Polaris Infrastructure: Still 20% IRRs Over The Next 4-5 Years

Summary

• Polaris Infrastructure continues its solid plan of developing the San Jacinto asset. The existing asset without new wells or a binary unit is worth ~$20 CAD.
• 2 new wells yielding ~12MW, and a binary unit adding 6MW of capacity are worth a combined $10 CAD per share with relatively low risk and high visibility.
• Room to increase the payout ratio after 2020, growth in dividends, and deleveraging should serve as catalysts to drive shares towards $30 in 2021, which would represent 21% IRRs.

(It's been roughly a year since I last wrote on Polaris Infrastructure (OTCPK:RAMPF), so I thought it was time for an update given the recent share price decline from ~$20 to $17.50 CAD.

Please note all figures are in USD unless otherwise noted. Also note that because the company uses USD in their financials, and pays their dividend in USD, but has a CAD listed share price, I calculate USD target prices and then convert them into CAD at a rate of $1.29/1.

Current Asset - San Jacinto "As Is"

Polaris' main asset remains the San Jacinto project in Nicaragua, which as of the end of Q4 2017 was producing roughly 57.8MW of power, however this was reduced by ~2MW by removal of one of the wells for injection service, where the company injects the well with increased fluid to build pressure so it can be used in production. If we adjust for this, the company generates ~60MW of power, net.

Based on the company's 2017 revenue, this production implies pricing of ~$1.07/watt, which is in line with where their PPA with built in inflation escalator of 3% per year would have them. For a brief reminder, Polaris has a 72Mw PPA with the largest Nicaraguan utility that is USD denominated and allows for 3% inflation per year.

My estimates for the existing production are laid out in my model below.

Note that in 2017, Polaris' tax rate was significantly elevated due to changes in tax codes. Most of this expense was non cash as Polaris has significant NOL's that exempt it from paying cash taxes. One will note that in the last 2 years 100% of Polaris' taxes have been non cash deferred taxes.

As per their Annual Report (page 25):

"The Company does not expect to utilize any of the net operating losses carried forward in Nicaragua, totaling $57,073,557 as at December 31, 2017, because the Company's subsidiary in Nicaragua is not subject to income taxes for a period of 10 years. The Nicaraguan subsidiary was granted a tax-free holiday under the tax laws related to the commercial production of electricity from renewable resources."

This tax holiday significantly increases the free cash flow power of the company.

Based on my assumptions in the model above, I arrive at a valuation of $21.50 USD per share (~$27.75 CAD), assuming a WACC of 10.08% as detailed below

One can of course debate what WACC is appropriate. Because of the company's significant use of debt, it is likely that an eyeballed WACC will appear low. Note that there is no tax shield on the cost of debt.

We do know, based on their current financing arrangements, that their cost of debt is somewhere between 7 and 8% (their Phase 1 facility charges 8.09%, and their Phase 2 charges 7.46%, and their subordinated credit facility charges 6%). I believe if the company were to refinance today, rates would likely be roughly the same as the credit risk of the company has arguably decreased since its restructuring, but USD denominated interest rates have risen globally since then.

For argument's sake, at a 15% cost of equity, my value per share of the existing assets is $15.50 USD, or ~$20 CAD. Whether a 15% cost of equity is appropriate is debatable, but I believe that represents an attractive hurdle rate, and shares trade well below that implied value regardless.

While I believe a case can be made for a lower cost of capital, I'm more than willing to use 15% as the company still offers excellent value at that discount rate.

Expansion Opportunities

The current drilling program is set to see 2 additional wells brought online this year:

Well SJ 12-4 is a 4-5MW well that will be stabilized in the next few months.

Well SJ 12-5 will be 8-12MW, though it is early in the process so that number may change. Polaris has historically been fairly accurate in their measurement of the wells as they understand the geology of the site fairly well, so I am reasonably confident in the low end estimates of these two wells.

Based on a $15 million drilling cost per well, which is high (in the last 2 years, Polaris has spent ~$50mn on capex, of which ~$11mn is maintenance, thus the three wells they have added have come at a cost of $13mn per well), 10% salvage value, and 20 year useful life and 15% cost of equity and 2% decline rate a 4MW well has an NPV of ~$1 USD/share.

