trade in there somewhere.
TER: What about renewable energy as a job creator? Clearly, a nascent industry isn't employing a lot of people, but what's the prospect for renewable energy companies producing large numbers of jobs?
JM: Oh, I think they will and I think they already have. It's certainly the fastest-growing sector in the German economy now, and it's probably now one of the largest sectors in terms of jobs. Going through the whole value chain from manufacturing to service, installation and operation, I think there are millions of jobs to be had.
TER: You're saying it's not just jobs for engineers, but also for workers.
JM: No, not just for engineers. It runs the full gamut—it's construction, maintenance, managers, business offices, etc.
TER: Assuming we lost some of the older energy-industry jobs, could renewables augment jobs in the future?
JM: Yes, I think we'll see a net increase. Construction is certainly job intensive. Renewable energy plant operations are not as job intensive; however, all the service industries that these facilities require are indeed job intensive.
TER: I looked at some alt energy exchange traded funds (ETFs) and indexes you recommended back in mid-June. I put them in an unweighted portfolio and they seemed to show some weakness right after President Obama's State of the Union speech in January. Do you think that resulted from the fact that he didn't commit to an alternative energy plan, or was it just part of the general weakness in renewable energy companies?
JM: No, I don't think the speech had any particular direct impact. Obama's speech was positive for renewable energy stocks—targeting 80% clean energy by 2035, even though we know that has no teeth to it with this Congress. The weakness is a continuation of a trend that started in January 2010, when we saw a rotation into yield stocks and an exit from project stocks. In the second half of 2010 (Q210), project stocks did not enjoy the same rise as the general market. Project stocks are defined as those that need to raise equity to get their projects done and are not yet mature enough to have a positive cash flow. So, the market is continuing to punish stocks that need money.
TER: The ETFs and indexes you recommended were up 16% over the past 52 weeks versus a 23% return for the S&P 500. On a relative strength basis, do you think they are a better value today and are you still recommending them?
JM: Yes. There are two groups here. The project stocks have held these indexes and ETFs back, and they continue to do so. For example, our yield stocks are up 18% in the last six months while the project stocks are up only 1%. There are also a wide range of returns in the project stocks—from up 100% to down 79%, whereas the yield stocks are in a much tighter band—between 7% and 30% up. So, these project companies are now all "show me" stocks. We see them move on achievement of milestones, and this is why we changed our valuation methodology in Q210 to what we call an "as-is" basis—meaning we only value equity-financed projects. We give no value to pipeline projects that may require the raising of equity. You have to see the cost of that equity before you can put a proper valuation on any project.
TER: You moved to a model of not discounting the non equity-financed projects.
JM: If you include the projects that aren't equity financed, you have to include an assumption in your model as to the price that they can raise equity. And as we've seen in this market, everyone would have been wrong in terms of the prices they had in their model.
TER: What kinds of stocks are you recommending investors sell today?
JM: I cover the project companies; within that sector, I have three stocks that are at a Hold rating. They are Ormat Technologies Inc. (NYSE:ORA), Run of River Power Inc. (TSX.V:ROR) and Magma Energy Corp. (TSX:MXY). I think all three of those are fully valued for the coming year.
TER: So, a Hold rating means you should sell?
JM: We define Hold-rated stocks to give less than a 10% return. So, although there may be small returns left to be made, your money might work harder somewhere else.
TER: What about non-renewables like natural and shale gas and oil sands? I know gas is still weak; do you expect these to strengthen further?
JM: Well, results largely have been negative for gas and positive for oil. Obama's speech included gas as a partial clean energy source because it has half the emissions of coal. It is also necessary to reduce emissions in the mix, as backup gas plants must be built for wind and solar for when the wind doesn't blow and the sun doesn't shine. The only risk I see is that if natural gas plants are built instead of other types of renewables, you won't want to see a gas plant actually replace wind or solar. After all, gas plants still have half the emissions of a coal plant but a natural gas plant could be built in roughly 18 months for just about $1 million per megawatt (MW). I believe both the politics and fundamentals of needing gas to back up some renewables will help going forward.
TER: Geothermal is, of course, an alternative energy source. Is it renewable?
JM: Oh, absolutely—there's no fuel cost for renewables. Essentially, what you're doing is taking hot water out of the ground and using it to spin a turbine to make electricity, and then you put the water back into the ground. So, as long as you don't take the water out of the ground faster than you can put it back in the ground, it's a completely sustainable, non-depleting resource, hence it is renewable.
TER: I know you like some geothermals. Could you talk about those names, please?
