We currently estimate that >50% of Scatec's operating portfolio and under-construction/backlog/pipeline projects are facing material risks to project returns and/or solar policy.
Updating our March 2019 thesis, bankrupt South African utility Eskom continues ratcheting up renegotiation pressure on above-market renewable PPAs (including Scatec's) while Egyptian project economics were compromised as we anticipated.
Vietnam, an "extremely important growth market" per CEO and largest component of backlog/pipeline, decapitated its solar subsidy program in late November in favor of dramatically reduced compensation through competitive auctions.
Business risks touch new highs almost daily just like its share price and valuation metrics since our March 2019 article.
We question Scatec's ability to (1) achieve its 2021 operating portfolio target of 4,500MWs (3.8x Q3 2019) reliant on at-risk markets such as Vietnam and (2) achieve targeted equity IRRs.
Short Thesis Overview
Since publishing our short thesis on Seeking Alpha in March 2019, emerging markets solar developer and independent power producer (IPP) Scatec Solar ASA (SSO:NO and STECF:US) has not behaved as we had expected. Shares have rallied ~25-30% to new all-time highs despite a koldtbord (Norway's version of the smörgåsbord) of new risks to project economics and policy compounded by the impending threats detailed in our prior article.
Esplanade estimates that over 50% of Scatec's operating portfolio (28% at-risk), under-construction assets (93% at-risk), backlog (90% at-risk), and pipeline (49% at-risk) are confronted with material project returns or policy risks. We question Scatec's ability to (1) achieve its 2021 operating portfolio target of 4,500 megawatts (MWs) (3.8X Q3 2019 portfolio) heavily reliant on at-risk markets such as Vietnam and (2) achieve targeted equity (levered) IRRs of 12-14% (recently and discreetly reduced from 15%).
Source: Esplanade Capital Analysis
Previously, we focused on the elevated risk of slashed subsidies on Scatec's existing South African assets (which government officials reiterated as recently as December 3, 2019) and of eroded projects economics on Egyptian assets due to elevated costs. We provide further damning evidence on these factors below. However our short thesis has been further buttressed by a bountiful koldtbord of new risks which have surfaced over the nine months since last publishing.
- Scatec's Vietnam backlog and pipeline (20-25% of entire backlog/pipeline) is now threatened as the government has swiftly ended an overly generous solar subsidy program (on which Scatec relied for its lofty targeted returns) in favor of a highly competitive auction mechanism that could slash compensation ~50% and compress equity IRRs from mid-to-high teens to low-single digits (or negative for certain pipeline projects). On the Q3 2019 call, CEO Raymond Carlsen stated that "Vietnam for us will be an extremely important growth market."
- Scatec's reported revenue and EBITDA have missed sell-side estimates in every quarter since we published raising questions about the economics of and forecastability of Scatec's supposedly stable and predictable business
- In Q3 2019, Scatec discreetly lowered equity (levered) IRRs to 12-14% from 15% since its 2014 IPO for the operating portfolio and future additions to that portfolio
- Scatec may be overstating its backlog by ~17% per their own published presentations
- Esplanade has identified a series of policy revisions that jeopardize Scatec's operating, under-construction assets, and backlog/pipeline in Ukraine, Honduras, Argentina, and Bangladesh
We suspect that investors remain largely unaware of these as the sell-side continues to promote Scatec while ignoring any evidence that counters their bullish view.
South Africa: Solar PPA Slashing More Likely Than Ever
Esplanade views the likelihood that South Africa renegotiates above-market renewable energy power purchase agreements ("PPA") (including Scatec's 190MWs) of generously subsidized solar assets as even greater than when we posted our March 2019 piece. As we were about to post this update on December 3, 2019, South African government officials publicly reiterated their push to renegotiate "costly renewables contracts".
Given shares sit near all-time highs, Scatec shareholders are discounting a much more optimistic scenario for the most profitable assets in the company's operating portfolio (representing 16% of operating megawatts but ~25% of Power Production segment TTM EBITDA).