An 8MW well has an NPV of $4.60 USD per share. The reason for the huge difference in value is simply due to the nature of the geothermal and resource business: there are large upfront costs but relatively low operating costs (particularly for geothermal) so given every well costs roughly the same to drill, additional "unexpected" power is delivered at extremely high incremental ROIC's.

Adding these two wells together to our conservative estimate of value for the existing San Jacinto production, we can arrive at a valuation of ~$20 USD per share, or ~$25.80 CAD.

Binary Unit

In addition to the expansion offered by the two new wells, the company has also completed the design and some permitting phases for the addition of a binary unit. As a refresher, a binary unit effectively heats hydrocarbons and then uses that steam to produce energy. It is used in largely colder/weaker geothermal plants, but when added to an asset like San Jacinto can add ~10% increase to power output.

Based on the company's existing assets, I expect that the binary unit will add ~6MW of power per year. This unit will cost $30 million to build, and represents a very attractive use of capital because there is no exploration risk: adding a binary unit to the plant will increase the output. Further, Polaris has the resources from cash on hand today, let alone the significant cash they will generate in 2018/2019, to fund the entirety of this project.

If the company were to use 60% debt financing, assuming a 25 year life, the project would yield ~23% IRRs on the equity, and an NPV of ~$3.35 USD per share.

The binary unit has been a consistent theme at Polaris, and now that it is clear the process is moving forward in a major way, it looks less like option value and more like something investors can count on in the future as a growth project.

Final Value Estimate

Adding the existing assets, new wells, and binary unit together, I arrive at a valuation of $23.35 USD or ~$30 CAD per share, making the shares roughly a double at today's prices. Were this to take 5 years to play out, with the current 4.4% dividend yield, this would represent ~15% IRRs.

Catalysts

I believe there is likely some upside to the above IRR estimate due to two factors which should accelerate the market's realization that Polaris is worth significantly more than where it trades today.

1) Dividend Increases:

The company has stated that over the course of 2018/2019 it will wind down its drilling program (as per page 2) meaning that capex is likely to fall towards ~$5.7mn per year in maintenance capex. This means distributable cash flow will ramp significantly, and assuming no increase to the company's existing payout ratio, the dividend should ramp as well.

I expect that out of a desire to retain balance sheet flexibility, Polaris is unlikely to raise their payout ratio significantly from the ~50% it stands at today.

I also model mandatory debt repayments which are lined out in the company's annual financials (figures in thousands of USD):

Examining the sources and uses of cash, assuming 4MW added to San Jacinto in 2018, and another 10MW in 2019 (new wells aren't likely to be added until later in 2018, thus won't affect a full year of financials). I believe that the company can finance the Binary unit internally without any trouble, but that would mean a payout ratio that stayed constant for the next 2 years.

Note that in the below analysis I use free cash flow to equity, which is cash from operations less after tax interest less net debt repayment. Thus, this metric accounts for interest expenses AND the mandatory debt repayments given above and is representative of the true discretionary cash flow Polaris has access to.

As you can see, once the binary unit is financed, the company generates significant cash flows and coupled with a moderate increase in the payout ratio, results in almost a tripling of the dividend.

I do not expect this to triple the share price: one reason Polaris trades at only a 4.4% yield (versus say a lower risk Brookfield Renewable at 6%) is that Polaris has significant embedded growth. Once the binary unit is completed, I expect the standing yield on the shares will be significantly higher than today.

That being said, in 2021, the yield on my target price is close to 7% which I believe is reasonable. Thus, I think we can definitively say that the company's dividend generation power is likely to exert a strong pull on the share price over the next 4-5 years, making that 15% IRR easily attainable.

2) Deleveraging (New Equity & Multiple Expansion)

As outlined above, by 2020 the company is producing significant cash and would see the cash on its balance sheet grow by ~$10 million per year. I expect that at the very least some of this will go towards deleveraging the company.

The thing about deleveraging is that it is an incredibly easy way to create shareholder value. Indeed, I have seen a lot of research which shows that the primary way private equity is able to outperform is because they take advantage of deleveraging.

Every dollar of debt that is paid down becomes $1 of equity. But more than that, the new equity is lower risk because of the reduced claims of bondholders before the equity. This lower risk means that equity should be worth more, and garner a higher multiple.

