Tom Konrad, CFA
Ormat is the 500-pound gorilla of the geothermal power industry. Should you buy the stock?
I’ve owned Ormat Technologies (NYSE:ORA) stock off and on since I first began to invest seriously in clean energy companies. At one of the first renewable energy conferences I attended five years ago as part of my quest to understand the renewable energy investing landscape, I encountered a representative of the Geothermal Energy Association (GEA). Here’s how I recall our conversation:
Me: “What are a few of the leading geothermal power companies?”
GEA Rep: “Ormat.”
Me: “Are they a leader in the technology, in development, or in running geothermal power plants?”
GEA Rep: “All three.”
Me: “Wow. But surely there are some other companies worth mentioning.”
GEA Rep: “Not really.”
I was stunned. Shouldn’t a geothermal industry representative make every effort to be even-handed when discussing companies in the industry? Not in geothermal power, at least not five years ago: After this article was published, I was contacted by another GEA rep who wanted to make clear that the above is not the GEA’s current position.
Ormat Technologies is a giant in an industry of pygmies. Of the publicly traded geothermal stocks, only Calpine (CPN) comes close to matching Ormat as an independent power producer (IPP). But that is the only way in which Calpine rivals Ormat. As I discussed in my geothermal power sector overview, Calpine’s main business is power production, and less than 1% of it comes from geothermal. In contrast, Ormat’s Ormat Energy Converters (ORC) are the gold standard for the Organic Rankin Cycle turbines used in electricity production from the most common lower temperature geothermal resources.
The Ormat Energy Converter is the core technology around which the company was built. Starting in 1972, when Ormat commercialized Organic Rankin Cycle technology for remote power solutions, ORCs have been tested, adapted and customized to a wide range of real world conditions, and have a multi-decade proven track record in geothermal power, waste heat recovery, and remote power. According to Ormat’s most recent quarterly report, OEC’s account for over 90% of installed binary generation (which includes all Organic Rankin Cycle generators.)
Although this is a series about geothermal companies, the potential waste heat recovery, where an ORC is used to convert waste heat from industrial applications such as cement plants should not be underestimated. Unlike geothermal, waste heat recovery is a very low risk source of reliable green power. Developing a geothermal resource is always risky because of the geology of geothermal reservoirs, which is much more complex and usually occurs in hard (and hard to drill) volcanic rock formations than is typical of oil and natural gas, which occur in sedimentary basins.
Ormat’s large size and experience developing and managing geothermal reservoirs give the company several advantages over other geothermal firms. In today’s tight credit environment, Ormat is less dependent on Department of Energy loan guarantees in order to obtain financing for geothermal projects than the smaller players, although those guarantees make such projects more attractive. They also have internal expertise for all stages of geothermal exploration, development, and operation that the smaller firms can generally only match by hiring outside contractors, one of which is often Ormat. Their scale and large number of projects under development allows for a level of diversification, so the whole company is not invested in any one such risky development prospect.
Conversely, Ormat’s large size, prominence in the industry, and NYSE listing mean that any gains in the stock price are not likely to come from the company being “discovered” by a new class of investors. Future gains will have to come from internal growth rather than rising investor awareness.
Below is a brief summary of some important share statistics.
|Share Price 10/6/10||$29.93|
|TTM Income Yield||2.8%|
|TTM Free Cash Flow||-$159M|
|Cash on Hand||$54M|
|Consensus 5 year expected growth (p.a.)||29%|
|Past Five Year’s Growth (p.a.)||-0.5%|
The very high P/E ratio of over 35 is enough to fully discount analysts’ projected five year growth rate of 29%. From just those two statistics, Ormat would appear to be fairly valued. However, the company’s aggressive expansion of its geothermal projects has led to heavy investment far in excess of operating cash flow, leading to negative free cash flow. My reading of the most recent quarterly report and investor presentations leads me to believe that management intends to continue this high level of investment for some time to come.
Without enough cash on hand to fund this level of investment, the company will have to raise significant additional debt or equity to proceed with it’s investment plans. Given the current availability of generous DOE cash grants and ARRA loan guarantees for geothermal projects, Ormat should not have too much trouble raising the necessary funds, but this need for external funding is still likely to impact Ormats’ future stock performance. If funds are obtained by issuing equity, earnings per share will not grow as fast as revenues. If funds are raised as debt (as has been recently the case) the company’s Debt/Equity ratio will increase, along with the riskiness of the company’s earnings. In either case, the extreme P/E ratio seems unlikely to be justified.
Although I think Ormat is a great company with great technology in a market segment enjoying strong and growing government support, I find it impossible to justify the company’s $30 stock price. I sold my most recent holding in the company at around $30 in mid-2009, and I am waiting for income to increase or the share price to fall significantly before I’d consider buying this stock again. Nevertheless, given Ormat’s domination of one of my favorite sectors, geothermal stocks, I’ll buy it as soon as I can at a more favorable valuation.
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