In fact, a major Norwegian investment bank published sales commentary on November 21, 2019 noting that Scatec's CFO is now admitting publicly that bankrupt, South African state-owned utility Eskom will likely amend above-market renewable energy PPAs.
Source: Norwegian investment bank morning sales note (November 21, 2019)
Though we applaud management for finally recognizing that South Africa will likely slash overly generous PPAs, we believe this likely restructuring could bankrupt the 190MWs of solar assets by impairing its ability to service debt.
Today, Scatec receives ~US$0.21 from Eskom for each kilowatt-hour produced at its 190MWs of projects in South Africa; Eskom can self-produce electricity for ~US$0.02 per kilowatt-hour, and Eskom awarded renewable PPAs at ~$0.068 per kilowatt-hour in the last subsidy round, Bid Window 4, in June 2015. As context, global solar PPA pricing has collapsed to $0.015-$0.03 per kilowatt hour including including Scatec's winning $0.0244 per kilowatt-hour bid this July in financially distressed Tunisia.
If Eskom marks the legacy PPAs to current global solar PPA rates, these 190MWs and likely the 258MWs under-construction Upington solar project default on their debt as project-level EBITDA heads to zero. Should Eskom merely mark the legacy solar PPAs to Bid Window 4 levels of US$0.068 (over 2.0x current global solar PPA awards and Eskom self-generated electricity costs), then Scatec's 190MWs of operating assets still will not be able to service the project debt. Esplanade estimates that debt service coverage ratios would plummet from ~1.8X on a TTM basis to 0.4X.
Source: Scatec quarterly filings for TTM actual performance, REIPP PPA prices
Esplanade's point-of-view is further strengthened by the chaotic series of events that has plagued South Africa and Eskom since our March 2019 article.
- Emboldened by their commanding May 2019 electoral victory, the African National Congress (ANC) has ratcheted up pressure to renegotiate above-market renewable PPAs signed between 2011 and 2013 including Scatec's 190MWs of operating solar assets in South Africa. See here, here, and here.
- Furthermore, these heated negotiations could delay completion of Scatec's 258MWs Upington South African plant previously scheduled to reach commercial operation by the end of 2019 but delayed into early 2020 with Q3 2019 results
- In July 2019, Eskom's CEO abruptly and unexpectedly resigned citing Eskom's "death spiral". See here for more details.
- In November 2019, Eskom and its debt guarantor South Africa both saw their debt downgraded.
- In its Q3 2019 results, Scatec quietly wrote down its project equity in operating South Africa assets by 30% without a peep from the sell-side (see debt service analysis above).
- Eskom continues to detail the hefty financial burden that above-market REIPP contracts foist on Eskom and South African citizens
- With unit electricity costs ~500% greater than Eskom's self-generated electricity, renewable IPPs like Scatec represent ~20-25% of total generation costs despite comprising only ~5% of total electricity production
Egypt: Costs Up & Project Size Down
We previously highlighted that the Egyptian government put significant incremental cost on all developers in its signature 1,465MWs Benban solar park of which Scatec claimed 400MWs. Sell-side analysts and Seeking Alpha commenters pushed back sharply on our analysis by regurgitating management's talking points that incremental costs in Egypt, if any, should be considered immaterial (one sell-sider suggested a very specific US$5.6M figure).
Source: Seeking Alpha comment to March 2019 article
With Scatec's Egyptian assets now completed, we can objectively benchmark our critical claims. When signing their PPAs with the Egyptian government in April 2017, Scatec specified six (6) projects totaling 400MWs requiring total investments of US$450M. In fact, Scatec repeated these figures through their Q1 2019 filings.
However in their Q2 2019 filing, management quietly decreased the project size from 400MWs to 390MWs with almost zero attention paid by the sell-side. More telling, Mohamed Amer, Egypt Country Manager at Scatec, publicly declared that the company had invested US$500M in a November 24, 2019 interview, a US$50M increase from their public filings (10.0x what Scatec communicated to covering sell-side analysts).
