The Energy Report: In your last interview, your primary concern in making investment decisions was safety. I know you focus primarily on Canadian companies, but has all the "fiscal cliff" talk influenced your approach to renewable energy investments?
John McIlveen: With the fiscal cliff, I could see how renewables might get pushed to the back burner in the process of cutting a budget deal. Some renewable incentive policies might even be used as a bargaining chip to get other budget items through, such as higher taxes or spending cuts.
TER: How have the oil and gas market dynamics in 2012 affected the outlook for companies in the renewables industry?
JM: Renewables are very competitive with oil-fired power, but not with gas or natural gas-burning plants. Gas sets the marginal price for power and affects the prices for a new project that developers are trying to build. This doesn't affect existing projects because these are all under long-term contracts with fixed prices that generally include an escalation clause. But for bidding a new contract, a low gas price pinches the budget for developers.
TER: How much do current prices affect the timing of any new investment decisions in the renewables field?
JM: In those states that don't have a renewable portfolio standard—and about two-thirds of the states do have one—there isn't going to be much incentive for renewable power, period. States that do have renewable portfolio standards, such as California, have to consider how they will achieve the percentage of renewable power objectives that they have. If they really want to hit their portfolio standards, they're probably going to have to pay up in terms of the power price they're willing to contract for. There's still incentive on the state level to proceed with renewable energy. But on the federal level, not so much. Most of the incentive programs, such as investment tax credit grants and/or biodiesel tax credits, for example, are all expiring.
TER: Are the dynamics different in Canada than in the U.S.?
JM: Each province has its own way of going about things. Some have incentive programs. Some do not. Some have a high tariff structure. Some do not. In the U.S., if natural gas is going to affect the local market in terms of new project prices and power prices, then developers may just put a project on the back burner. They would perhaps look to areas outside the U.S. that may be getting power supplied by oil-fired generation, such as much of the Caribbean and more remote mining sites in South America. When you're replacing the cost of oil, which in some jurisdictions is as much as $250/hour, renewables at as much as $100/hour look pretty good.
TER: Where do you see the best growth opportunities in renewable energy?
JM: Within the U.S. it's more case-by-case or more like state-by-state, depending on how much they want renewable power. Probably the best growth opportunities lie more in the Caribbean and Central and South America where they don't have a natural gas supply and import oil to generate electricity. Using renewable power and cutting oil imports is great for their balance of payments and at the same time their consumers are getting a lower price for the power.
TER: Getting to specific companies you cover, I see that you've raised your target price for Ram Power Corp. (RPG:TSX) substantially, from $0.68 to $0.90/share. What's the story there?
JM: Ram Power just came on-line with 36 megawatts (MW) in the last quarter and will add another 36 MW before the end of this year. I'm looking for Ram to generate $40 million ($40M) in EBITDA for 2013. That puts the current valuation down around four or five times enterprise value to EBITDA. But the market has to see the cash flow before it's going to give any value to it. It's looking for show-me stocks for juniors, and this is not just limited to Ram Power. All the junior stocks are capital constrained, so they have difficulty raising new money to expand or to take on new projects, compared to the more mature companies that pay a dividend, which have great access to capital and a decent valuation in the market from which to raise more money.
"Probably the best renewable power growth opportunities lie in the Caribbean and Central and South America where they don't have a natural gas supply and import oil to generate electricity. "
Back in January, I thought safety was really the main concern, and that situation still continues today. Whereas the dividend-paying, more mature power companies have done well and are mostly up on a year-to-date basis, almost none of the juniors are, barring a special situation such as a potential takeover. This would be the case for Shear Wind Inc. (SWX:TSX.V), Western Wind Energy Corp. (WND:TSX.V) and Finavera Wind Energy Corp. (FVR:TSX). So if you were interested in buying the junior companies, you shouldn't be buying them expecting near-term growth, because they're capital constrained. If you're buying them, you're hoping they'll get taken over because their valuations are very cheap—much below what I would think they would be in the private markets.
We're starting to see M&A activity among the juniors, whereas the seniors are still all about yield. In just the last four weeks the seniors seem to be declining somewhat, which is perhaps an indication that the market is seeing that yield stocks may have become a little bit too pricey and are starting to look for value elsewhere. This also goes for banks, real estate investment trusts and a lot of the yield stocks in general.
