RE Royalties: The Market Has Completely Missed This ESG Play
Summary
- RE Royalties operates as an investor in renewable energy development, providing financing to develop projects and then collecting a royalty stream after the project starts operations.
- The business model is extremely attractive, given the asset-light model, recurring revenue streams, and secular shift to ESG investments.
- Despite this, the stock yields over 3% and trades at a fraction of peer valuations while growing at an impressive clip.
Sometimes while browsing for companies, I stumble across gems that I wasn't even looking for. While looking into an obscure royalties business, Pardee Resources (OTCPK:PDER), I discovered RE Royalties (OTCQX:RROYF) (TSX.V: RE) while trying to comp different parts of Pardee's business. RE is a pure-play publicly listed business invested in loans and royalties for renewable energy production. The Company does a good job generating investor relations materials despite their size - and has an updated presentation on their website. I've since spoken with Management and came away very impressed with their execution in the space, and shocked at the complete lack of following they have, both the miniscule volume on their shares and only 31 followers on Seeking Alpha. They don’t even exist on Stocktwits. In other words, the opportunity is there for investors to get in on the ground floor of something special.
Note: I'm presenting all my numbers in CAD as the company reports this way. I'll translate that to a USD share price target at the end)
Business
(Source: Feb-21 Investor Presentation)
There are many advantages to being in the royalty business, like low operating expenses:
(Source: Feb-21 Investor Presentation)
One of the things I love about RE Royalties is their capital-light business model. Total operating expenses were $433k in Q3-20. Rent is under $100k/year, total salaries and benefits are about $500k annually. Given their limited headcount and success operating remotely during Covid, the team is actually looking to reduce their rent expense going forward.
Since the Board/Management team own 33% of outstanding shares, they receive a significant portion of their income from the quarterly dividend payments. This is a good sign that Management will prioritize shareholders in their decisions. Most of the remaining shares are held at family offices comfortable holding their shares and collecting dividends (investor deck points out RE is over 80% Canadian controlled). Hence so few shares are trading currently. If you’re interested in learning more about the Management team, there’s a good interview with the COO you can check out. The CEO is also speaking at an event on 4/15 with some other buzzy stocks.
On the revenue side, RE has two main sources of income: royalties and lending income. Royalties were $187k in Q3-20, up 32% Y/Y (and over 100% in the trailing 9 months Y/Y). Financing income was $270k, only up 1% Y/Y, but for the trailing nine months it is up 20%. There had been no new PRs regarding projects since Aug-20, as Management has been focused on raising $10m via "green bonds" that pay 6% annually. As of March 15th, the offering has been fully subscribed, and the underwriters retain the option to purchase an additional $10m. Given the business previously raised capital via convertible notes that accrued 7% and 8% interest, respectively, this new financing is cheaper and more shareholder friendly.
Unsurprisingly, RE waited less than a month after closing the offering to fully deploy $10m into a four-year loan for an Australian battery project. The terms are fantastic, 10% interest and a future 15-20% gross margin royalty for an estimated 10 years. These kinds of deals are RE's bread and butter.
Case Studies - Actual Investments
- Belltown: In FY20, RE sold their 1% interest in a solar project in Texas back to the producer for about $400k. While this buyout seems to go against the company investment philosophy of collecting royalties for years after a deal, I love this one. First - RE only posted a letter of credit for Belltown, it remained mostly undrawn due to significant limitations when granted. The purpose was to aid the developer’s liquidity profile while getting connected to the grid, which they were able to do thanks to RE restricting $2.8m on their balance sheet for 6 months, collecting some interest, then offering a royalty buyout option. A roughly $500k return on a six month $2.8m investment is a solid IRR.
- Aeolis: On the less impressive side, RE made a loan to Aeolis for $1.2m in exchange for $100k annual payments for 20 years. The payments will increase annually at half of BC CPI, which if you use 1% as a placeholder for that you end up with a ~6% IRR. This was the first deal they did, more of a proof of concept than a model for future deals. I'm not too worried they'll do this again. Due to the senior secured nature of the royalty as well, there's a small chance they might be able to sell it somewhere else at a similar or lower rate lower than 6% to redeploy the capital in a better investment.
- Jade Power: RE made a $3.8m loan for certain projects in Europe (solar, wind and hydro). They got a 7% interest rate and a 1% royalty on 37MW of generation. In June-20 they sold 2MW of the royalties for $47k and reduced their remaining royalty by ~10%. Using this to estimate a royalty value per MW, the rough math indicates the remaining royalty would be worth around $0.9m (compared to $0.7m book value currently). All told, with the full repayment of the loan at the end of FY20 the IRR here should be close to 20% and provide them with a few more million to do their next deal.
- Ontario Rooftop: A $5m loan was made for one year at 10%, with additional royalties granted on the portfolio. Based on one building bought back by its owner (46 kW for $3.5k), the royalty portion would have a present value of $1.5-2.0m (it is carried at 300k on the balance sheet). Royalty values vary significantly by building in this portfolio, so I don't want to read too much into this implied value, the truth is probably somewhere in between. The IRR on this deal should easily be ~20% depending where the other royalties shake out.
