This research report was jointly produced with Seeking Alpha Author Long Player.
Pattern Energy (PEGI) is a renewable Energy company that generates a fair amount of cash and is growing. The Stock recently traded at $17.2/share and its most recent dividend was $0.422 which provides an annualized yield of 9.8%.
Understanding the Business
PEGI is in the business of owning and operating renewable energy projects. So far, these projects are dominantly wind farms. This involves a number of advanced wind turbines located in a desirable area to harvest wind energy. The projects all have long-term Power Supply Agreements (PSAs) – typically with local utilities. The counterparties to such agreements have, in almost every case, very solid credit ratings. There is, thus, very little market risk or price risk associated with the projects. The main variables are the wind itself and downtime due to malfunction or other factors. The relatively low level of risk provides a strong basis for a yield-oriented investment.
PEGI operates its projects (some of which are partially owned by other companies) as somewhat independent entities. Each project is a separate limited liability corporation (‘LLC’), and has substantial debt financing but almost all of the debt is non-recourse (some of it is partial recourse). Thus, the impact of a failure at any one project is limited. PEGI’s 25 existing consolidated projects are in the United States, Canada, Chile, and Japan. PEGI’s PSA contracts average a term of 14+ years with 90% using Siemens and GE equipment. Its fleet of wind turbines is relatively young and has an average age of less than four years. Counterparties to PSA agreements include utilities like PG&E (NYSE:PCG), SDG&E, and Westar (NYSE:WR) and non-utility entities like Morgan Stanley (NYSE:MS), Citigroup Energy, and Amazon (NASDAQ:AMZN).
A Defensive Stock
PEGI provides electricity, which is a basic necessity. Therefore, the company is unlikely to be affected by economic cycles. As an alternative or “green” electric producer, that company stands out for its profitability as well as the growth of that profitability. PEGI is also part of a group of companies that is trying to bring more “green” electricity to the world. As costs for this technology continue to drop, they may succeed with this wind technology far more than many would have foreseen.
Source: PEGI December 2017 Presentation
The company has invested in countries that are relatively stable and value renewable energy sources. As such, political upheaval is generally not a concern. Successful ventures in Japan could yield some long-term competitive advantages. Japan tends to be a notoriously hard market to penetrate. Therefore, the information shown above is a big deal. Japan would like to avoid importing oil and gas to some extent. Wind technology promises the hope of reducing the energy import bills.
Above all, this technology is not dangerous should a volcano erupt or a major earthquake hit the area. A few years back a major earthquake caused all kinds of problems with a nuclear reactor. The cleanup from that earthquake continues. The nuclear reactor may never go back into service. Wind technology has no such issues. In some ways, wind technology to generate electricity is a blessing in a land where mother nature is very active.
A Beaten Down Stock
The stock has tanked recently for two main reasons:
- Investors’ fears that U.S. Tax Credits for renewable energy will expire in a few years.
- The stock got beaten down some more (down by another 10%) after the company declared that its quarterly dividend will not increase. As a reminder, PEGI had hiked its distribution every quarter for the past 16 quarters prior to this announcement.
Based on 2018 “Cash Available for Distribution” (or CAFD) guidance, PEGI’s is currently trading at just 10 times CAFD (using midpoint CAFD guidance of $166 million and 95.1 million shares outstanding). The yield is now close to 10%. These valuations are bargains for a growing cash flow and distribution. Mr. Market appears to have tossed away everything but a select group of companies. Companies not in that select group keep getting cheaper.
Interestingly, the company is far larger now and has a better yield than at the time of its initial public offering in September 2013 when the stock was trading at $22/share.
Today, the stock is trading at $17.2/share and the distributions have grown by 35% since the IPO, making it a very attractive investment.
Yet, Mr. Market couldn’t care less. Mr. Market is busy sending the stock to new lows. Sooner or later the growth should outweigh the market disdain. The investor is being paid nearly a 10% distribution to wait for that attitude change.
Source: PEGI December, 2017 Presentation
As long as management continues to make only accretive acquisitions, this company should continue to be an attractive investment.
Risks of ‘tax credit’ expiration are overblown
The finalization of the tax bill last December brought greater clarity to Pattern Energy’s future as it has preserved the critical credits for wind and solar for the time being. Still, this did not calm investors’ fear that tax incentives remain at risk in the longer term. Here is our take on this:
- A great deal of PEGI’s planned expansion is outside the US and will be completely unaffected by any potential future change in tax benefits.
- Within the United States, should tax credits expire, the effects would be primarily on the development side of the business rather than on existing facilities on the operational side. PEGI is primarily an operating company although it has now some participation on the development side. The point to note here is that the profitability of the existing facilities of PEGI in the United States should not be impacted.
- In the U.S.A., most states now have renewable portfolio requirements (and in some cases targets) for their utilities which require that certain percentages of power be generated by renewable sources by certain deadlines. So with or without subsidies, wind farms have to be built. They will just cost more to the end user, but they will still have to be built and to operate to meet the minimum required targets.
- Renewable energy is growing rapidly, and the cost of producing wind and solar technology is dropping every year. So in a few years, renewable energy operators will be able to compete with other forms of energy without the need of any subsidies.
While PEGI did not raise its distribution in the last quarter, a very important aspect is the analysis of next year’s guidance that management has provided:
- PEGI is expecting a very strong year in 2018 with “Cash Available for Distribution” (or CAFD) to be in the range of $151 million to $181 million, or 14% higher than the 2017 CAFD using the midpoint of the range.
- During the year 2017, PEGI agreed to acquire 206 MW of owned capacity in 5 Japanese projects which represent the company’s entry into one of the most robust renewable markets in the world. PEGI is now expanding internationally and the income from these projects will kick in during the year 2018.
- The 2018 guidance includes 24 projects expected to be operating and contributing during 2018, including 4 new projects in Japan and Canada which were not operational during the year 2017. This is encouraging, as we have been saying all along that the growth in PEGI’s earnings will come from outside of the United States.
As of March 11, 2018, there are 15 banks and analysts who cover the stock with a consensus rating of “Overweight” on the stock, and an average consensus price target of $24.67, suggesting a ~43% potential upside from the current price (source: wsj.com).
At $24.67/share, this would put the valuation of PEGI at 14 times cash flow, which is very reasonable. We should note that PEGI traded well above $24.67/share in September 2017, just a few months ago.
The shares of this company are in the bargain bin. With a solid outlook and cash flow growth for 2018, combined with a very low valuation, PEGI is set to greatly outperform within the next 12 months. With a 9.8% yield and +40% upside potential, PEGI could very well generate returns of over 50% in the next 12 months. The pullback provides a unique buying opportunity.
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Disclosure: I am/we are long PEGI.
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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