TER: In the oil and gas business it seems that almost any company that's reasonably successful gets taken out after five or six years. Is that going to be the case with most of these smaller companies in the renewables field?
JM: I think so, but I'll put them into two categories. There are junior companies with power plants that are on-line and those without. I don't think the market is paying good money for a company with a pipeline of undeveloped assets. So if you've got some rights to a bunch of sites that you're evaluating, but no power purchase agreement signed, you're not going to get much value for those assets. However, power assets on-line, generating real cash flow, are going to be attractive to anybody larger than that company.
TER: One of the companies you mentioned last time was U.S. Geothermal Inc. (GTH:TSX; HTM:NYSE). What's happened with that one since you last talked with us about it?
JM: U.S. Geothermal has been bringing assets on-line and hitting its milestones. I'm looking for it to produce an EBITDA of $15M in 2013 and be cash-flow positive for the first time. It has on-line assets, which could make it an attractive takeover target. I would think that Ram would be pretty attractive as well.
"Back in January, I thought safety was really the main concern, and that situation still continues today."
Alterra Power Corp. (AXY:TSX) has had a number of events that could make it a very interesting story. It received an offer for its geothermal assets in Iceland. If this sale goes through, the company would have more than $120M cash on the books and be debt-free. Alterra also has other projects with permits and power purchase agreements where it could redeploy that cash. Also, General Electric Co. (GE:NYSE) is selling some wind and hydro assets in British Columbia, two of which involve joint ventures with Alterra—one hydro and one wind. If the price is attractive enough, Alterra might also sell along with GE or perhaps, if it's a passive buyer, it may want Alterra to stay and run the assets. A lot of events are working in Alterra's favor that can create cash, which it could deploy into its other development projects.
TER: So, Alterra could become some sort of midtier-type growth company that could expand on its own, rather than being taken over immediately.
JM: If no one wants to take out Alterra, then it's likely that by the time a number of these events unfold in 2013, it may actually become a dividend-paying company in 2014 or 2015.
TER: There's been quite a bit of turmoil in the solar energy industry this year, particularly for hardware producers. How are the companies you follow in solar energy production doing?
JM: Hardware producers are a totally different animal than the power producers. We get a lot of calls from the press relating to government-guaranteed programs. A power producer has a fixed price and a fixed quantity contract for 20 years, so it's a good bet for a loan. Manufacturing, especially in the solar chain, involves many steps, and not everyone is integrated through the whole chain. A lot of boom-bust cycles occur within the equipment manufacturing industry, even for wind power. So, there just isn't the type of certainty and predictability that you have in financing a power generator.
TER: The wind energy production industry is also dependent a lot on government subsidies. One of the companies you discussed last time was Western Wind Energy, which has been embroiled in both internal power struggles and possible takeover deals. Where does that one stand now?
JM: Western Wind put itself up for sale last summer and has been allowing potential suitors into the due diligence room to look at the company. We don't know who the eventual buyer will be or the price to be paid. Over a year ago there was a soft offer from a suitor for $2.50/share, so that's where the stock is hovering, waiting for more news on the potential sale. But, a group of dissident shareholders did come forward and wanted to change the board to people they felt would be more committed to the sale of the company. The existing board beat that back in a shareholder vote and so remains in control, but at the same time they state that they are committed to selling the company. It looks good from a risk-return profile because there isn't much downside to owning it at $2.50, whereas I think there could be some significant upside when the final bids are in.
TER: Any projected time on when they might be accepting an offer from somebody?
JM: We're expecting an update soon. They've been at it now for a good three months of due diligence and it could be another three months before a final offer is accepted.
TER: Have there been any interesting developments with some of the other companies that you've been following?
JM: BIOX Corporation (BX:TSX), which makes biodiesel, is suffering from a symptom of the industry as a whole. It's actually shut down its plant because of weak prices in the biodiesel market due to the expiring of the $1/gallon tax credit and the fact that the volume mandate set by the EPA is just about filled for this year. So, they lose money at the market prices today, which I'm sure is the case for many biofuel producers. This is an industry that is incentive driven and needs those incentives to go forward.