- Alpin Sun: In Feb-18 RE created a special purpose entity in the US to buy four developing solar projects for $5m. By Dec-18 they struck a deal to sell only two of the projects for $6m, while maintaining an ownership interest of the other two. The project has hit some delays that have held up portions of the payment, but they seem very capable of identifying opportunities like this that result in a significant return on their invested capital.
Valuation Modeling
To model this I looked at the OpEx line items to try to decipher just how much operating leverage they have, and it's a lot. RE doesn't need to grow their team to keep doing deals and admin. They also have a deal with the CEO's former company to handle certain back office tasks to keep costs down. Therefore RE is hitting an inflection point where most incremental income should be at a very high margin. My assumptions for the model were as follows:
- Rent & IT: 10% FY21 dip for footprint reduction, then 5% increase annually
- Legal & Reg, Charitable Donations - increase at revenue rate
- Audit, Marketing & IR, Wages - 10% annual increase
- Admin, Consulting - 20% annual increase, though I nerfed the FY21 fees since FY20 was inflated due to Green Bonds
- Cost Recovery - held flat (conservative)
- Interest Expense: Set as $728k for FY21 (6% on green bonds and 8% on convertible note) and grown at finance income growth rate thereafter to capture incremental capital raises.
As of Dec-19, they had royalties on about 240 MW of operational power generation, compared to about half that at Dec-18. I'm forecasting 40% growth in FY21 and FY22, and 30% Y/Y royalty revenue growth going forward. I'm basing this on the projects that came online in FY20 and the recently announced battery deal and decelerating to a more conservative growth rate then what the company has been doing over the last few years.
On the finance income side, I've got FY20 around $1.2m, and expect they can grow another 50% in FY21 with the new loan and redeployment of capital from Jade and Ontario repayments. I'm keeping my anticipated growth rate to 50% for FY22 and 40% for the following years. Consider that they had $17m of secured loans outstanding at Sep-20 and were able to go get another $10m from individual investors at 6% over a few months. With $27m already invested, my FY22 finance income estimate of $2.7m starts looking a lot more like a conservative floor than a ceiling. In the next year or two I anticipate they can enter a more significant credit facility with a larger institution to really accelerate their deal pace.
(Source: Author Model)
There were 32.4m shares outstanding at Sep-20, plus 332k warrants, 503k shares from a Nov-20 note conversion, 2m more eventually from a Feb-20 note issued, and 1.35m options. At an estimated $1.20 share price, this comes out to $44m market cap. There was $2m cash prior to the $10m green bond issuance. This leads us to a $52m EV for the company.
Comparison
RE was the only pure-play renewable royalty business I'm aware of until Altius Renewable Resources (TSX: ARR) IPO'd in Canada last month. This comparison is important for a few reasons:
- Altius (OTCPK:ATUSF) raised $100m selling 40% of the company, valuing the business at $250m. They're a well respected value royalty business, and have Apollo (APO) as a partner, so with that kind of money backing the enterprise, people pay attention. They also have a nice presentation that lays out their deals to work together with Triglobal and Apex on a wide array of projects.
- In terms of actual deals, ARR only has one operational investment in their FY20 results. If you read carefully, you will see that they're limiting themselves to North America and targeting 8-12% IRR on their deals. With the $100m IPO and $70m incremental future investment by Apollo, they're going to have a huge chest to go do some deals.
- Since Apollo has the right to acquire up to 50% through their future investment, we can think of the value as investors paying $250m for 89% of an interest currently, and likely 50% of an aggregate ~$240m asset pool when Apollo makes their full $80m investment ($70m pre-IPO, $100m IPO, $70m incremental investment). If the full amount is invested at a midpoint 10% IRR, that would represent $24m of annual return. So a 50% interest is yielding $12m, or 4.4% on their current $275m market cap. And these kinds of returns are at least 4-5 years out based on looking at their TGE deal pipeline - with nothing before the second half of FY22, and significant future investment required to fully spend their war chest:
(Source: ARR Prospectus)
Using what I believe are conservative assumptions, I've got RE generating around $4m of annual cashflow by FY25, which if they were valued at a 4.4% yield would be a $90m EV (equity double). And once RE reaches that scale, their incremental margins are mouthwatering. Valuing RE at a higher 7% yield on FY28 expected cashflow would be a $170m EV (4x upside).
I understand Altius and Apollo earning a premium due to scale and reputation, however their larger scale will give them far less of the flexibility to go after smaller deals with higher returns that RE has been finding. Additionally, their North America restriction and tethering to Triglobal and Apex significantly reduces their scope of potential deals.
I see the premium being offered to ARR as a reflection of investors hunger for ESG investments, and the attractive business model that royalties provide. If RE can get more eyeballs it will help them to grow their investable capital, increase daily volume, and rerate their share price.
