A few weeks ago, I wrote an article on the upcoming Clean Power Call in the Canadian province of British Columbia (BC). In a nutshell, the Clean Power Call consists of an auction conducted by the government-owned integrated power company to award long-term power purchase agreements (PPAs) to private wind developers. This is the model that has dominated in Canadian wind power so far. The notable thing about this model is that the PPA facilitates access to financing significantly for successful bidders, since the counterparty is a proxy of a credit-worthy government. EarthFirst Canada (EF) (ERFTF.PK or EF.TO) is one of the most active small-scale Independent Power Producers (IPP) in this region of the country. The company already holds a PPA for 144 MW of wind in BC (the Dokie I project), as well PPAs for a combined 75 MW of wind in other parts of the country. In total, the company’s development pipeline in Canada is roughly 2400 MW, which is quite large for a pure-play wind power IPP. A few months ago, EF was hit by the triple whammy: (1) it announced cost overruns for its flagship Dokie I project – capital costs were going to shoot up to $360 million (~$2.5 million/MW) from a previously planned $325 million (~$2.26 million/MW); (2) the firm’s wind consultant reduced its estimate of the annual electricity output for Dokie I by 2.3%, thus reducing potential cash-flows and the amount of leverage the project can employ; and (3) the credit crisis swung into full gear, making it all but impossible to find reasonably-priced capital to complete construction of the project and even impacting EF’s investment bank and financial partner negatively. With the Dokie I project less than 10% complete, running out of cash at this juncture could prove highly problematic. The result from all this was that in late August the firm announced it would engage ‘strategic’ advisors to help formulate next steps. In other words, EF is no longer able to secure the project finance facility it was counting on to build Dokie I and it will almost certainly run out of cash before too long. EF has about $65 million in the bank right now and ploughed through, according to its Q2 2008 cash flow statement, $51.7 million in project development costs in the first six months of the year. But is all lost for shareholders? I, for one, am not so sure. Like in many other industries, the result of this credit crisis for the wind developer sector will be a shakedown and consolidation. EF has about 220 MW of wind PPAs with solid counterparties (government-owned utilities), and an attractive growth pipeline. Canadian provinces have shown a willingness to push the wind industry forward, and, if anything, this could strengthen as the economy softens in Canada and governments look for counter-cyclical infrastructure spending. Lastly, I know from my own work in the field that a number of large international wind IPPs with good balance sheets are looking to enter the Canadian market, which is viewed by many as a potentially-strong market for wind. EF has gotten battered so badly in recent weeks that I decided to take a look. Generally, when I invest, I analyze companies as going concerns, or businesses that will be around for at least the duration of my investment in them. In my view, EF should not be looked at as such; the company will either go out of business entirely or its assets will be picked up by another IPP. This makes analysis of this company quite easy, as all one has to do is go over the balance sheet and figure out whether there is more value per share in the business than what the stock is trading at. Valuation The graph below shows the company’s balance sheet as at Q2 2008, the latest period for which financial statements are available. I went through each item on the balance sheet and adjusted them by a discount factor meant to represent the fact that, should the business be bought out, it would likely be a fire-sale price. The adjustments I made are discussed below.
Cash – Cash should be cash, and probably doesn’t need to be discounted. However, since EF probably used some of its cash in Q3, I reduced the amount by an arbitrary 50% and didn’t make it up elsewhere on the balance sheet. This is part of working my margin of safety into this analysis as I go along. Other current assets – I assigned no value to any of the other current assets. Why not? To be safe. Fixed assets – Those are computers and chairs. I also assigned no value to them. Windpower prospect development costs – This is the 500-lb gorilla in the room. This item effectively represents the nominal value of all of the expenses that have gone toward developing the wind projects to date. This includes items like foundation work on the projects, turbines, electrical connections, etc. Generally, companies would expense those items, and record them as costs on the income statement and reduce their income accordingly. However, EF has so far capitalized the majority of it, or made these expenditures into an asset. While some might term this approach “aggressive” as it understates losses on the income statement, it makes it a lot easier to perform this kind of an analysis, as it gives us a good idea of what a starting point would be for an asset sale: the total amount spent on project development to date. Here, I reduced the item by 70%. I think this is quite aggressive and the firm might fetch more than $0.30 on the dollar for those assets, but these are very uncertain times so better safe than sorry! Liabilities – I kept all liabilities all as they were, again to be safe. The result I came to was net (i.e. minus liabilities) adjusted assets of about $36.3 million, or roughly $0.35 per share. I had had a buy order at $0.10 for about a month (on the TSX) and it finally kicked in last Wednesday (Oct. 22). The position I took is tiny as this is emphatically a bet on a take-over or at least a significant asset sale. At the price I got and considering the analysis above, I think I have a solid margin of safety in case I missed something in my analysis. Nevertheless, I have no objective basis on which I can base the probability of EF being taken over rather than failing, thus my taking only a very small position. UPDATE (Dec. 1, 2008): Despite having placed itself under creditor protection, EF still managed to submit bids for the upcoming BC Hydro Clean Power Call. They are clearly still looking for a major asset sale but the question is: what is the likelihood that BC hydro will award them power purchase agreements if they are uncertain the projects can be developed? I am holding on to my shares but have written this investment off. To be continued… DISCLOSURE: Charles Morand has a position in EarthFirst. DISCLAIMER: I am not a registered investment advisor. The information and trades that I provide here are for informational purposes only and are not a solicitation to
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