The offer contains a fair premium to market value.
Accounting for off-balance sheet debt makes the company quite levered.
EBITDA is lower than what it looks like.
Discounting CAFD leaves 34% downside, taking the offer is smart.
At its Q3 earnings on Monday, Pattern Energy Group (PEGI) announced that it agreed to be acquired by Canada Pension Plan Investment Board (CPPIB). As with any takeover, a logical question is whether the price offered is fair and if holding the shares is perhaps a better alternative. In this article I will explore the merits of the offer and show why shareholders would be wise to accept it.
First of all, there is an upcoming dividend payment of $0.42 per share. Shareholders who offer their shares are entitled to that dividend, plus the $26.75, which makes the current fair value (assuming zero interest rates) $27.17 per share. The stock closed Tuesday at $27.29, so perhaps it’s even better to take that offer by the market now instead of the $27.17 from CPPIB. Disregarding the current market price, there are several fundamental reasons to take the offer.
The offer contains a premium
Despite the fact that the offer was below the stock’s close prior to announcement, it is a fair premium over the price before M&A rumors spread and were confirmed by the company. A possible logical counter argument would be, that after three months the stock could’ve appreciated to this level on its own. Stock returns of peers are usually a good indication of where the stock would be without these rumors. I have compiled a chart below that shows the stock returns of PEGI (in orange) and four other YieldCos.
Source: Seeking Alpha.
The company’s thesis has been that there was premium of approximately 14.8% to Pattern Energy's closing share price on the last trading day prior to acquisition rumors. I think that the chart above shows that the company is right and that the reason Pattern traded where it did was solely because of the M&A speculation. Over the past three months, peers were up 7% on average, while PEGI was up 20%.
Pattern Energy contains a lot of leverage
We must not forget that Pattern Energy has a lot of debt. Gross debt totals $3.1bn in my calculation, which includes a fair portion of $685m unconsolidated debt. In its 10-Q report, Pattern included a table of its share in unconsolidated debt. I do account for this off balance sheet burden in my multiples table, but not all data providers do.
Source: PEGI Q3 2019 10-Q.
In addition to the above, it should be noted that Pattern Energy also has an upcoming earnout payment of $103m, related to a Japanese project, which a prudent analyst should also treat as corporate debt.
EBITDA is overstated and most peers are cheaper
When we look at EV/EBITDA, and EV/CAFVD Pattern Energy is among the most expensive stocks among its peers.
*Net project debt was excluded in EV/CAFD, and interest on corporate debt was added back to CAFD. **Pro forma payout calculates payout on run rate CAFD. Source: author’s own calculations and estimates. For 2019/2020 estimates, CAFD and EBITDA, midpoint of respective company guidance was used whenever available. For NEP, the proportionate share of debt, EBITDA, and CAFD to public unitholders was used after also accounting for convertible preferred shares and financing deals. TransAlta Renewables’ (RNW in table) financials are in CAD. Most recent quarterly financials were used for each ticker.
The rather high ND/EBITDA could be partly caused by the fact that I have not accounted well for the Japanese projects under construction in my forward EBITDA estimates. However, I don’t think that a possible error there can be that material as I used far higher KW/h pricing assumptions for the Japanese assets than what is usual for US renewable energy. A difference between my calculation and market perceptions can be explained by something else. My EBITDA definition is materially different from the adjusted EBITDA that the company reports.
The company reports a trailing twelve months EBITDA of $359m, but the EBITDA proportional to its ownership of underlying assets is lower than the reported figure. The company is very diligent when adding back EBITDA from minority stakes it owns, but conveniently forgets to treat minority stakes that others have in its assets in the same way. This becomes apparent as the company has to account for distributions to noncontrolling interests when reconciling EBITDA to CAFD (second highlighted text in the figure below).
Source: Q2 2019 company presentation, with highlights added by author for emphasis.
YTD distributions to noncontrolling interests of $21m on a $200m EBITDA are an indication that EBITDA is quite significant. I calculated the weighted (by MW) average ownership by PEGI of its consolidated assets at 81%. For H1 2019 EBITDA, this means that the adjusted EBITDA should be closer to $162m (200m x 81%), and the trailing EBITDA would then be $291m. In the multiples table, 2020 estimates were used and my EBITDA estimate for Pattern Energy is about $350m.
The bottom line is that the only peer that is clearly more expensive than PEGI is NextEra Energy Partners (NEP), which is overvalued for different reasons.
Discounting CAFD leaves downside
I made an updated CAFD forecast for the company, using the same method as in my YieldCo guide (to be found among my author’s picks).
Source: author’s own estimates, including upcoming projects that are paid for.
The CAFD in the forecast seems quite negative, and this is caused by cash corporate taxes kicking in at a point in the future, depreciating assets (for which no CapEx is provisioned), PPA expiration. These effects are partially countered by declining debt service as the company uses operating cash flows to repay project debt.
Using this CAFD forecast, I calculated fair value by discounting CAFD by 8%, which is the same rate I use for other YieldCos. My personal view is that 8% is still too low, but my point is clear enough. I also lavishly put Pattern Development at 3x book value after deducting the 12.6% of its cash flows that PEGI preferred shareholders will receive.
Figures are in mln USD, except for FV per share. Source: author’s own calculations.
The fair value of $17.7 per share is a third below the $26.75 that CPPIB is prepared to pay. My method could be too conservative, but other YieldCos, such as Atlantica and Clearway Energy do show upside under the same method.
No matter the angle we take, Pattern Energy looks fully valued at the offer price of $26.75. In my opinion, shareholders will do well by offering their shares to CPPIB, or selling at a higher market price whenever available.
Disclosure: I am/we are long AY, CWEN.A. 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.