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Western Wind: A Clean Energy Rodney Dangerfield?

Tom Konrad CFA

Renewable energy power producer Western Wind Energy Corp (WNDEF.PK, WND.V) feels it gets no respect.  In particular, they have long felt that the investing public does not recognize the value of the company's existing and nearly completed wind farms. 

Kingman solar and wind.png
Western Wind's Kingman I Wind & Solar park. Photo courtesy of the company.

Independent Valuation

Almost every company will tell you that their shares are undervalued, but what's a bit more unusual in this case is that their assets (Wind farms with a little solar thrown in) are fairly easy to value with a rigorous discounted cash flow (DCF) model.  While wind and solar resources vary from hour to hour and even year to year, the expected energy production from wind and solar farms is fairly predictable over time, and all Western Wind's projects except for Mesa have Power Purchase Agreements (PPAs) with electric utilities that specify the prices those utilities will pay for as long as 20 years, leading to fairly predictable revenue streams over time, and fairly low uncertainty in asset valuation.  The company is currently selling electricity from Mesa at the spot price, but they are in the process of negotiating a longer term PPA.

Last year, company management decided to back up their words by hiring the independent DAI Management Consultants, Inc to value the company's equity stake in their renewable energy projects.  Western Wind has a 30MW operating wind farm (Mesa), an operating combined wind (10MW) and solar (500kW) farm (Kingman I), a 120 MW wind a farm and that is nearing completion and expected to be fully operational by the December 2011, and a 30 MW solar farm in Puerto Rico (Yabucoa) that is expected to be completed by the end of 2012.  Windstar and Kingman have signed PPAs and debt financing in in place, and Mesa is fully financed and operating under a spot price sale agreement. Yabucoa has a signed PPA and the company expects to close financing for it by the end of 2011.

Assumptions

Western Wind has released the results of DAI's valuation in a series of press releases as the valuation of each project was completed.  The complete valuation is not public because it depends on the terms of the PPAs, which are confidential.  (Confidential PPAs are a practice which I believe is counterproductive as well as counter to free market principles.  Nevertheless, keeping PPAs confidential is standard utility industry practice, and could only be banned by utility regulators; it's not something I or Western Wind have the power to change.)  They did, however, release the assumptions on which DAI's valuation was based.  These assumptions are included in the table below.

Assumptions used by DAI in valuation model.

 

Windstar

Kingman I

Mesa

Yabucoa

Project type and size

120MW wind

10MW wind, 0.5MW Solar

30 MW Wind

30MW Solar

Commercial operation date in valuation model

Dec 31, 2011

Dec 31, 2011

Existing operations

Dec 1, 2012

Remaining asset life

30 years

30 years

20 years (older assets)

30 years

Power Purchase Agreement  (PPA)

fixed price for years 1 to 20 via signed PPA and merchant prices thereafter

fixed price for years 1 to 20 via signed PPA and merchant prices thereafter

fixed price per CPUC MPR for years 1-20

fixed price for years 1 to 20 via signed PPA and merchant prices thereafter

 

 

 

 

 

Land

Owned

Owned

27 year right of way

40 year lease

Tax incentives

30% cash grant and 100% bonus depreciation

30% cash grant and 100% bonus depreciation

None

30% cash grant, 50% bonus depreciation and 50% Puerto Rico investment tax credit

Source of key assumptions

Independent engineer

Independent engineer

Management

Management

Debt --to-capital ratio

54%

54%

35%

43%

Term of debt

20 years

20 years

15 years

20 years

Cost of debt

6.0%

6.0%

5.1%

6.0%

Discount rate on equity returns

Under PPA: 11.48% Merchant generator:15.75%

Under PPA: 11.51% Merchant generator:15.85%

Under PPA: 10.52%
Merchant generator:NA

Under PPA: 10.96% Merchant generator:14.74%

Weighting of income approach vs cost approach

75%

75%

100%

75%

Construction cost contingencies

5%

5%

NA

5%


One assumption that I would have liked to see is the expected capacity factors for each of the wind farms, since that is key to knowing how much energy each project is likely to produce, but otherwise the disclosure seems comprehensive. 

Assuming the capacity factor estimates are accurate, an assumption which shows the fairly conservative nature of the valuation is the second-to-last row "Weighting of income approach vs cost approach."  This row indicates that for each of the incomplete wind farms, only 75% percent of the valuation given is based on a DCF model; the other 25% of the valuation is a replacement cost approach using comparable market transactions.  This is conservative because the DCF model should give a considerably higher value than cost when valuing a wind project because unfinished projects trade at a discount: Why invest money if the expected returns (DCF valuation) are below what you could get by selling the project?

