Operational and financial improvements at alternative-energy firm Ormat Technologies have underscored the stock's bargain price, says Morningstar's Mark Barnett.
Erik Kobayashi-Solomon: Hi, I'm Erik Kobayashi-Solomon for Morningstar. Today, it's my great pleasure to welcome Mark Barnett, who is a Power and Utilities Analyst here at Morningstar to talk about one of his best ideas, Ormat Technologies.
Mark Barnett: Thanks for having me, Erik.
Kobayashi-Solomon: Thanks for coming. So you had kind of identified Ormat as one of your best ideas kind of back in the summer and there's been kind of quite a lot of news since that time. I know that you've recently updated your forecast and projections and just wanted you to kind of walk us through where you are right now?
Barnett: Sure. Notwithstanding the market turmoil, Ormat did have a bit of a busy summer. We've had third quarter earnings, which along with…
Kobayashi-Solomon: Looked pretty good to me.
Barnett: Yeah, well, especially given the sequential improvement at the North Brawley Field, where, as you know, there have been some sustained losses and they've had a lot of trouble getting that plant where they wanted to.
Kobayashi-Solomon: That's a troubled Nevada plant.
Barnett: That's correct.
Kobayashi-Solomon: The Nevada generation plant.
Barnett: So, what we saw in the third quarter earnings and just generally since the last time that we were here, first, what's going on with our thesis. Where are we hitting our targets, is Ormat hitting their targets? So the first thing that we have been looking for was improvement there at Brawley. What Ormat showed and definitely gave some guidance around was, they're dialing back on that project, They said, listen, we're going to cut back the operating losses, we're going to stop trying to demonstrate higher capacity here until we know how to do this profitably.
Kobayashi-Solomon: So dialing back in terms of, they are not going to put a lot more capital expenditures?
Barnett: Right.
Kobayashi-Solomon: They are not going to put a lot more money into the ground that you're going to get the generation up?
Barnett: Right, and operating expenses as well for replacements of equipment and whatnot. So that's going to start showing up in a big way in the fourth quarter and in 2012. So we really like that they've decided to bite the bullet on that plant.
Second, we had a lot of operational updates in terms of when projects are going to come online, when some of them weren't going to come online on schedule. So a couple of projects were shifted out a little bit further, and so we've had adjusted our forecasts for that and that will show up in our EBITDA projections for 2012, '13, '14.
Kobayashi-Solomon: I see. When you say they shifted out, this shifting is not a material one in terms of timing of cash flows?
Barnett: Not particularly, because generally, when you have a geothermal project, even if you have a in-service date, say of 2013, the plant won't be producing its full amount of output in 2013 to begin with.
Kobayashi-Solomon: It's kind of a staggered production.
Barnett: Exactly. It can go stepwise. So, and it does push it out a little bit further into our forecast, but we don't look at only a three-year forecast, and then all this has gone from 2013, therefore the Company is worth less.
As Morningstar does a five-year explicit forecast, so we are able to incorporate some of that coming in a little bit later. It just wasn’t enough of a meaningful hit, especially when you combine it with the positive results on the product side of the business, where the Company signed a number of fairly large agreements that were a bit of a surprise.
Kobayashi-Solomon: This is, just to refresh my memory. The product side of the business is not where they are generating power themselves, but they are selling parts and materials to other companies that are generating, using these parts to generate?
Barnett: That’s right, yeah. It’s basically build, design, sometimes operate, but often they just sell to a third-party. A number of large contracts came in, in 2011, which kind of were a bit of a surprise. So there is some cash kind of coming in the door there that we hadn’t projected, which will come ahead of our forecast.
Kobayashi-Solomon: That’s going into the pipeline. That’s in the order of pipeline right now, so they should see those cash flows in 2012?
Barnett: 2012.
Kobayashi-Solomon: Alright.
Barnett: There are some that are going to actually be coming in 2013, but we don’t necessarily project that far out on the production side…
Kobayashi-Solomon: Right. I see.
Barnett: … if there is some uncertainty, but another major development or a couple of other developments is we were looking for some financing.
Kobayashi-Solomon: So I was just going to ask you about that. I mean, just aside from the operational issues, of course, we had this whole thing with Solyndra and the loan guarantees, and I think that Ormat had some real headline risk because of that. So what’s going on with Ormat?
