EAM - EAM Solar

[klarmanite]

This is an interesting small cap idea I think. Only one analyst covering the name. I have previously posted this on SumZero.com.

 

 

EAM SOLAR (NOK 83)

LOW RISK, 13% DIVIDEND YIELD AND 100%+ UPSIDE TO FAIR VALUE

 

ELEVATOR PITCH

 

EAM Solar (EAM NO Equity) is a Norwegian company managing solar parks in Italy. It is listed on Oslo Axxess under the ticker EAM, and will probably be listed on the main bourse at some point in the near future. It is run by a solid management team with deep industry and financial expertise. Through long contracts (so-called feed-in-tariffs) with the Italian government, most of the cash flows from the plants are secured for the next 17 years. The capex needs are extremely limited. What little maintenance is needed is accounted for in the opex numbers. This means EAM will generate piles of cash for shareholders. Company policy is to pay out 100% of FCFE in the form of dividends. EAM trades at a normalized FCFE yield of 13% + today.

 

This is possible because investors are relatively unfamiliar with the solar power plant business model and confuse it with the rest of the solar value chain which is much more cyclical. Many investors also wrongly think the political risk is high. It’s not. The small size of the company and illiquidity of the stock also makes most institutional investors hold their nose (based on feedback to company management recently). This will prove to be a huge mistake.                   

 

I believe this is a unique opportunity to buy a company with very safe cash flows at a ridiculously low price.

 

 

WHY DOES THIS OPPORTUNITY EXIST?

 

In addition to the stock specific factors mentioned above (illiquidity, size), there are a few important reasons why EAM is able to earn such attractive returns on low-risk assets.

 

1. By exploiting pressured sellers in the market both over the last few years and more recently (January 2014), the company has managed to acquire stable, producing assets at a very attractive price. As an example, one of the project portfolios was bought from a PE company that had to be liquidated.

 

2. The fact that Italy sponsored solar power plants by awarding the aforementioned Feed-In-Tariffs (FIT) for periods up to 20 years to comply with central EU regulations regarding minimum renewable energy capacity allows EAM to earn outsized returns for the next 17 years. The government has since stopped awarding these projects, but the exisiting contracts will be honored.

 

3. Regarding political risk: The reason I am so sure they will be honored and not delared void is that there is nothing to gain politically by pulling the tariffs. This is because the consumer pays directly over his electricity bill, it is not a budget item that someone can pull to the benefit of another to please some special interest group. And there has been very little noise about this from the consumer. Supposedly these tariffs amount to an addtional 5-8% on the bills, not enough to get peple really fired up (I doubt most people are even aware of this). Also, most of these plants are owned by Italians, so there is little risk of some populist attack on «capitalist foreign interests» e.g.

 

 

VERY SHORT BUSINESS OVERVIEW

 

EAM is the first pure-play «Solar Power Plant Owner» listed company in the world (march 2013). After the recent private placement on January 20th, the company has a portfolio of 35 solar power plants, with a combined power production of about 53 570 MWh/year. These are all operational assets. The company takes no newbuild risk, no grid connection risk and no Feed-In-Tariff risk. Solar power plants are extremely stable and easy to maintain.

 

At current power prices, about 80% of revenues are fixed until 2031 through FIT agreements with GSE, the state entity in charge of renewable energy. GSE is owned by the Ministry of Economy and Finance. As mentioned above, the cost of the FIT is paid by the end consumer, it is not paid out of the state budget like the case has been in other countries. This reduces political risk (and since the FIT system contains no provision that allows for the retraction of FIT agreements, a revision of the FIT would also be at odds with the Italian constitution).

The remaining 20% is variable (aka RID, = whole sale price), but is capped on the downside by a minimum guranteed price by the Italian government for power plants under 1 MW capacity. Most of EAMs plants fall into this category (which, incidentally, also mostly protects EAM from any Robin Hood tax regulations on utilities).

 

 

Since solar power plants generally lose some efficiency over time(*), the revenue generated by these assets can be assumed to fall by a very small amount every year. Based on conversations with analysts and company executives, I think however, that the cost estimates presented by the company are on the high side (management says they’ve been very conservative and that there are several levers to pull to reduce these markedly).  I have therefore assumed that the negative impact on EBITDA from the anticipated slow reduction in power plant performance is mitigated by the positive impact on EBITDA from likely cost savings (some of these plants have been poorly operated in the past). Even if these factors should not contribute positively, the fall in average annual revenue would only be about 5%, which would not impact dividends that much.