For those interested in more valuation comps, check out some of these junior royalty businesses on the mineral side, courtesy of Ely Gold (OTCQX:ELYGF):
(Source: Ely Gold Investor Presentation)
Many comps here trade around 2x their NAV, all yield less than RE, and EV/FY21 EBITDA basis mostly trade just shy of 20x. What RE has despite trading near similar multiples, is a growth story:
(Source: Feb-21 Investor Presentation)
Catalysts
- ARR IPO drives more investors to look at this space and discover RE
- RE gets more attention from ESG investors (31 followers on SA today, no Stocktwits page, no analyst coverage)
- RE inflection to a cash-generating business starts showing up on investor screens
- RE cross-lists on a US exchange
- Reduced go-forward cost of capital as business scales
- Upcoming investor roadshow
- EFT like Invesco Clean Energy (PBW), Invesco Solar (TAN) or First Trust Clean Energy Index (QCLN) takes notice.
Risks
- Very low float and volume
- Concentration in a handful of deals currently exposes RE to a setback if they have a deal go sideways
- ARR drives down prospective investment returns by drawing more investors into the space
Conclusion
After talking with Management, digging into their financials, and comparing the RE business to the recent ARR IPO, I find RE's shares significantly undervalued. This seems to be due to the very low public float/volume and investor awareness of the opportunities in the renewable royalty space. I expect in the following year that investor awareness will increase while RE's results accelerate from their recent deal making. With a potential multi-bagger return on the table, I’m a proud RE Royalties shareholder. Using ARR above as a comp, I’m putting a $2.50 CAD/$2 USD price target on shares, with an upside case of $4.50 CAD/$3.60 USD.
This article was written by
Analyst’s Disclosure: I am/we are long RROYF. 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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Comments (40)
The current pipeline is insane right now. I am buying more and more.The Company has a robust pipeline of potential royalty financing opportunities and is in advanced discussions on several opportunities that have a cumulative transaction value of $46.8 million Canadian dollars, and include the following:Renewable Natural Gas 1: $8.5 million loan and royalty acquisition of two renewable natural gas projects located in the United States. The loan will be used to complete the conversion of an existing facility, and the construction of a second facility, for converting agricultural waste from local dairy farms to produce renewable natural gas.Battery Storage 1: $12.5 million royalty acquisition with a United States company to finance the production of mobile utility-scale battery storage units, for sale and rental to electricity utilities in the United States. Battery Storage 2: $5.8 million sale-leaseback and royalty acquisition with a Canadian company to finance a battery powered electric generator rental pool program for a major utility located in California. The battery powered generators are portable and will be utilized for emergency backup power to assist the utility in building grid resiliency during the California fire season.Battery Storage 3: $10 million loan and royalty acquisition with a Canadian company to finance the acquisition of a portfolio of operational commercial-scale battery storage projects and to finance the construction of a second portfolio of battery storage projects, located in Ontario.Battery Storage 4: As previously announced on March 29, 2021, the Company has entered into a non-binding letter of intent for a $10 million loan and royalty acquisition with Canigou Molonglo Bess Pty Ltd. (“Canigou”) to finance a 10-megawatt battery storage project located near Canberra, Australia. The Company continues to advance due diligence with Canigou with the aim of completing the transaction in the fourth quarter of this year.
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•If the current growth continues RER will have the ability to pay out more Money in terms of dividends in the future. Will there be a stated policy of say maybe handing out 50% of the recurring royalty income and use the rest of the 50% and the Money from finance income to strike more royalty deals?oThis a great question, but it is hard to say at this point. As everyone who works at RER is a shareholder, we would love to see the dividends increase over time and we believe the royalty model is perfect for servicing dividends. But as far as any changes to our dividend policy in the future, that is ultimately a board decision.
- Bryce Andersob VP investments
As an shareholder for both Altius and RER i find the coverage of RER non existant. I see great potential in both companies. That battery deal is unheard of in terms of both interest rate on the loan and royalty procentages. I've talked with management a bit and here's the answer why they are not doing the entire life of the project (From Bryce Andersson VP investments)
• Do you have any plans for closing royalty deals that span the whole Project Life instead of the up to 20 years time horizon now?
o Hard to say. We have looked at this in the past but the issue is forecasting what power prices will be 20+ years from now. We typically tie the royalty to the life of the Power Purchase Agreement as that rate is fixed, so it is much easier to agree with the project owner on what the revenues should like during the term of this agreement. Past 20 years, the owners are usually quite optimistic about production and pricing but we try to take a more conservative approach as there is a lot of uncertainty. All of which makes it hard to agree on a value for the part of the royalty that extends past 20 years (or the term of the PPA).
This serves as a reminder that investors in the space need to know what they're doing. Expertise is important and RE has that.2. RE just signed on of their best deals (from my perspective) less than 30 days after they finished raising their $10m from green bonds - from speaking with Management they're not having any shortage of opportunities. By not limiting themselves to North America I think RE has a pretty long runway of opportunities.3. I don't think Apollo would be getting in the space unless they thought there was a pretty long runway. Altius also has a pretty good track record of timing their entrance and exit into royalty spaces. I'm sure there's a risk that governments get more involved making grants to projects, more people get involved in the space, etc. But for now they don't seem to be having any issues finding deals and it wasn't risky enough to keep Apollo and Altius out of the space.