Archaea Energy (NYSE:LFG) reported its full-year 2021 in March; LFG appears to be that rare breed a successful SPAC that exceeds expectations, delivers on promises, and brings products to market ahead of schedule. As a result of its excellent year, I am increasing my forecast valuation of Archaea Energy to $6 billion (against the current valuation of $2.4 billion) and expect it to hit these targets within 2-3 years.
Archaea energy produces renewable natural gas (RNG). If you need background on this market or how the industry works, please read my first article on this company written before they completed the SPAC merger 'Rice Acquisition: The Rice Brothers Are Offering A New SPAC, And I Am Buying'.
That article talked about the people behind this company in great detail; they have a reputation for delivering profitability in this industry with on-time below-budget execution of their plans. Their first company Rice Energy multiplied early investments by 30! This trend appears to be continuing at LFG and is on track to deliver a large, profitable company and excellent returns for early investors, of which I am glad to be one. The Rice brothers have a second SPAC vehicle (RONI). I will be writing an article about that project as soon as we have some clarity.
I wrote an article just after the SPAC merger was confirmed Archaea Energy: Merger complete in October 2021 and identified the management's targets and opportunities. This article is an update to the two previous ones. In this article, I will focus on the progress made in 2021 measured against previously guided targets.
LFG produced and sold 5.72 MMBtu of RNG; that figure is 5% above previous guidance. They also produced and sold 871,508 (MWh)squared.
At the end of Q3 October, LFG was operating at 23 sites, and by the end of Q4, that had increased to 31. The new sites include six that are electricity only and will have RNG production added in 2022 (new guidance).The Soares site came online and is the first Dairy site the company operates. Soares results will be significant as there are 4,000-7,000 commercially viable RNG sites at Dairy farms in the US. (author estimate see article 1)
Ahead of schedule and below budget, the Assai site in Pennsylvania is the highest capacity operational site in the US. I wrote about this in length in my first article, it is the world's largest RNG site, and Archaea will use its technical success here to leverage future negotiations. The site includes 85 megawatts of power generating capacity forecast to deliver $40 million in EBITDA annually.
Landfill flows into the site are expected to continue increasing for several years. Two other sites, Keystone and Alliance, are in the vicinity and have been granted significant landfill expansion awards in 2021. Archaea expects to add gas flow from the Alliance site this quarter; gas from keystone is already being piped.
This is a fundamental part of the Rice brother's plan forward selling their RNG to investment-grade companies. This strategy deleverages risk and significantly increases the company's ability to raise capital if and when needed. In 2021 Archaea signed two long-term fixed-price contracts for 8.6MMBtu.
Archaea is not yet where they want to be in this area; currently, only 25% of production is part of long-term contracts; they hope to increase this to 75% by 2025 and remain on track to achieve this goal.
All targets and guidance for production in 2021 were met or exceeded.
Archaea is developing a sustainable competitive advantage with its technical knowledge and good management. This new product (or technology) will give them a market-leading cost base, a market-leading lead-time and enable them to develop sites previously thought to be uncommercial because of low RNG flow rates. Version 1 is an entirely new concept not in the original pipe prospectus and not previously mentioned by management.
Historically each RNG site has been developed using a custom-made system that captures the escaping methane. It is a combination of wells dug into the site, vacuums, and blow/flare units directing the escaping gas to a central point where it is collected and cleaned.
The central collection system for each site has been a unique unit designed, specified, and manufactured with a complex supply chain and more than one subcontractor. It takes several years, and because every installation is custom-made, it is too expensive to apply to landfill sites with lower volumes and slower flow rates. The economics didn't make sense.
Archaea has designed "Version 1", a skid-based unit built in advance and available on the shelf. It replaces what was previously custom made with a modular system; Archaea intends to use Version 1 on all of its planned new sites for 2022 and has secured the necessary parts for all 22 units. Archaea wants to have these units ready to deploy off the shelf; this is a significant competitive advantage for Archaea; they will develop sites much faster than the competition and make money from less favorable sites. With current supply change disruption, this is a big issue.
Version 1 will revolutionize the industry; it reduces capital expenditure by around 40% per site, and its interchangeable parts mean it can work with volumes from 2,000 to 9,000 scfm. Development time will be less than 18 months, well below industry standards.
According to the EPA, there are 548 active Landfill to RNG sites in the US, and a further 500 are considered economically suitable for development.
LFG believe that Version 1 will add 500 previously unprofitable sites to the EPA list giving them more than 1,000 addressable landfill site, double the number available to the competition.
The backlog was another area of substantial progress in 2021, leading to higher profits for many years to come. The backlog is a list of sites Archaea intends to develop; it represents future revenue and is the primary driver of future profits. When the contract for the gas rights of a site is signed, Archaea adds the project to the backlog; five sites were added in Q4 2021, bringing the total to 10 sites added in 2021. Ten new sites is well above target, and my original model was for four additional locations.