 

(*about 0.5% per year after the first year, in which efficiency falls by 3% generally. None of EAMs plants are in their first year of ops, so this first year fall is irrelevant. )

 

VALUATION

 

Considering the low likelihood (it is not impossible however – management indicates they may have a few more opportunities on hand) of substantial further growth for EAM, I am not assigning much value to expected growth in earnings or cash flows. With management saying there are in fact several opportunities for further acquisitions, this is likely too conservative. My opinion is that a company with this risk profile should trade at about 7.5% yield, which implies 150 NOK. This is, again, likely very conservative. Comparable companies (diversified utilities) in the US I have looked at with higher earnings risk trade at yields down to 4-5%, and a wide selection of comparables in the EU trade at 5.5-6% even though their cash flows should really be perceived as riskier in my opinion.

 

Yield pricing Share price

9% yield 125

8% yield 140

7% yield 160

6% yield 187

 

Coming up with a proper WACC for EAM is hard, since it was just listed and has no no peer group (yet).  I think a proper discount rate should be about 8% considering the low risk nature of the cash flows. Even if one assumes that to be aggresive and used say 10%, the value of EAM would be 117 NOK not including the residual value of the plants after the tariff contracts expire.

 

Based on today’s market price of electricity, management’s estimate of the cost of operating the plants at that point in time (much lower for a variety of reasons)  and the remaining production capacity of the plants at that point, an additional residual value of about 15-17 NOK per share seems reasonable to add on.

 

Which means that even using a 10% discount rate, EAM is worth at least 132-134 NOK. Note that the total DCF value using an 8% discount rate is 192 NOK (including residual value), which would be fairly consistent with a yield pricing at 6% in line with peers (6% yield = 187 NOK).

 

 

My average fair value estimate is 171 NOK, based on the average of 7.5% yield pricing and the total DCF value including the residual value of the plants after tariff expiry.

 

See attachment for key figures.

 

CATALYSTS

Listing of comparable companies

Several similar companies will be listed in the near future. This creates institutional interest and a peer group which facilitates comparison and will likely lead to repricing. See this article: http://finance.yahoo.com/news/solar-company-spinoffs-lure-investors-174905835.html

Dividend payments

After the company reports solid performance and pays out hefty dividends a few times, the undervaluation will become too obvious to ignore. Greed will replace fear.

Increased leverage  special dividend

Management has indicated that there is a real possibility that leverage can be increased through taking out bank loans with collateral in the existing power plant portfolio (pre-P31). This could mean an extraordinary dividend in 2014 as well, in addition to the 13% ordinary dividend.

 

RISK FACTORS

 

Company does another equity issue to finance bad investments.

Mitigant: Company has published explicit investment criteria (see appendix) that must be followed. This reduces the risk of poor investment decisions in the future.

 

Currency risk

Mitigant: None. No opinion on the movement of currency pairs, whether that be EUR/NOK or EUR/USD.

 

Tax hike

Mitigant: Italty’s economy is struggling. A tax hike on corporations seems unlikely as the rate is now 30%.

 

Lower power prices (RID)

Mitigant: None. I have no clue what will happen to power prices in Italy. However, they could also go up…

 

Interest rate risk

Mitigant: I expect the company to issue bonds in time, which should be doable at interest rates lower than 6%,  but this is dependent on growing to a size where a credit rating can be issued on the company.

 

Inflation

Since most of the income is fixed in nominal terms but costs are not, rising inflation impacts profitability. Mitigant: The variable (RID) price element should rise as well in such a scenario, ceteris paribus.

 

[roughlyright]

This is interesting idea. Are you able to buy this at interactive brokers or TD Ameritrade. I noticed that the ADR is not listed on Pink sheets.

[klarmanite]

Hi

 

I don't know. No ADR as far as I know.

[rayfinkle]

klarmanite-

 

cool idea. I know solar pretty well, and it definitely makes sense that this is a misunderstood asset. A few thoughts and a question--we can PM for more Q&A if you'd like:

-WAAC: these are always tough, but I can provide serious backup for 10% WAAC being a pretty conservative / high WAAC...seems like you're comfortable with this

-Panel degradation in a downside case would be 0.5-0.75% per year

-Have you run the math on what you are buying a watt of capacity for? in other words, what does the enterprise value translate to on a per watt managed basis. this is a pretty easy way to judge the value here... power price vs. fully burdened installed price for similar small/commercial scale installations should set the market return. This information is pretty widely available, I can point folks to it otherwise.