Incorporating these material but largely ignored changes into our models, we estimate that Scatec's equity (levered) IRR on this massive project collapsed from ~19% to ~11.5% well below their stated 15% IRR targets (until Scatec discreetly lowered these targets in Q3 2019 as we detail later in this article).
Source: Esplanade Capital Analysis, (1) Scatec company press release, (2) Financial press comments from Scatec Egypt country manager, (3) Scatec references 15% equity IRR for operating portfolio in company reports before lowering targets to 12-14% in Q3 2019 (detailed in Project Returns Compression below)
Vietnam: From "Extremely Important" Growth Market to Uneconomic Market in A Month
On the Q3 2019 earnings call on October 19, 2019, Scatec's CEO specifically called out that "Vietnam for us will be an extremely important growth market." A quick glance at Scatec's backlog and pipeline suggests that he was probably understating Vietnam's importance to Scatec.
Source: Bloomberg New Energy Finance
Vietnam surged to ~4,500MWs (6.0x its 2020 national target of 850MWs) of heavily subsidized solar deployments in 2019, and to mitigate that massive government financial liability (20-year duration for subsidies) and relieve electric grid congestion from the influx of solar, Vietnam precipitously ended its subsidies in favor of auctions. As reference, Scatec had expected feed-in tariff subsidy rates of $0.07-$0.075 per kilowatt hour as it executed on its massive pipeline through 2022. Recent auctions in neighboring (but immature solar market) Cambodia awarded solar PPAs at $0.038 per kilowatt-hour, and India consistently auctions solar capacity at $0.02-$0.04 per kilowatt-hour.
Based on the revised policy, Esplanade estimates that equity (levered) IRRs collapse from over 20% under subsidy scheme to about 0% under an auction mechanism. We question Scatec's ability to deliver on its backlog and pipeline in Vietnam at even modest equity (levered) IRRs and consider Vietnam, the largest contributor to the company's 4,500MWs 2021 target, at considerable risk.
Source: Esplanade Capital Analysis/Proprietary Research, Scatec Solar 2019 Capital Markets Update presentation (September 2019), Azure Power (AZRE:US) CQ3/FQ2 2019 Earnings Presentation, Cambodia PPA benchmark
In late November following Vietnam's about-face on solar subsidies, Renesola, a US-listed solar developer, announced its exit from Vietnam citing insufficient profits from the revised solar policy, perhaps a preview of Scatec's next move.
Business Performance: Disappointing and Unpredictable
Given shares have rallied almost linearly to all-time highs, a logical investor might have expected Scatec to blow away consensus expectations, but Scatec has defied logic. Scatec's reported revenue and EBITDA have missed sell-side estimates in every quarter since we published raising questions about the economics of and forecastability of Scatec's supposedly stable and predictable business.
Source: Scatec Solar reported results and FactSet
We also note that consensus expectations for 2019 and 2020 have declined materially since we published on March 15, 2019.
Project Returns: Quietly Guided Materially Lower
Since its IPO in 2014, Scatec has guided investors to 15% levered IRRs on its operating and future asset portfolio. In conversations with Scatec bulls, they almost always point to these mid-teens equity returns as unshakable and a given for all assets deployed by the company.
Well, in Q3 2019, Scatec discreetly lowered equity (levered) IRRs to 12-14% from 15% (since its 2014 IPO) for the operating portfolio and future additions to that portfolio. We illustrate above several instances where expected and future expected returns will fall well below the 15% hurdle rate (e.g., South Africa, Egypt, and Vietnam).
Though we think Scatec prudently lowered their IRR hurdle rate to 12-14%, we don't think they lowered it enough based on our estimate of expected returns in Vietnam and other geographies such as Ukraine, Honduras, Argentina, and Bangladesh (detailed below).
Overstating Backlog: The Mystery 50MWs
While we suspect the investor relations team simply neglected to include 50MWs of backlog projects in its October 2019 Investor Presentation, we think a potential 17% overstatement of project backlog worthy of mention.
