Update (Mar 27, 2014): Cardinal has now been recontracted for 20 years as a dispatachable plant. Management has guided that they will need to spend $30 million to upgrade the plant and the expected Adjusted EBITDA from the plant is $7 to $9 million. While this is not as lucrative as hoped, it nevertheless eliminates the downside risk – that is no new contract. Based on a rough update to the valuation model, the base case valuation for the company is now approximately $5.0. If the plant delivers at the higher end of the range, the valuation could reach $5.2. More details to follow later.
Update (Jan 24, 2014): The valuation model for this company has been revised to be more conservative (no change in the underlying thesis, just some of the assumptions) and it results in the following changes to pricing scenarios:
- Bear Case: $3.5 (formerly $4.0)
- Base Case: $4.9 (formerly $5.2)
- Bull Case: $8.2 (formerly $6.5)
Based on the revised pricing scenarios, the company still continues to be a “Buy”.
The release of Ontario’s Long-Term Energy Plan (link) since the publishing of the original article provides some extra comfort regarding the chances of Cardinal being re-contracted in at least some capacity. Figure 9 from the report shows that the cost of sourcing electricity from Combined Heat and Power plants is approximately $80 to $200 per MWh. A cursory review of Cardinal’s revenue shows that the plant sells power for approximately $90/MWh to the grid, which makes it one of the lower cost facilities in the province. The report does not provide information regarding the frequency distribution, so it is difficult to say whether there is just one plant that sells power at $80/MWh or whether there are many; this would have a bearing on the re-contracting probabilities. Nevertheless, the report does not seem to provide any new information that would be a cause for concern, and as stated above, the company continues to be a buy.
Price: $3.67 (Oct 23, 2013)
Buy under: $3.90
Intrinsic Value: $5.20 (Base Case)
Capstone Infrastructure Corporation owns and operates core infrastructure assets such as power plants, a water distribution utility, and district heating plants in Canada, UK, and Sweden. The net book value of these operating assets is $1.1 billion.
Capstone derives the majority of its income from its net 465 MW of operating power plants in Canada. Other than the 156 MWe gas cogeneration plant in Cardinal, Ontario, the facilities generate power from either wind, solar, hydro, or waste biomass. Capstone recently acquired the equity in Renewable Energy Developers Inc. in an all-share deal worth around $70 million[i]. The acquisition brought a net 95 MW of operating wind plants and a further net 79 MW of contracted development projects in to the portfolio. Most of the power plants operate under long term (typically 20 years) fixed-price power purchase agreements (PPAs) wherein the off-taker must purchase all power produced.
In 2011-12, Capstone acquired a net 50% stake in Bristol Water, a regulated water utility that provides water to the 1.2 million residents of the city of Bristol, England. The utility is a monopoly and has a perpetual license to operate. The service rates are increased annually, subject to regulatory approval, and are a function of inflation and investment in the infrastructure.
Capstone also has a 33.3% investment in Värmevärden, a holding company that operates seven district heating facilities in Sweden with an aggregate installed capacity of 639 MWth. Given the nature of district heating, Capstone has a set of captive residential and industrial customers whose facilities are deeply integrated in to the company’s network and are therefore unable or unlikely to switch to alternatives. Service rates allow for adjustments based on the price of fuel[ii] and inflation.
Geographic Distribution of Revenue (2012)
AFFO by business segment (2012)
As an owner and operator of core infrastructure assets, Capstone’s revenue stream is reasonably stable, secure, and predictable. For the power operations, the PPAs ensure a guaranteed client for a majority proportion, if not all, of the power generated. In its water and district heating operations, Capstone is a regulated monopoly with no competition. While being regulated sets a ceiling on service rates, it also sets a floor since the operators are allowed to earn a reasonable return on their investment.
Ordinarily investing in infrastructure companies does not provide outsized returns, however under the current circumstances, investors are extremely pessimistic about the company and have consequently depressed the share price to such an extent that further downside is very limited[iii]. The three key factors affecting the price are:
1. Renegotiation of Cardinal PPA: Cardinal currently accounts for 41% Capstone’s AFFO[iv] and its PPA expires in 2014. Uncertainty regarding securing a new PPA has therefore concerned investors. As Figure 3 shows, the intrinsic value of Capstone after fully excluding the Cardinal plant is $4.70. The current price of $3.67 therefore appears to be a market overreaction to the re-contracting issue.
2. The management announced a surprise cut to the dividend in late-2011 resulting in a market backlash. The revised target for the dividend payout ratio is 70-80% of AFFO. The addition of new wind power assets from the acquisition of Renewable Energy Developers should support the dividend comfortably even if there is a 50% cut in the revenue from Cardinal. However should Cardinal’s revenue drop below the 50% threshold, the dividend would be under severe pressure in 2015 and beyond.
3. Share prices of the utility sector have been broadly hit due to rising dividend yields. While companies that do not grow could continue to experience a decline in share prices, Capstone’s internal growth pipeline should allow it to grow organically and therefore increase AFFO and dividends, and thus continue to attract investors.
Depending on the outcome of the Cardinal PPA negotiation and the proportion of existing revenue and AFFO that will be lost, the intrinsic value of the company ranges from $4.0 (Bear Case – 0% revenue contribution from Cardinal) to $6.5 (Bull Case – 100% of existing revenue maintained). The more realistic outcome – conversion to a peaking plant (capital cost of $50 million for the conversion) and retaining 50% of current revenue (Base Case) – provides an intrinsic value of $5.2. For this scenario, the projected ROIC and ROE for the company are 6.57% and 12.48%, respectively.
After allowing for a 10% dilution to account for the DRIP program and any potentially dilutive acquisitions, and applying a further 30% margin of safety, an entry price of $3.9 is obtained. The valuation is obtained through a DCF analysis using a WACC of 6.91% (debt ratio of 65%), and where applicable, a perpetual earnings growth rate of 1%. The various scenarios for Cardinal post-2014 model revenues at 0% (Bear), 50% (Base), and 100% (Bull) of the current level with historical average gross margin, while retaining 100% of fixed costs.
Composition of intrinsic value
Disclosure: I currently own shares in this company (long) and may conduct future transactions without prior notice. This stock was also pitched to the Rotman Student Investment Fund, and the fund may choose to transact in this company at its discretion.
[i] There is now an open cash offer from Capstone to acquire ReD’s outstanding debentures for $101 plus accrued interest.
[ii] Fuel Mix: 65% wood waste, balance is waste industrial heat and heating oil.
[iii] As per the current scenarios, technically there is no downside. However if a 30% discount (i.e. a margin of safety), were applied to the bear case, a value of $3.29 is obtained. This represents a potential downside of 11%.
[iv] Adjusted Free Funds from Operations