-Any chance you can forward the analyst reports? Would love to get a better sense for the market perspective.

 

Thanks for the idea!

[Packer16]

What about SUNE as a comp.  It trades at about $6.43/MW while EAM will trade post transaction at $5.04/MW.  Based upon SUNE's valuation and EAM leverage (Euro 73.4m), I get an upside of 61% from the current market cap (before dilution).

 

Packer

[rayfinkle]

What about SUNE as a comp.  It trades at about $6.43/MW while EAM will trade post transaction at $5.04/MW.  Based upon SUNE's valuation and EAM leverage (Euro 73.4m), I get an upside of 61% from the current market cap (before dilution).

 

Packer

 

I have to refresh on this a bit but doesn't SUNE manufacture panels as well? I think they do, and this is a much worse business. I'd have look back to see what they were bought for in prior years. Will come back with this.

[klarmanite]

Comps will be available soon. The institutional lemmings should flock to EAM once a peer group exists.

 

http://finance.yahoo.com/news/solar-company-spinoffs-lure-investors-174905835.html

 

[klarmanite]

Latest numbers out.  Based on the information in this release I have revised my numbers a little, but nothing dramatic.

 

http://energeia.no/news-media/latest-news/

 

Some interesting commentary:

 

The European financial crisis and Basel III funding

requirements has reduced European banks possibilities to

secure funding for long-term project finance, which has

limited the financing of solar power plants in Europe from

August 2011. Although the project financing showed signs

of reopening in 2013 the recovery of a normalized bank

financing market is still not in place.

 

This has affected EAM Solar, although the outcome is

positive so far through the acquisition of power plants of high quality and with a price significantly below market

terms as seen in 2011 and 2012.

 

In Italy the main incentive program expired in 2013,

which most probably will reduce the volume of new built

solar power plants the next couple of years. As Solar PV

power plants have become cheaper, Italian authorities

expect 1 – 2 GW of new capacity to be installed annually

without subsidies.

 

The secondary market is strong, especially in Italy, with a

steady availability of projects that have been in operation

for 1 – 3 years. Sellers are mainly EPC companies and

financial investors.

 

 

Dividends

 

In addition to performing good acquisitions and good

operations, EAM’s main focus is to secure a continuous

dividend distribution to the shareholders.

Based the Company by-laws, recent change in Norwegian

company law, and the decision made by the Company’s

extraordinary general meeting the 17th of December 2013,

the Board of Directors in EAM will distribute dividends

on a quarterly basis in 2014.

 

Dividends will be distributed in April, July, October and

December. The quarterly dividend will be based on an

assessment of the short-term liquidity development and

in accordance with the intention as stated in Company’s

by-laws article 11.

 

Outlook

 

Closing of the P31 portfolio

 

The financial closing of the P31 portfolio acquisition is

anticipated conducted before the end of the 1st quarter

2014. According to the SPA, the final closing date is the

end of April 2014, however, the parties may agree to

prolong the closing period if deemed necessary

There is a possibility to start a partial closing when a

minimum of 20 SPP’s is cleared, i.e. all conditions

precedent to closing of the transaction has been met.

In conjunction with the closing of the acquisition and

subsequent increased scope of EAM's business in Italy,

Energeia Asset Management AS will establish an

operational office in Italy during the first half 2014 as part

of the organisation to manage the day-to-day operation of

EAM Solar ASA's power plants in Italy.

 

Further acquisitions

 

The management company, Energeia Asset Management,

is in continuous discussions and assessments with further

portfolios of PV power plants, mainly in Italy.

At current, the pipeline of projects that may be relevant to

consider for acquisitions is in the range of 500 to 1,000

MW in total.

 

 

[rayfinkle]

Klarmanite-

 

Have you done italy-specific research on the prospect of retroactive FIT changes like those that impacted spain? Link below. Seems like the big risks are: 1) sovereign / FIT related, 2) management capital allocation to new projects is bad.

 

 

 

http://www.pv-magazine.com/news/details/beitrag/spain-publishes-retroactive-pv-fit-cuts_100010298/#axzz2t9YQSSPT

[klarmanite]

Yes. The FiT is differently structured in Italy. It is not financed over the budget, but rather by the consumer directly through an addition to their utility bill. There is a good explanation of this structure in the december presentation on EAM's website. Since there is no real political incentive to retract the FiT, the risk is low, in my opinion.