Barnett: Well, people were very nervous that, first of all, the general debate in Washington around the budget and then kind of a snafu like Solyndra would jeopardize these programs, these loan programs. What we saw was that Ormat successfully completed the program. They’ve arranged the financing through John Hancock. They’ve already withdrawn $150 million worth of their project down or up they’ll be in stages. Then there is a second piece of that which will probably altogether be above $300 million and fairly cheap financing supported by the government. So that’s a major plus.
Kobayashi-Solomon: So even in the face of all of these headlines about Solyndra, they were still able to get a substantial amount of financing.
Barnett: That just speaks to the strength of the projects that they are offering. I mean, there is a huge – there’s a world of difference between a Solyndra and an Ormat, and Solyndra was a new venture, people who aren’t solar people.
Kobayashi-Solomon: Kind of a science fair experiment?
Barnett: Yeah, to a certain extent. Geothermal, Ormat has been designing these systems since the '60s and the technology is well understood. They do it very well. They have an established track record. These plants are already close to completion. So it’s just a totally different situation. Also, they’ve managed to receive some financings for international projects, which…
Kobayashi-Solomon: This is a private financing deal.
Barnett: Right, and internationally, Ormat actually does have a fairly large opportunity as well outside of the pretty exciting opportunity in the U.S. I mean, they have – Kenya is really looking to be like a really exciting place for them. They're going to expand a plant they have there. So, that was also something that we incorporated into our forecasts.
So, basically all things, considered there are a couple of negative items and some really positive items, and the most important thing we said in our thesis thus far continues to be reaffirmed. So, I mean that's what we're watching for as things go forward.
Kobayashi-Solomon: A big part of your valuation rests on a large jump in revenues because of increased power generation over the next couple of years.
Barnett: That's right.
Kobayashi-Solomon: Can you talk about just a little bit how you're expecting, what you're expecting in terms of power generation over the next couple of years? How likely or unlikely are some of these things to come online?
Barnett: Essentially, what we believe is that Ormat had their fingers burned a little bit with this recent project at Brawley. In their messaging to the investment community, they kind of over-promised and then under-delivered because of it was not operational…
Kobayashi-Solomon: It was a bad combination, right.
Barnett: It was a bad combination. We really think that they have sort of dialed it back a little bit in terms of their projections. So, a little bit more conservative on timeframes for developing new plants and the like, but – so when we look forward in our generation forecast, nothing in our model assumes that they're going to do anything extraordinarily beyond what they have in their pipeline already.
Kobayashi-Solomon: So basically you're assuming pipeline growth?
Barnett: We're assuming pipeline is realized. Now, of course, there are risks to that because geothermal is a tricky thing, and as this last plant showed, sometimes it just doesn't end up – the plant doesn't end up functioning, does the way that you thought, but we don't believe it makes sense to forecast that a company is going to spend money to lose money looking forward, and those are sorts of negative surprises that you just have to be comfortable with as a risk when you invest in a company like this.
Kobayashi-Solomon: Right, sure.
Barnett: I mean, that really is part of the – this is really the backbone of our about 19%, 20% growth in EBITDA that we expect from 2011 through '15, that's coming from plants that they have at least a fairly late stage of development. It's not assuming that their very large exploration portfolio produces any extra fruit, but it will naturally down the line, but that's not incorporating …
Kobayashi-Solomon: Maybe that will offset some of the shortfalls, if there are any shortfalls or something.
Barnett: It's potential, but you know the lifetime of a project is fairly long. So, we wouldn't want to make any kind of real aggressive assumptions about that.
Kobayashi-Solomon: Right, sure. So, not making any heroic assumptions, you're still reiterating your $28 fixed value for the firm and still really like it?
Barnett: Yeah, it's still a deep five stars, still a Morningstar best idea, so yeah.
Kobayashi-Solomon: Great.
Barnett: Happy to talk about it.
Kobayashi-Solomon: Thanks very much for coming in and telling everybody.
Barnett: Thanks for having me, Erik.
Kobayashi-Solomon: And thank you for joining us. I'm Erik Kobayashi-Solomon for Morningstar.
