Ormat Technologies' Moat Delivers Overseas

 Ormat Technologies (ORA) has rebounded nearly 40% off its lows in 2012, handily beating the S&P 500 and the Morningstar Utilities Index. Still, in today's yield-hungry market, it is one of the few firms in our domestic utilities coverage universe to offer a compelling discount to our fair value estimate along with a narrow economic moat and a strong long-term growth profile. The Sarulla contract signings expand Ormat's beachhead in a potentially huge growth market, Indonesia. In addition, the firm has won a string of projects in New Zealand and Honduras and is exploring in Chile. Even with delays, we project development will drive 11% annual revenue growth and 13% annual EBITDA growth over 2012-17.

Ormat is one of the largest geothermal power producers in the world, with more than 570 megawatts of geothermal generation capacity in the United States, Guatemala, Nicaragua, and Kenya. The firm gets about one third of its revenue from manufacturing geothermal and recovered-energy equipment for third parties. As a baseload power generation source, Ormat's geothermal plants run at much higher capacity factors than intermittent wind and solar sources, making them the most attractive renewable energy option for many utilities where the heat resource is available.

Geothermal power is a unique resource from a number of perspectives. The source of electricity, operational challenges, financing needs, and consistency of power supply all differ greatly from other renewable resources. Geothermal is typically viable in areas with an underground steam resource or with hot rock. With steam or hot water, steam is harnessed through combined-cycle turbines. These resources are the low-hanging fruit of development. More commonly, a lower-heat resource needs to be stimulated by a geothermal fluid that will be flushed through the "well" to heat up and then into a vaporizer and turbine to drive electric generation. Ormat's technology is focused on the latter, where low- to medium-heat resources require highly efficient specialized equipment to maximize the capacity of the power plant.

Typically the biggest challenge for geothermal developers is access to financing. Most geothermal projects require an initial exploration drilling phase to prove out the resource for development, typically funded by corporate cash. This limits the ability of many smaller players to manage the long development cycle for new geothermal construction. Ormat's size and ability to fund early-stage development from its balance sheet is a huge advantage over smaller competitors. This allows the company to take more chances and explore a larger portfolio of land, increasing the odds of proving a viable resource and securing external financing.

Ormat's unique business model and technological dominance combine with drastically less exposure to volatile fossil fuel commodity prices to make this company the only independent power producer with a moat in our coverage universe. Ormat's narrow moat is supported by a history of strong cash returns on invested capital as well as a sizable competitive advantage within a rapidly growing global industry.

The impact of Ormat's troubled Brawley power plant was clear in 2010-11 as the company struggled to operate it at a higher capacity. The decision to write off much of the plant's value and cease efforts to expand production will take significant pressure off returns. While cash returns on invested capital have been attractive, Ormat's opportunities beyond our explicit five-year forecast are critical in assessing the company's economic moat. Currently, the company has a roughly 92% market share in low-heat nonsteam projects. However, the Sarulla project shows the value of Ormat's energy converters even in a higher-heat project that uses combined cycle steam, where the market is dominated by Japanese manufacturers like Mitsubishi and Toshiba.

While geothermal resources and the applicability of Ormat's industry-leading equipment vary significantly, the huge investment potential during the next 20 years supports major growth potential for Ormat. In addition, its integrated business model helps drive down costs and expedites what is typically a very long development period.

New Projects Slower, but Impressive Growth Remains
Ormat's U.S. project pipeline is also considerable, with projects ranging from the early exploration stages to those nearing completion within the year. However, project delays and permitting issues have cropped up and pushed some projects out of the ongoing development pipeline. A plateau in renewable energy demand in California as the utilities approach renewable portfolio standard targets through Phase II also idles significant expansion potential at Ormat's existing sites. Ormat has an exploration portfolio of 41 sites not currently in development that are unlikely to progress without either an exceptional resource or an extension of state-level incentives for utilities to contract further renewables. Nevada, where Ormat has 13 such sites, could be an exception.

Our 2013-17 forecast incorporates additions of roughly 220 MW, including 116 MW of new U.S. projects under development. Capacity growth and the Sarulla products order--worth $254 million in revenue that we begin recording in 2015--drive 11% annual growth in revenue through 2017. Factoring in a modestly declining operating cost structure and improving gas prices and power purchase agreements in California, we expect 13% annual EBITDA growth for the combined business.

Ormat's Valuation Remains Compelling
Ormat trades at a 16% discount to our $27 fair value estimate, as well as a 9% discount to its U.S. independent power producer peers on a 2014 enterprise value/EBITDA basis and a 12% discount to its peers on a 2015 EV/EBITDA basis.  Importantly--and a key difference from its IPP peers--Ormat's cash flow growth beyond 2015 doesn't rely on a rebound in natural gas and electricity pricing.

While the stock's rally from 2012 lows has brought Ormat out of 5-star territory, we believe there is more room to run and significant upside potential, should the product segment win new business beyond our forecast, concentrated overseas.