 

 

[rayfinkle]

Yes. The FiT is differently structured in Italy. It is not financed over the budget, but rather by the consumer directly through an addition to their utility bill. There is a good explanation of this structure in the december presentation on EAM's website. Since there is no real political incentive to retract the FiT, the risk is low, in my opinion.

 

Thanks. I've talked to some folks in the industry who have a similar read. I'm going to read the law myself tomorrow.

[rayfinkle]

Yes. The FiT is differently structured in Italy. It is not financed over the budget, but rather by the consumer directly through an addition to their utility bill. There is a good explanation of this structure in the december presentation on EAM's website. Since there is no real political incentive to retract the FiT, the risk is low, in my opinion.

 

Thanks Klarmanite- At this point I'm just trying to confirm the FIT risk. Their december presentation was good, but I'm interested in reading the law itself. Have you spoken to management or otherwise verified the presentation's claim that reduction of FIT couldn't happen? This would basically amount to a back door tax--but without having a good sense of politics on a pretty local level it's tough.

[rayfinkle]

Separately, how do you reconcile the "fully invested post transaction" dividend figure of 5.6 euro/share (roughly 13.5 NOK) to the prior dividend of 5 NOK... sorry for bombarding with questions, I'm just ticking down a list. Thanks again.

[klarmanite]

Hi

 

Numbers

 

The december presentation is irrelevant in a few respects now that the P31 transaction was smaller than the company initially expected. Frankly, they couldn't raise more. Pushback from major american and european funds was that the transaction was too small. I have heard the same from a friend who is a manager at one of Norway's largest mutual funds. "Really interesting, but not big enough for us."

 

In the end, EAM raised enough money to buy the P31 portfolio. The 'fully invested' column in the presentation is thus irrelevant because there is, for now, no more money to invest. So 'post transaction' is the more relevant column. The numbers are however, unlikely to be identical in practice. My numbers will be closer, but probably not exact either. But the recent results for the last quarter confirmed my numbers in my first post are pretty close to what we can expect.

 

Tariffs

 

I have met with management and talked at length regarding the FiT issues and other risks. I am confident it will not be a problem. According to the CEO, there is no aspect in the relevant legislation that allows for a retraction of the tariff system in place. No new plants are now given such good terms, and most of the owners of these tariff-relevant plants are italian. So a "the foreigners are robbing us" narrative from politicians is unlikely. As the tariff-marked funds are not possible to re-allocate at will by politicians since it is not part of the budget process it seems unlikely someone will make this a priority. Nobody stands to benefit politically.

[klarmanite]

So my point is that the dividend capacity question is straightforward once you disregard the "fully invested" column. The new plants dramatically increase FCFE and dividend capacity.

[klarmanite]

Interesting comments from Preben Rasch-Olsen at Carnegie Oslo today (the only sell-side analyst covering EAM):

 

He writes that Sun Edison announced completion of the initial capitalization of its YieldCo yesterday. The CEO has previously estimated the vehicle to trade at around a 5.5% dividend. This spin-off should raise awareness of EAMs business model, and help school investors. More on this here:

 

http://www.prnewswire.com/news-releases/sunedison-completes-the-initial-capitalization-of-its-yieldco-vehicle-goldman-sachs-provides-250-million-facility-253534751.html

 

It is also obvious that this will act like a trigger for EAMs shareprice if the market can see a peer trading at 5.5%, EAM won't trade at 12% for long. Alternatively he says, EAM should be a prime takeover candidate.

 

I continue to think this is the best opportunity I've seen for a long time. Overlooked, misunderstood and dirt cheap with safe cash flows. Amazing that the market continues to disregard this stock.

[klarmanite]

Note that on my numbers, EAM would be worth 195 NOK/share if it traded at 5.5% dividend yield. It closed at 81 yesterday. My target yield is higher, as I've said before (6-7'%), but that's still 153-166 NOK/share.

 

It's a steal.

[frommi]

I can be wrong but i think this stock is near worthless in 17 years. Solar panels have a life expentancy of around 20 years and the government substitutions are only valid for 17 years. After that they get the normal electricity price which is a lot lower. This company can only grow by stock dilution or debt, so it should be valued with zero or slightly negative growth. It trades at around a PE of 9 which is fair in my opinion given the case that i am right.

 

Am i wrong?