Another row worth noting is the third to last, "Discount rate on equity returns."  This is extremely important because DCF valuations are highly sensitive to the discount rate assumption: a slightly lower discount rate can lead to a much higher project valuation.  Discount rates vary with the riskiness of the project, and with interest rates in the economy in general. (Risky projects should have higher discount rates, and we see this reflected in the fact that when power is to be sold on the spot market rather than under a PPA, DAI used a significantly higher discount rate.) 

As an investor, the simplest way to judge if an equity discount rate is appropriate is to ask yourself if you would be willing to earn that discount rate as an annual return for owning a slice of the project.  For myself, I would be happy to own a slice of a operating or nearly-completed wind farm for 10.5-11.5% per year.  I'm not quite sure why the Yabucoa solar farm is given a lower discount rate than the others even though it is over a year from completion, but I still consider the return to be sufficient.

Given these assumptions, DAI came up with the following project valuations:

Project Valuations from DAI


Windstar
Kingman I
Mesa
Yabucoa
Project Valuation
$358 million
$32 million
$25 million
$206 million
Project Liabilities
$275 million
$24 million
nil
$152 million
Value of Western Wind's Equity stake
$203 million
$16 million
$24 million
$110 million
Value Per diluted share (70m shares)
$2.90
$0.23
$0.34
$1.57

I then calculated the implicit value per share of Western Wind and adding in the value of the company's tax loss carry-forward, and assuming that all unexercised share options and warrants with exercise prices below the current stock price would be exercised.  This has the effect of increasing the number of shares outstanding from 60 million to 70 million, and adding $12 million dollars of cash to the company's balance sheet to reflect the cost of exercising the options and warrants.  Note that the fully diluted shares given on Western Wind's website are 71.8 million, but this included the exercise of options and warrants with exercise prices above the current share price: the exercise of those options would result in a net gain to investors who buy at the current price.

Share Valuation

Value (millions $)
Value per diluted share
 
(70 million shares)
Total DAI Company Valuation (including above projects plus project pipeline)
$383
$5.47
Tax Asset (loss carry forward)
$9
$0.13
Value of Cash Paid for Exercise of Warrants & Options
$12
$0.18
Total $404
$5.78
Share price (10/31/11)
$1.60
Appreciation needed to reach fair value
3.6x

As you can see, I arrived at a per-share valuation of $5.78, three and a half times the current share price.   I think it is unlikely that the company's share price will go quickly to this fair value given the current climate of uncertainty, but even if the company were to remain at this current 3.6x discount, we could still expect the stock to rise over time, for a couple of reasons.

First, if the Windstar is completed on schedule by the end of the year, it should no longer be valued partially based on cost, and should be valued solely based on DCF.  This should lead to an immediate value boost, as discussed earlier.  Kingman is already fully operational, and so should also be valued solely with a DCF model.   Second, as time passes, cash flow will be produced from the operating farms (and Yabucoa will come closer to completion), and this should lead to a gain in value approximately equal to the discount rate on equity returns used in the project valuations. 

Hence, even if a company trading at a 3.6x discount to fair value does not attract takeover offers or the share price does not quickly adjust upwards for other reasons, we can expect at least a 10% annual return just from accrued income and impending project completion.  In fact, since the valuations above were completed in February (Windstar) and May (the other three), the current valuation of the company should be at least $18 million or $0.26 per share higher today than shown in my table above.  But who's counting?

I personally found the calculations above convincing, and began buying the stock in September.

WND-V.png

Possible Takeovers

If the relatively slow 10-12% annual growth in the project values is not enough to excite investors, the possibility of a buyout offer seldom fails to do so. 

The first hint we got about takeover offers was on October 1st, when Western Wind asked  the Investment Industry Regulatory Organization of Canada (IIROC) to review the large numbers of matched trades which had been occurring over the previous six months.  In the complaint to IIROC, Western Wind stated "it has been made aware in the past few days, that a certain party would like to make a take-over bid of certain or all of the assets of the Company," with the implication that the company's share price had been manipulated down to make a low takeover offer look attractive to investors.

On October 11, the Company revealed that Algonquin Power and Utilities (AQN.TO/AQUNF.PK), a company I also own, had expressed interest in buying the company at $2.50 a share.

I most recently wrote about Algonquin in a review of the larger alternative energy power producers.  I chose not to discuss Western Wind and another Renewable Energy project developer, Finavera Wind Energy (FNV.V/FNVRF.PK) in that article because they are earlier stage companies, because I was in the process of buying shares of both at the time, and I did not want to raise the price for my own purchases in these relatively thinly traded stocks. 

