Polaris Infrastructure: Possible 25% Dividend Yield in 2016
GuruFocus.com
From http://www.goodwoodfunds.com/
Earlier this year the financially-stretched Ram Power Corporation ("Ram Power") underwent a substantial recapitalization, refinancing, renegotiation of underlying project debt terms (the project lenders are various development banks generally affiliated with the World Bank), change in Board composition and management, name change to Polaris Infrastructure Inc. ("Polaris" or the Company) and share consolidation - in all of which Goodwood Inc. played a key role.
The recapitalization resulted in C$54.6 million in Polaris secured debentures (C$53.0 million of principal plus C$1.6 million of accrued and unpaid interest) being exchanged for roughly 5.5 million common shares at an issue price of C$10 per share while the refinancing brought C$74 million of new equity priced at C$8 per share (these per share figures reflect the share base outstanding after the share consolidation, there are now roughly 15.6 million shares outstanding).
So the former debentureholders own approximately 35% of the Company's stock while the new money (i.e., the C$74 million of new investment) owns approximately 60% (the balance of the shares outstanding are owned by a mix of the pre-existing Ram Power shareholders, new management and Director equity compensation and an equity incentive fee earned in respect of capital brought in by non-Goodwood entities). Immediately after all the above changes and factoring in various mostly one-time expenses, the Company was left with approximately C$70 million of cash and no debt at the Polaris level (i.e., holdco level).
Polaris' sole operating asset is the 72 megawatts ("MW's") capacity San Jacinto geothermal plant in Nicaragua which is currently generating approximately 51 net megawatts or approximately 5% of that country's electricity needs. So the plant is currently operating well under its 72 MW's capacity and the long term, US dollar-denominated power purchase agreement ("PPA").
At this net MW's level, San Jacinto's profitability is running at US$40.5 million of EBITDA, which, after an estimated US$5 million in regular capital expenditures (i.e., at the plant level), leaves approximately US$35.5 million for project debt service (both principal and interest) and distributable cash to the parent (i.e., to Polaris).
The new project debt terms stipulate that, upon Polaris spending a minimum of an additional US$25 million on San Jacinto, the project debt's interest, fees and repayment terms will all be adjusted such that, for example, the 2016 total debt service would drop from US$37 million to approximately US$22 million (note that as at June 30, 2015, project debt was US$202 million while project cash was US$37 million leaving net project debt of US$165 million). As well, these new project debt terms allow for distributions to be flowed up to Polaris so long as no project debt covenants are being breached and it is anticipated that no taxes will be payable on distributions Polaris receives from San Jacinto for a number of years.
Note that geothermal reservoirs normally experience gradual declines in output for which, as is the case with San Jacinto, there is commonly put aside cash for future additional drilling to offset these declines. In the case of San Jacinto we assume a 3% annual decline in the current production rate and we note that a portion of the US$5 million in plant level capital expenditures is set aside in a drilling fund such that every 3 years the plant can self-finance the drilling of another production well. So the figures we calculate below incorporate a 3% decline in the current US$40.5 million EBITDA to US$39.9 million for 2016. Further we would note that the US dollar PPA has a 3% per annum price escalator which would suggest that we are being too conservative with our annual decline rate assumption on current EBITDA. But, in the interests of conservatism, we will just apply our production decline rate assumption but not the PPA escalator.
Originally, the plan by new management was to spend circa US$30 million to drill two additional production wells, on top of the current 8 producing wells, and to improve the reinjection wells. But, compelling potential economics has resulted in management now thinking that a third production well should be drilled which would bring the total budget to US$36 million to US$37 million. Every additional producing MW adds an approximate US$1 million of EBITDA and almost all additional EBITDA is additional free cash flow to Polaris since plant level sustaining capital expenditures are already covered from existing EBITDA. In light of the better rates available today for renting of drilling rigs (the slowdown in oil & gas activity helping in this regard) and given the reservoir knowledge that has been developed over the last several years combined with the upside potential of adding producing MW's, there is a compelling risk-adjusted financial argument to be made in favour of this expanded drilling plan. It is anticipated that the first 2 new wells and the reworking of the reinjection wells will be accomplished during October and November of this year while the third well could be drilled in February of 2016. Thus, Polaris could be in a position to begin receiving distributions from San Jacinto beginning early 2016.