[klarmanite]

Hi

 

No and yes. Growth must come from funds from new equity or debt. But you get a 12-13% dividend for 17 years. Also the residual value is not zero, since solar panels true life span is much longer than 20 years. I calculate a residual value of 17 NOK (calc not shown).

 

Look at it this way:

 

Value EAM                                 EUR         NOK

FCF / 8% discount rate                 170.3 1425.6

+ residual FCF value plants PT 10.4 86.8

less net debt                               -68.4 -572.5

equals equity value                    112.3 939.9

per share                                 22.1 185

 

of which contract period value         20.1 168.3

of which residual value                   2.0 17.1

 

[klarmanite]

So if your required rate of return is more than 12-13% per year, this is not tempting. I'm happy with that in this case.

[frommi]

Then your return is more like 6-7%, because each year you get a part of your investment back. This would be in line with what you normally get for these type of subsidized solar installations. In germany you could get up to 10% 10 years ago, but that is long over and italy is reducing its substitutions for new installments since 2011, too.

[klarmanite]

My DCF calculation above is quick and dirty, but even under the absolute strictest assumptions using the companys actual WACC (which is lower than 8%, it'sactually 6.7%), I calculate a DCF value of 105 NOK + a likely residual value of 17 for a fair value of 122...that's a defensive case.

 

Looking at it differently, you could say that assuming you can reinvest dividends for the same return  (which you would if the market values EAM like it does today and efficently prices EAM under the same conditions but also the assumption that it is dead after 17 years) and no residual value, the internal rate of return (IRR) is 11%, not 6 or 7%. Your inital investment is 81 NOK, and every year for 17 years you receive 10.6 NOK in dividends which you can reinvest at the same rate of return. If you pay taxes on dividends (we don't) that may change the picture for you under these assumptions.

 

I would also add that the company can create value over time through value accretive purchases even if they raise funds or increase debt (in fact they just did, twice). None of that is taken into account above. My point is that even with no faith in management creating value, the stock will provide a safe and very decent return. In the case of the market being willing to price in value creation by management, this will be priced as a yieldco and that entails a much, much higher valuation and stock price.

[frommi]

Ok assuming you are right why shouldn't the management just increase their salary every year and reduce your dividends? Its not that they need your money anymore, the plants are built and the cash is flowing and new plants are not as good as the old ones because of reductions in the substitutions. I can't see why the management should do anything here, they have built their own cashstream with other peoples money and can collect it while creating the next company. I would probably do it that way, but i was not smart enough to do it as the opportunity was available.

[klarmanite]

I understand your concerns in principle, but nothing suggests this will happen here.

 

I can see why they would try to create value. They get paid a fixed percentage of pretax profit. That inentivizes them to grow profitably.  Take a look at the management agreement. I think they're properly incentivized.

 

As to the reducing dividends thing. No, that won't happen. Quoting the company website:

 

"The company by-laws declares that the entire annual surplus shall be distributed as dividends to its shareholders. Changes to or exemptions from this article requires the support of at least nine tenths of the votes cast and of the share capital represented at the general meeting." Not very likely to happen, then.

 

Also, we know several people among the management and board members by reputation / personally over many years and have met with them recently. The CEO is a well known name in the financial community in Norway and neither he nor any other key personell has ever been known for that kind of behavior. Nothing is certain in this world, but it would be out of character for these guys to behave shareholder undfriendly.

 

Also, there are still existing projects available under the old tariffs  with favorable economics. EAM does not build anything, they operate assets that are already connected and operational. You can take a look at their explicit investment criteria for more details, it's all available information. If they can't find good projects, then they won't invest.

 

[klarmanite]

Additionally, the 3 largest shareholders in EAM Solar are also owners in Energeia Asset Management, the company that own EAMs management company EAM SPM.

 

From the company prospectus:

 

Company/owner Indirect ownership Function

 

Jakobsen Energeia AS (Viktor E. Jakobsen) 28.334 % Executive Director of EAM Solar ASA

Naben AS (Audun W. Iversen) 28.334 % CEO of EAM Solar ASA

Sundt AS 28.33 % Shareholder of EAM Solar ASA

Canica AS 7.51 % Shareholder of EAM Solar ASA

Bjørgvin AS 7.51 % Shareholder of EAM Solar ASA

 

Together, these 3 companies own 1 852 000 shares i EAM Solar.

 

They are all well known and respected players in Norwegian finance. Any wrongdoing here would be disastrous for their reputations.