After the Algonquin offer became public, there followed a series of press releases from Western Wind and Algonquin, with Western Wind basically saying that the price was way too low, and that they were looking around for other offers, and Algonquin making it clear that they weren't ready to raise their price significantly.  Western Wind made the point that Algonquin was not the ideal acquirer because, as a Canadian company, they would not be able to realize approximately $1 per share worth of tax deductions in the form of accelerated depreciation on the company's wind farms.  Before making the bid public, Algonquin had entered into a "lock-up agreement"  with a large Western Wind shareholder owning 18.6% of the company.  The shareholder had agreed to support Algonquin's bid, giving the company the confidence they needed to make the bid public.

At Algonquin's request, Western Wind formed a special committee to consider any formal offer for the company, including Algonquin's.  Nevertheless, on October 26th, Algonquin terminated the lock-up agreement and indicated they were no longer interested in pursuing the deal.  I can only speculate as to Algonquin's reasoning, but my feeling is that they were not interested in a prolonged takeover battle which would probably require them to raise their $2.50 initial offer.

About the same time, Western Wind announced that it was discussing a buyout of a 100 MW wind project, in order to remind investors that there was a lot more to the company than the possibility of a takeover from Algonquin.

It concerned me that Western Wind was considering the acquisition of a wind project if they thought their own shares were so far undervalued.  Why not just buy up the company's own undervalued shares instead? 

I tried to get some details from Western Wind's investor relations contact, but he could not reveal any details of the negotiations, which are at a very early stage.  He did say that the reason the project's owners are willing to sell is because they cannot get the capital to develop it.  Western Wind expects that, if the company proceeds with the deal, it could find a way to develop the property with minimal or no share dilution.  Lack of dilution is no guarantee that such an acquisition would create more value than a share buyback, but it is comforting that they are paying attention to shareholder value.

What it Means

As a long-time Algonquin shareholder, I'm pleased to see that the company was only interested in buying Western Wind at a knock-down bargain price, and hope that they continue to take that approach to all future acquisitions.

As a Western Wind shareholder,  I was a bit disappointed that the deal did not go through.  I'm not immune to the lure of a considerable and very quick profit on my WNDEF shares.  On the other hand, I did not buy those shares because I was expecting a near-term takeover.  Instead, I bought them because I expected (and still expect) long term appreciation based on the fundamental value and earning power of a company with large wind projects just now coming online.
 
The IR spokesman also pointed out that the company is considering a share buyback in 2012 using some of the proceeds of the Windstar and Kingman federal cash grants, as announced last December.

Give Western Wind Some Respect

Western Wind became profitable only in 2010, and is right in the middle of the transition from being primarily a renewable energy developer to a renewable energy power producer with strong cash flow.  This change means this Rodney Dangerfield of a company will begin to get some respect from a new class of investors, and the attention brought by the takeover offer seems to have attracted the attention of a few such.

Although Western Wind's shares fell when Algonquin decided not to pursue its offer, the shares are still trading higher than they were in September.  But at $1.50-$1.60 per share, there is still considerable room for appreciation to fundamental value. 

In the near term, the free cash flow after operational expenses from Windstar and Kingman alone should be $14 million annually, with the potential for another $4-5 million from Mesa and Yabucoa, or 26 cents a share before company level expenses and the benefits of accelerated depreciation and cash grants.

For that alone, Western Wind deserves a lot more respect from investors.

DISCLOSURE: Long AQUNF, WNDEF, FNVRF.

DISCLAIMER: Past performance is not a guarantee or a reliable indicator of future results.  This article contains the current opinions of the author and such opinions are subject to change without notice.  This article has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.



was posted on AltEnergyStocks.com.


       

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Comments

Found this analysis very convincing and bought shares. What do people think about the letter released today and a potential proxy battle? I don't like the uncertainty but neither do I think it would be successful.

I'd say the potential proxy battle in itself is may not be great news, but it's certainly not as bad as management makes it out to be- they don't want to lose control, so they are trying to make sure we vote against any new potential directors.

On the other hand, if there is a potential proxy battle, it means that a 3rd party thinks the stock is worth more than it's current price... hardly a bad thing.

The 1603 Grant in Lieu of Tax Credit is set to expire at the end of 2011. Will that hurt Western Wind?

http://www.renewableenergyworld.com/rea/news/article/2011/12/finance-outlook-2012-can-projects-move-ahead-in-this-difficult-economic-environment

The valuation of the wind projects was made under the assumption that the 1603 grants would expire at the end of the year.
WND just received their 1603 grant for Kingman.

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