Four of the five new sites already have gas to electricity in place, and Archaea intends to build RNG plants on these sites. The 5th site has no energy generation in place at the moment. The backlog growth continued into 2022, with three new sites added.
Archaea now has 38 projects in the backlog with gas rights in place, 28 are new builds, and the others are classified as optimizations. Archaea intends to bring 22 of these sites online in 2022. They will be using Version 1 on these sites and have purchased the parts needed to assemble the 22 Version 1s.
It is a crucial target for 2022. Bringing 22 sites online using this new tech in 1 year will demonstrate a capacity well beyond many competitors.
Optimization is where Archaea uses its advanced technology and know-how to improve a site already in production. They do this in the following ways.
1) Increase uptime of equipment and increase the array of gases the equipment can cope with. 2) Improve gas processing technology. 3) Improve flow by better drilling and flow technology. 4) Accept additional flows from close by sites
The full-year 2021 reported figures missed one key metric. Profit, Archaea guided in the initial pipe document to profitability from day 1, this has not proven to be the case. Archaea reported a 2021 EBITDA of -$9.5 million. We must dig into this to see why this happened.
Archaea reported a net loss on operations of $77 million, revenue was reported as $206 million (above target) lifted by a beat on the production volume of RNG. Is this the familiar SPAC problem of lapse cost control? Archaea pointed to $25 million in G&A costs; the actual figure has come in at $45 million. In the recent earnings call, CEO Nick Stork said that he did not expect any future increase to this figure as he believes the organization is at scale.
What to make of this? If Nick is correct and they are now at scale, everything is good. They have increased headcount and all of the other costs associated with it. They have also increased the potential size of the operation; in fact, the possible size of the profits has more than doubled, whereas G&A has increased but not doubled. I will watch this closely going forwards. It would not be the first time I have lost money as a SPAC balloons its cost base past its income.
Archaea is developing its pipeline of sites and the Version 1 off-the-shelf unit. Archaea spent $242 million for the full year 2021, primarily on acquiring the rights to additional sites purchases of equipment for other sites to come online in 2022. $51 million was spent on sites already under development, primarily Assai and Boyd county. This activity, along with the previously discussed G&A increase, was the cause of the loss suffered in 2021; however, we can't view it as a negative. Archaea is growing and growing quickly. It is acquiring future gas rights and developing the equipment to make them profitable. We will likely have a similar story in 2022 as the sites coming online this year will not be able to contribute an entire 12 months of revenue; however, we can assume profitability will arrive in 2023.
This view of profitability in 2023 is the consensus of wall street analysts.
Long-term debt is quite high but in line with this type of business, with large costs coming upfront to develop long-term stable cash generation. Archaea has enough cash on hand and the ability to borrow when they need to.
The current backlog accounts for 35MMBtu of annual production or, put another way, $400 million in annual EBITDA. It is a very conservative figure. Archaea is cautious with the sales price they use and the value of the environmental credits they receive.
Monetizing the environmental benefits of RNGRIN: Renewable Identification Number. The Environmental Protection Agency issues RINs. Each RIN is proof that the equivalent of 1 gallon of Renewable Natural Gas has been injected into a shared pipeline. The EPA organizes a market for these RINs where they can be traded. LFG uses a long-term price of $1.50 per gallon RIN, 25% below the current market price; for much of the recent past, RINs have been near $3.
Archaea stated that every $0.50 on a RIN will add $20 million to EBITDA; readers should note that LFG produces gas and they sell that gas, the EPA awards them RINs, which they can then sell, but the timings do not match exactly.
The sites currently in production and on the Archaea backlog should generate an annual EBITDA of $400 million. I expect this figure to increase as more sites are added to the backlog in the coming years; however, as the backlog is confirmed, I will use that to give a potential valuation.
I am using an EBITDA multiple of 14 to be compatible with my first Archaea article (x14 still appears reasonable and is in line with other green energy and environmental services companies).
It gives a value of $5.6 billion, increasing 24% from my original figure. The current market cap of $2.4 billion suggests a short-term upside of more than 100%. I am growing my position at the current price of $20.2 per share and targeting a 100% return within two years.
SimplyWallstreet provides the following DCF valuation which agrees with my view.
During 2022, I will be monitoring Archaea and measuring its success against the following targets. 1) Assai, 95% operational target met. 2) 22 New sites brought online. 3) The backlog increased again by 10+ sites. 4) Version 1 is in operation and working well. 5) Movement on lower flow sites towards commercialization6. Movement on other products, Ethanol, Hydrogen and solar.
2021 was a year of execution for Archaea; they completed the SPAC merger, brought Assai online, beat their production targets, scaled the business, increased the backlog, and brought version 1 to life.
It was an excellent year; if they can continue to execute in this manner, I expect my investment to be rewarded.
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Disclosure: I/we have a beneficial long position in the shares of LFG either through stock ownership, options, or other derivatives. 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.
Additional disclosure: I have bought LFG for the third time ($16, $18 and now $20) my position is now what I consider full size and as a result, I will not add further. I intend to hold the position for 1-2 years.