Polaris Infrastructure - More To Come

| About: Polaris Infrastructure (RAMPF)
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Summary

After a big run up, shares are still way too cheap.

Dividend raises are the catalyst for shares to reach fair value.

Future project provide the possibility of an even greater upside.

The recapitalization and a successful drilling program make past financial statements meaningless in predicting the future development of the company.

After a big run up of over 90 % in the last year one, can ask the question if it is time to sell shares of Polaris Infrastructure (OTCPK:RAMPF). In this article, I will show why shares are still undervalued by a big margin. I will also shine some light on the company's debt issues.

Polaris Infrastructure is a geothermal company focused on developing and operating geothermal plants in Latin America. Currently, the company operates one geothermal plant called the San Jacinto Geothermal power plant, in Nicaragua.

History

In May 2015, the company underwent a recapitalization. This recapitalization was necessary because the company had piled up too much debt.

The recapitalization led to a big dilution of the old shareholder base. Bondholders also suffered. The secured debentures of the company were converted into equity while the project-level debt had its duration extended and its return enhancement reduced.

Debt issues

The new terms of the company's debt can be seen here:

Debt Issue

Expiration Date

Interest Rate

Phase I Senior Debt

December 15, 2024

Three-month LIBOR plus 6.5%

Phase I Subordinate Debt

December 15, 2025

6% fixed

Phase II Senior Debt

December 15, 2028

Three-month LIBOR plus 6.5%

Phase II Subordinate Debt

July 15, 2029

6% fixed

All issues have special covenants that make them non-standard debt issues. A valuation has to take this into account due to the different possible future debt payment scenarios.

The senior debt issues both offer the possibility of future interest rate reductions. If the following production conditions are met during the last three month of each period, the interest rate will be reduced by 0.5% every time the conditions are met:

  1. May 13, 2015 - May 31, 2017: 58 MW (net)
  2. June 1, 2017 - May 31, 2018: 55.1 MW (net)
  3. June 1, 2018 - May 31, 2019: 52.3 MW (net)

Current gross production stands at 68 MW. Assuming net production at 90% of gross production like in the past, the current net production stands at 61.2 MW. Therefore, I do not see a reason why those rate reductions should not be implemented.

The subordinated debt issues both have a return enhancement of 3% of the annual EBITDA. The enhancement is capped at 13% of the principal amount of the issues.

Now we can calculate the future interest rates of the company. Here, I show the two extreme outcomes. The one with and the one without return enhancement. As explained above, I see the interest rate reduction as a given. Therefore, I include it in both calculations.

First, I show the future interest payments under the assumption that the EBITDA enhancement of the subordinate debt is fully used:

Issue

Principal

Current Interest rate

Interest rate 2017

Interest rate 2018

Interest rate 2019 and beyond

Phase I Senior Debt

$41.13

7.35%

6.85%

6.35%

5.85%

Phase I Subordinate Debt

$12.77

13.00%

13.00%

13.00%

13.00%

Phase II Senior Debt

$111.57

7.35%

6.85%

6.35%

5.85%

Phase II Subordinate Debt

$17.71

13.00%

13.00%

13.00%

13.00%

Overall interest rate

8.29%

7.87%

7.46%

7.04%

Next, I show the future interest payments under the assumption that the EBITDA enhancement of the subordinate debt is not used:

Issue

Principal

Current Interest rate

Interest rate 2017

Interest rate 2018

Interest rate 2019 and beyond

Phase I Senior Debt

$41.13

7.35%

6.85%

6.35%

5.85%

Phase I Subordinate Debt

$12.77

6.00%

6.00%

6.00%

6.00%

Phase II Senior Debt

$111.57

7.35%

6.85%

6.35%

5.85%

Phase II Subordinate Debt

$17.71

6.00%

6.00%

6.00%

6.00%

Overall interest rate

7.13%

6.71%

6.29%

5.87%

Together with the principal payment taken from the last Management's Discussion and Analysis, we can calculate the future total debt payments.

Here are the total debt payments for the two cases with and without return enhancement until 2022. Given the predictable nature of the business, I think some leverage is appropriate. Therefore, I assume other debt payments will be refinanced.

Future total debt payments with full return enhancement:

2016

$22.50
2017 $24.87
2018 $25.34
2019 $24.93
2020 $26.46
2021 $27.17
2022 $27.75

Future total debt payments without return enhancement:

2016 $22.50
2017 $22.76
2018 $23.34
2019 $23.07
2020 $24.76
2021 $25.66
2022 $26.45

The difference between the two scenarios is $10.48 million. Given the substantial cost of the return enhancement covenant, I think it is likely that management will buy back the subordinate debt issues.