Source: Scatec October 2019 Investor Presentation
Other Nuggets: Death by A Thousand (Subsidy) Cuts
- Ukraine: Ukraine, like South Africa, is seeking to retroactively cut "unaffordable" solar subsidies including those awarded to Scatec's 47MWs Rengy project. These frictions could also jeopardize the 289MWs of projects currently under construction. On November 19th, Scatec smartly sold down 40% of its equity stake in the under-construction 55MWs Chigirin project. We are baffled by FMO, the Dutch development bank which took the 40% equity stake, but then again, so much related to Scatec baffles us.
- Honduras: We have learned that Honduras is seeking to renegotiate legacy above-market renewable energy feed-in tariff subsidies awarded in 2015 driven by financial distress at the government-owned utility ENEE (very similar to the current risks Scatec is facing with Eskom in South Africa).Scatec currently controls 95MWs of operating solar power plants in Honduras of which all 95MWs (Agua Fria and Los Prados plants) were awarded under the targeted subsidy regime.As context, domestic Honduran owners have already agreed to a US$0.03 per kilowatt-hour reduction to their feed-in tariffs while international owners like Scatec are protesting any reductions to above-market compensation.We estimate that Scatec is currently receiving ~$0.14 per kilowatt-hour which would be reduced to at least ~$0.11 per kilowatt-hour based on local owner concessions. That equates to a ~21% reduction in revenue from Honduras.
- Argentina: Heightened political and economic turmoil including currency controls and rampant inflation has "torpedoed" solar development in Argentina. Scatec is constructing an 117MWs project in Argentina, but Scatec has already pushed out completion on its Q3 earnings call blaming "ground conditions". Industry sources in Argentina are suggesting that political issues are endangering even already authorized projects financings.
- Bangladesh: In November, Bangladesh announced that solar subsidies/tariffs will be renegotiated. Scatec claims 62MWs in backlog and another 350MWs of pipeline in Bangladesh. Many legacy solar PPAs have been signed for an $0.18 per kilowatt-hour subsidy versus recent projects accepting subsidies as low as $0.0749 per kilowatt-hour.
Scatec remains difficult to value. In addition to the risk factors detailed above, Scatec also suffers from complicated financials due to its controlling and non-controlling stakes in projects combined with its intra-company transfers. As one example from Q3 2019, Scatec reported consolidated net debt of NOK9,678M versus proportionate net debt of NOK6,091M, and consensus estimates represent a convoluted mish-mash of consolidated and proportionate figures.
Though we consider Scatec handsomely valued at 15.0X 2019E EBITDA and a token 0.9% dividend yield, we direct our concerns toward its ability to achieve aggressive EBITDA forecasts whether consolidated or proportionate. Unquestioning bullish sell-side analysts forecast ~70% EBITDA growth in 2020 despite Scatec continually missing their estimates, and trading at ~5.5X 2019E book value, the market values Scatec's pipeline at many multiples of its operating portfolio. We obviously hold a different perspective.
Source: Esplanade Capital Analysis, FactSet
In our March 2019 article, we suggested that Scatec was worth NOK35 to NOK54 representing 47% to 66% downside from current levels:
Today with 25% more consolidated debt, 10% more shares outstanding, and materially more project return and policy risk, we believe the valuation range of Scatec should be reset even lower.
Esplanade estimates that over 50% of Scatec's operating portfolio (28% at-risk), under-construction assets (93% at-risk), backlog (90% at-risk), and pipeline (49% at-risk) are confronted with material project returns or policy risks. We question Scatec's ability to (1) achieve its 2021 operating portfolio target of 4,500 megawatts (MWs) (3.8X Q3 2019 portfolio) reliant on at-risk markets such as Vietnam and (2) achieve (recently reduced) targeted equity (levered) IRRs of 12-14%.Source: Esplanade Capital Analysis
Source: Esplanade Capital Analysis
Disclosure: I am/we are short STECF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.