Thus, not only will Polaris be in a position to put money towards building equity, but I believe the company will de-risk over time, which should be rewarded with a higher multiple.

Expected Return Summary

Following the dividend assumptions above, and assuming a $30 CAD target price in 2021, this would represent a 21% IRR. Were that scenario to play out over 5 years instead of 4, returns would drop to an 18% IRR which is still excellent.

Risks

1) New Wells Are Less Powerful Than Expected

If the two wells mentioned above produce less power than expected, that would obviously be a negative to my valuation. There are two mitigants to this, one is the obvious margin of safety in the valuation today even without those wells; the second is management's history of being fairly accurate in estimating power production due to their good understanding of the site and geology.

2) Country Risk

Nicaragua is run by a dictator, and Latin American dictators have a history of expropriation. As I described in my initiation on Polaris, I believe the current administration is relatively business-friendly, but I believe that there is a self-interest explanation as to why they will not seize renewable assets.

Nicaragua, for those who are not familiar, has made it a policy (driven by their national security interests due to their high level of oil imports; don't get awed into thinking they are doing it for the good of the planet) to use renewables for all of the country's power generation. This policy is motivated by national security, and thus the effective operation and financing of renewable resources is key to the country's and the administration's future.

Nicaragua is not a rich place, nor are geological engineers abundant resources in Nicaragua. Thus, the country is forced to import capital and knowledge to develop its resources, and because of high rates of growth, electrification, development, and the relatively early stage of renewables development, I believe the government can recognize it is shooting itself in the foot if it nationalizes assets now. To do that would scare away the capital and expertise that the country must import in order to get what it wants.

3) FX Risk

Polaris earns its revenues and pays its dividend in USD, yet its shares are priced in CAD. Thus, movements in the CAD/USD exchange rate will affect the company. I do not pretend to be a macro expert, but I suspect the USD may weaken in years ahead as rates rise around the world, making US debt and assets relatively less attractive by comparison. I think there is also a trade related argument for the current administration, as embattled as they are, wanting a weaker USD.

This will present somewhat of a headwind to Polaris shares as their USD dividend becomes less valuable relative to their CAD share price (meaning that for a given FX neutral yield, a declining USD would mean shares have to decline in value as well).

Other Issues

San Jacinto does not remain Polaris' only project. However, their other assets are in exploration and frankly the company has not focused on them and thus I would not assign them any value today. There is arguably option value, but that value would take years to realize and there is another use towards which Polaris may put excess cash flow.

There are a number of geothermal plants throughout Latin America, but these are usually of a small scale and operated by single asset operators or high net worth individuals. These assets are far too small for large pension funds, and thus Polaris is in a position where they may be able to consolidate the market once they have a solid and completed asset in San Jacinto.

Whether this will be an effective use of shareholder's money remains to be seen. I'm always skeptical of an acquisition strategy, but this management team has proven with San Jacinto that they can take a conservative and thoughtful approach to developing assets, so I will give them the benefit of the doubt for now.

As of now, this strategy remains a dream, but I suspect that it is one with a decent amount of potential.

The company has also announced (page 5) financing arrangements with the World Bank and government of Nicaragua to begin developing the company's Casita project.

The development of this project may delay a payout ratio increase as the company will wish to retain resources to develop this asset. Whether it will be successful remains to be seen, however with the new wells and binary unit bringing San Jacinto's production close to filling the 72MW PPA, the company will have significant internally generated cash flows to develop this project.

Even if the company's payout ratio stands at 50%, there will still be room to increase the dividend 74% from its current level, which should continue to drive shares higher.

Summary

I believe Polaris continues to offer excellent value at current prices. Just looking at the value of their existing asset, new wells that are already drilled (thus most of the costs are sunk), and a binary unit that has been high on the agenda and has progressed through the design stage, I arrive at a valuation of $30 CAD for the shares.

I don't expect value to be realized today, but I believe that over the next 4-5 years, the combination of large consecutive dividend increases, and deleveraging, will drive the shares towards that target price, which should result in an 18-20%+ IRRs over that period.

Beyond that 2021 horizon, I believe additional upside could be realized through intelligent capital allocation towards consolidating some of the many subscale geothermal projects throughout Latin America. Thus, I think that come 2021, shares are likely to still offer a compelling investment story, which should further support my target price at that time.

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Analyst’s 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.