If we take the current 8 production wells and divide by the approximate 51 net MW's of current production, we derive an average per well of 6.375 MW's. Justifiably one could consider this approach to be too aggressive as it does not take into account the Company's earlier non-commercially-viable drilled wells. However, based upon technical consulting ?advice that Goodwood Inc. obtained in the context of the refinancing, we believe that 2 additional wells would most likely yield an additional 15 net MW's so we believe this theoretical 6.375 net MW's added per new well is not too far-fetched (and again, the knowledge about the reservoir is much more extensive today than what it was years earlier which is a significant factor). In any event, if one were to apply this metric to the planned 3 new wells it would indicate an additional 19.125 MW's of production could be generated by the new wells. This very welcome outcome would result in Polaris being in a position to potentially pay out approximately US$29.4 million of annual dividends - calculated as: US$40.5 million (being the current EBITDA run rate) multiplied by 97% (to account for the anticipated 3% decline in 2016 production versus 2015) minus US$5 million (plant level capital expenditures) plus US$19.125 million (new production wells' contribution) minus US$22 million (2016 "new" project debt service principal and interest payments) minus US$2 million (Polaris corporate overhead) and assuming a 100% dividend payout ratio (note that the Board may not decide to pay out 100% of available free cash flow initially but we expect a substantial portion of free cash flow will end up being paid out as dividends).
At the current C$9.20 share price and 1.3242 USD/C$ FX rate and with approximately 15.6 million shares outstanding, the implied dividend yield on Polaris stock would be 27.1%.
The following table incorporates various assumptions on net MW's added, dividend payout ratios and shows the resultant dividend yield using the current C$9.20 share price, assuming a 3% annual decline in the output of the current 8 production wells and ignoring the 3% per annum price escalator in the US dollar-denominated PPA:
Success in MW's
0
5
10
15
20
50%
5.1%
7.5%
9.8%
12.1%
14.4%
60%
6.2%
8.9%
11.7%
14.5%
17.2%
Payout
70%
7.2%
10.4%
13.7%
16.9%
20.1%
Ratio
80%
8.2%
11.9%
15.6%
19.3%
23.0%
90%
9.3%
13.4%
17.6%
21.7%
25.9%
100%
10.3%
14.9%
19.5%
24.1%
28.7%
Note that the above figures are before factoring in that Polaris may construct a binary unit in San Jacinto. A binary unit takes water that is about to be flowed back underground and runs it through another system which can potentially add 10% to the then production rate. For example, if the plant is running at 65 net MW's after the new production wells are added, introducing a binary unit would take production to circa 71.5 net MW's. Encouragingly, the project lenders are willing to finance 70% of this capital expenditure under the existing project debt structure.
Further growth potential can be found in Polaris's Casita project which is also in Nicaragua and is 95% owned by Polaris. Previous management had spent approximately US$11 million in preliminary drilling at Casita to establish some confidence as to the potential size of the geothermal resource there. The Company has an engineering report on Casita specifying that it is a commercially-viable project at 85 MW's. We have confidence that new management will find creative ways to bring Casita into production while still being in a position to pay out material dividends flowing from San Jacinto. The Nicaraguan authorities are very favourably disposed towards developing more geothermal electricity production as the country still relies heavily on imported oil to generate electricity and has few other clean, low cost electricity generation options. Also, the World Bank has indicated it would be favourably inclined to provide a US$20 million drilling grant to Polaris to help develop Casita. With roughly C$26.5 million of excess cash (even after factoring in the now-contemplated enhanced drilling program), Polaris is in a position to consider development options for Casita including new modular geothermal plant technology which could be applied in a manner that substantially reduces development risk. Obviously, to the extent Polaris can effectively bring on stream an additional producing asset (in fact, one that has a higher indicated MW's production profile than San Jacinto itself) it would be a substantial additional positive for the Company and for Nicaragua.
Ignoring for the moment the potential valuation impact of Casita and assuming the bulk of Polaris' looming free cash flow will be paid out in dividends, we believe Polaris' stock will trade for a 10% to 12% dividend yield. This higher-than-normal dividend yield would reflect that currently Polaris has only one operating asset and the heightened jurisdictional risk, though on this latter point we take comfort in the ongoing, long term involvement of the World Bank. On an assumed 15 net MW's of additional production brought on by the drilling program and a 100% dividend payout ratio, Polaris stock would trade for C$18.48 to C$22.17 or 100% to 141% upside versus the current trading price. And, beginning next year at some point, an investor will be well-compensated with dividends while they wait for the market to revalue Polaris' stock. Note too that a strong argument can be made to put some value on Casita or factor in Polaris' excess cash should one not put a value on Casita.
An alternative valuation approach which does not rely on dividend yields would be EV/EBITDA. On this metric Polaris is equally inexpensive. Based on Bloomberg consensus estimates for 2016, a wide sample of Canadian renewable power companies is currently trading for an average of 12.6X 2016 EV/EBITDA. Assuming 19.125 net MW's added, a 3% decline in current EBITDA and, ignoring the 3% US dollar-denominated PPA price escalator (as per our scenario above), Polaris stock is currently trading for just 4.0X 2016 EV/EBITDA. Should Polaris stock trade for the Canadian renewable power group average of 12.6X EV/EBITDA, it would be trading at $51.86 or 464% upside versus today's share price. At a more conservative 15 net MW's added and using the Canadian group average for 2016 of 12.6X EV/EBITDA, Polaris stock would trade for $47.45 or 416% upside to the current share price.
No matter which valuation approach one applies and assuming even just modest drilling success, there is substantial upside in Polaris stock.