TER: What happens with BIOX if there aren't some positive developments in its favor?
JM: If you're in the business you've got to assume there will be some recovery in prices. After all, the volume mandates set by the EPA did go up by 28% for 2013. If too many plants shut down, producers can't meet the EPA volume mandates, and prices will have to go up to make those plants open up again. In the meantime, it's going to be a rough ride until the market finds that equilibrium price for biodiesel.
TER: Can this become a cyclical thing that's going to be on-again, off-again for some period of years?
JM: Each year, Congress allows the tax credit to expire. In 2011 they let it expire for the whole year and then reinstated it at the end of the year retroactively. This sort of incentive makes the market gyrate and something more consistent is needed for this industry.
TER: On the other hand, if investors want to take a crapshoot, it's an opportunity to play a little mini-cycle.
JM: That's right. So, if you've got some political savvy and you think incentives are going to be restored, then that would be a good play.
TER: What's been going on in the senior company sector?
JM: There's been an interesting development of late with Just Energy Group Inc. (JE:TSX), which is basically a reseller of electricity and natural gas, along with some other activities across North America. The stock has gone down from a one-year high of $14 to about $8.50/share today, resulting in a dividend yield of almost 15%. I bring this up to make a point about dividends. Investors often look at the dividends in a group, whether it be banks, real estate or utilities. In the case of power producers, the low yield in the group is around 4.3% and the high yield is almost 15%. That's quite a spread, but when you see a high yield, as in the case of Just Energy, it's because the market is pricing in the risk of a dividend cut.
"We're starting to see M&A activity among the juniors, whereas the seniors are still all about yield."
So, just because you see a high yield, don't go rushing to that when you see 14% versus 6%. When a company has a 6% yield in the power sector, it's likely because it's lower risk and the market thinks its dividends will increase over time. If you don't want to do a lot of homework, the simple way to pick these stocks is to pick the one with the lower dividend, because that one is probably going to increase over time, whereas a high yield may see a dividend cut.
TER: Are there any other of the more established companies you'd like to mention that look interesting?
JM: If you want to sleep well at night, you've got to be thinking Algonquin Power and Utilities Corp. (AQN:TSX) and Brookfield Renewable Energy Partners L.P. (BEP.UN:TSX), which are the two largest ones in the Canadian space. Northland Power Inc. (NPI:TSX) is also a premier company, which is about to double its megawatt assets over the next year. I would expect the stock itself to move a bit more sideways for about a year until it starts bringing all those new assets on-line. Once it does, you can start thinking about a dividend increase for 2014, but not for 2013. Innergex Renewable Energy Inc. (INE:TSX) is another solid company with a good track record of growth and executing on its development projects. Algonquin and Brookfield would be my short-term favorites here, and then late in 2013, I'd be looking at Northland and Primary Energy.
After that, we get to companies that are a little smaller but still decent investments. Capstone Infrastructure Corp. (CSE:TSX), Primary Energy Recycling Corp. (PRI:TSX) and Sprott Power Corp. (SPZ:TSX) all have lower yields as well, given that they have a good payout ratio. So they're 75% or lower in terms of dividend to free cash flow.
TER: Given what you currently see on the horizon, how should investors interested in alternative energy stocks play this market in the coming year?
JM: I'm still emphasizing safety for the majority of your holdings in this space. You might also want to pick up a few of the juniors that you think could become takeover targets or already are, such as Western Wind. We'll have to see what happens after the fiscal cliff is hopefully avoided and whether the federal government turns some attention back to renewables.
TER: We'll know much more about that relatively quickly. Meanwhile, we appreciate your input.
JM: My pleasure.
Jacob Securities Senior Vice President for Research John McIlveen has been with the firm five years and has a total of 26 years' experience in special-situations research and merchant banking. In 2004, he became Canada's first sell-side analyst to focus solely on renewable energy research and consistently has been ranked a top performer by Bloomberg on accuracy of estimates and returns. He is currently treasurer of the Canadian Geothermal Energy Association and a published academic with 15 papers, including his and coauthor Alan Rugman's 1985 best Canadian book-nominated "Megafirms: Strategies for Canada's Multinationals."
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DISCLOSURE:
1) Zig Lambo of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: None. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) John McIlveen: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.