Unfortunately, I could not find any information about their current trading price. If they are publicly traded, as a debt investor, I would take a good look at both issues.

Equity

After having looked at the debt issues, we can now take a look at the equity of the company. I will discuss the current business, future growth opportunities, management, country risk and at last value the equity of the company.

Business

The company has a PPA in place with Disnorte-Dissur, a subsidiary of Spanish utility TSK-Melfosur International. The PPA determines escalators of 3% until 2022 and 1.5% until 2029. This agreement makes the future revenue development of Polaris highly predictable.

Currently, the Jacinto plant is capable of producing 68 MW gross. The maximum production capacity was extended by a drilling project that ended last quarter.

Growth opportunities

The company is in the process of installing a binary unit. This unit will add 8 to 10 MW in capacity. Because the installation is free of exploration risk, I assume that the binary unit will start production in 2018 and cost the company $30 million to build.

The company has a second project called Casita. It has the potential to become a 100+ MW commercial project in Nicaragua. In my valuation, I do not take into account any possible future upside of this project.

Both opportunities are described in the current investor presentation of the company on pages 17 to 20.

The company also owns three non-core assets in North America:

Project Name Location

Orita Project

Imperial Valley, California, USA
Clayton Valley Project Clayton Valley, Nevada, USA
South Meager Project British Columbia, Canada

Source: Q3 2016 Management's Discussion and Analysis

The company plans to sell those projects. This could be another source of income. In my valuation, I do not anticipate any income from the sale of those assets because there is not enough information available to value the projects.

Management

The management team and the board of directors of the company were changed with the recapitalization in May 2015. The new management team has significant experience in the region, the sector and in financial matters. Therefore, I'm confident that in the future, the company will be run in a return maximizing fashion without putting shareholders at risk.

The CEO Marc Murnaghan is an ex-investment banker who specialized in energy investment. He became CEO after the recapitalization process. Due to his capital market experience, I believe he will run the company sensibly and de-risk future capital-intensive expansions by for example issuing non-recourse debt.

The board of directors includes Jorge Bernhard, Jaime Guillen and Thomas Ogryzlo. These board members have extensive experience in the region and will help Polaris operate smoothly in the region.

Country Risk

The government of Nicaragua has invested up to $400 million in connecting people to the electricity grid. The government plans to generate 90% of its electricity from renewable sources by 2020.

Because of the government's ambition, the Jacinto plant is a showcase project for the country. In addition, the major creditors of the company are development banks like the World Bank. Therefore, it is highly unlikely that the government will nationalize it.

Valuation

I value the equity with two different methods.

First, I value the equity via an expected return calculation. I assume that the binary unit will be operational by 2018.

I also take into account Polaris tax deal with the government of Nicaragua. Under the deal, the company does not have to pay taxes until 2023. In Canada, the company also does not have to pay taxes due to net operating losses and impairments the company experienced in connection with its recapitalization.

I use Warren Buffett's definition of free cash flow: operating cash flow - maintenance capex = free cash flow. The company expects maintenance capex to be $1.33 million each quarter or $5.32 million per year.

In millions 2018
Revenue $72.71
EBIT $34.83
Interest $13.48
Taxes $ -
Net income $21.35
Depreciation & Amortization $24.72
Operating Cash Flow $46.07
Capex $5.32
Debt repayment $11.86
Free Cash Flow $28.90
Market Cap $185.92
Unrestricted Cash $26.06
Free Cash Flow Yield 18.1%
Growth 3%
Expected Return 21.1%

The expected return calculation gives me an expected return in excess of 21%. This is extremely high and proves my point that shares are undervalued by a huge margin.

Due to the favorable tax deal with Nicaragua, I prefer to do a discounted cash flow model because the tax base will change after the deal ends. I assume the company will pay the normal corporate tax rate of 30% after deal expiration in 2022.

Due to its short-term duration of three years, the expected return calculation does not take this into account.

The result of my discounted cash flow analysis shows the fair value of the company is more than twice as high as the current share price.

Fair Value DCF $26.94
Current Share Price $11.78
Discount 128.7%

If you would like to receive my discounted cash flow model just sent me a message. I'm happy to share it.

Conclusion

My discounted cash flow model, as well as the expected return calculation, clearly show that Polaris is still undervalued. Because of the sizable discount, I initiated a position.

The discount to fair value should close with future dividend hikes. Assuming a payout ratio of 80%, the company trades for a 15% dividend yield in 2018. Due to the predictability of its revenue growth and low capital intensity, this dividend yield is far too high compared to the broad equity market.

Disclosure: I am/we are long RAMPF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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