JM: Yes, in the project category, Ram Power Corp. (TSX:RPG) has been badly beaten up, but the company will be bringing 36 MW online at San Jacinto-Tizate, Nicaragua in July. That should contribute $20 million a year in free cash flow. Drilling on the next 36 MW at the same site should be announced and is expected to be positive, as well. Also, Ram should be debt financed to begin construction on another 25 MW at the Geysers project in Northern California in Q2 and we should hear good drilling results at its Orita (Imperial Valley) in Southern California. So, there are a number of milestones for Ram throughout the year.
TER: You just reduced your target on Ram to $3.60 from $5, but there's still potential upside or an implied return of 150% from here. Could the company be considered a deep-value story right now?
JM: Yes, I would say so. We trimmed our target because the company ran $50 million over budget versus our forecast; so, essentially, the market took more than that off its market cap. Then the CEO resigned and we again reduced our target price to $2.30. And the market punished Ram again to the point that it's trading at just the value of its soon-to-be-online project in Nicaragua. These things always get overdone, and that's the situation with Ram.
TER: Other alternative companies?
JM: There is also Nevada Geothermal Power Inc. (TSX.V:NGP) and a few others— U.S. Geothermal Inc. (TSX:GTH; NYSE:HTM), Etrion Corporation (TSX:ETX) and Western Wind Energy Corp. (TSX.V:WND). They've all been logging milestones and the stocks have begun to recover.
Nevada Geothermal should increase production at Blue Mountain from 38–45 MW this summer, and it should complete a feasibility study on adding 17 MW to the site. We also expect to see another joint venture (JV), probably with Ormat Technologies (like the first one it did). The company would start drilling that one at its Pumpernickel site. We also expect some good results to come out of its Ormat JV at the Crump Geyser site.
TER: A depreciation tax shield might become a windfall for the company. Is that assured, or is it just a possibility?
JM: We've seen this in the sector, but we just haven't seen it in the geothermal industry yet. So, yes, there's a vehicle to allow for the tax monetization of a company's depreciation and depletion allowances— particularly under the new program that extended the investment tax credit (ITC) grants for another year, which means a company can write off 100% of the project in the first year. Normally, it would create nine years of income tax losses to shield income; but with this structure, they can claim the whole thing upfront.
TER: That would be roughly $20M for Nevada Geothermal, right?
JM: Yes, that's the number we'd be expecting.
TER: For a company with a $75M market cap, that's pretty significant.
JM: Yes, absolutely.
TER: What about U.S. Geothermal?
JM: U.S. Geothermal should complete its drill program and start constructing 23 MW at Neal Hot Springs, which is a joint venture with Enbridge Inc. (NYSE:ENB). The company could also announce a second JV with Enbridge on its San Emidio expansion of 9 MW. And it should also bring another 5 MW online in Q411, again at the San Emidio site. So, there are a few milestones to look for there.
TER: Is U.S. Geothermal now at free cash flow break-even?
JM: This year, it should be roughly -$2M free cash flow and in 2012 it should be break-even. Then in 2013, the company should move into a very healthy, positive free cash flow.
TER: And Western Wind?
JM: Western Wind is building 130 MW mostly in California, and it's doing it without raising any equity. Instead, the company is using the ITC grant as collateral to get equity bridge loans. The 130 MW should be online in December; and we expect further equity bridge-loan deals to expand, thereby avoiding adding any new equity into the market.
TER: Western Wind seems to have a lot of catalysts on the horizon. You rate it Speculative Buy with a target price of $2.35. That's still pretty good upside from where it's trading today at $1.41. But WND is up 44% over the past six months—a pretty good run for a company in this group.
JM: Yes, that's right—and that's based solely on the 130 MW it has under construction and the fact that the company was able to do it without issuing equity. There's still another window here next year for Western Wind to do more of these equity bridge deals using the ITC grant as collateral. Now, in our model we don't include any of those possibilities. We include them only when they are equity financed. So, if you add another 50–100 MW project to the portfolio and don't have to issue new equity to get that done, then it's going to be accretive to our model.
TER: How about one more?
JM: Finally, Etrion is a photovoltaic (PV) solar generator based in Italy that's listed in Toronto. In the last nine months, the company's brought on 47 MW—and it's adding another 10 MW in Q211. We also expect Etrion to break ground on an additional 40 MW in Q211.
TER: Thank you. It was a pleasure meeting you.
JM: Thank you. Have a good day.
Jacob Securities Research Director John McIlveen has been with the firm 4 years and has a total of 25 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.
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1) George Mack of The Energy Report conducted this interview. He personally and/or his family own the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Ram Power Corp. and Nevada Geothermal Power.
3) John McIlveen: 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: None.
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