Description

Description:

Algonquin Power is one of the safest, cheapest investments I have seen in my investing career.  It is the epitome of a Buffett "toll road" company - selling at one third of its intrinsic value. As a diversified North American utility focused on sustainable power sources (e.g. hydroelectric, energy-from-waste, wind power) Algonquin should prosper in coming years. 

 Incident

As a Canadian income trust, Algonquin Power Income Fund historically benefited from significant tax advantages, paying no income taxes at the corporate level (like REITs in the United States).  It paid out all of its free cash flow to unitholders in the form of distributions, and funded growth plans through equity raisings and debt financing.  The management compensation was strongly aligned toward maintaining a high distribution level (C$0.92 per share).  Throughout 2001 to mid 2006, the unit price mostly hovered around C$10. 

On October 31, 2006 the Canadian finance ministry announced that the government would begin taxing income trust distributions starting in 2011.  The income trust sector lost 20% of its stock market value virtually overnight, and has been out of favor since.  While Algonquin's unit price was significantly impacted, it is interesting to note that Algonquin's distributions remain significantly tax-advantaged even after this change by the Canadian finance ministry.  This is due to the fact that a significant proportion of the distribution is return OF capital, rather than return ON capital, and significant income is derived from US assets.  The return OF capital and US asset profits should not be subject to this new taxation.

 During October 2008, the unit price was slammed by the overall market panic, and a management decision to lower the distribution.  As mentioned above, the company had a history of paying a steady distribution of C$0.92 per unit per year.  The market probably expected management to cut its distribution by ~10% to ensure that the distribution was sustainable based on free cash flows.  The management instead decided to cut the distribution by almost 75% (to C$0.24 per year) and announced it would re-invest the retained earnings into future growth projects which they expect to find during the financial crisis.  Management stated that assets previously offered to Algonquin at too high a price were likely to become available at much more attractive prices.  Since debt financing may be hard to come by in the near future, utilizing free cash flow to fund growth is a thoughtful strategy. 

However, distribution-focused unitholders have exited the stock in a stampede, driving down the price to absurdly low levels (recent price: C$2.30).  Ironically, the stock price has been driven so low that it now has a robust, very sustainable distribution yield of over 10%, in spite of the distribution cut!  Most importantly, while the stock price has declined, there has been no impairment at all to the underlying business.  This gives us an amazing opportunity to pick up a Buffett-like toll road at a massive discount.

Company Overview

Algonquin owns a widely diversified portfolio of operating interests in 41 hydroelectric facilities, a 99 MW wind energy facility, one energy-from-waste facility, two biomass facilities, and five natural gas-fired generating plants across Canada and the United States. In addition, Algonquin owns 17 water distribution and wastewater treatment facilities located in the United States.  

Algonquin Power enters into long-term contracts (average remaining life: 17 years) with local/state authorities to provide electricity and water treatment.  These long-term contracts provide Algonquin with an "economic moat".  Our discussions with company executives indicate that upcoming contract renewals (responsible for ~6% of operating income) are likely to be successful on good commercial terms since they, like most of Algonquin's contracts, are located in power-constrained, local monopoly environments. 

Its most important business, hydroelectric power, benefits from predictable, low operating costs and modest maintenance capital expenditures.  Algonquin also operates several natural gas power plants, but it has astutely structured most of its contracts so that it is able to pass through input cost increases to its customers.  Algonquin's water treatment facilities are located in US localities experiencing significant population growth, and its agreements with local regulators allow it to submit "rate cases" for price increases to achieve agreed-upon ROI levels.

Algonquin's management has demonstrated a successful track record of managing its operations effectively, and making accretive acquisitions.  By diversifying its portfolio of assets, the management has mitigated the impact of natural hydrological variations in the core hydroelectric business - successfully delivering on an objective it defined in 2001.  Over this period, the company has more than doubled its revenues, and has broadened its geographical footprint across North America.  Management has also shown strategic focus, for example by divesting its non-core landfill gas facilities in California and New Hampshire.  The management's operational track record in value for shareholders is illustrated in its consistent improvement in per-unit cash available for distribution:

2001: C$0.73 per unit

2002: C$0.77 per unit

2003: C$0.86 per unit

2004: C$0.87 per unit

2005: C$0.93 per unit

2006: C$0.93 per unit

2007: C$0.95 per unit

 Valuation

Algonquin is best valued using a free cash flow model, since its GAAP earnings are significantly distorted by non-cash items, including depreciation and swings in the fair value of exchange rate hedges.  After the transition to the post-2011 tax regime, the baseline annual free cash flow would be over C$60MM, assuming no growth from current levels.  Using a conservative 10x multiple on this baseline FCF, and adding excess cash, we obtain an intrinsic value estimate of C$7.50 per share. This value is a bit too conservative, since the company has significant opportunities for profitable growth.  Indeed, based on company statements, upcoming rate cases with state regulators will likely boost run-rate profits by C$7MM by end FY09.  Adding this increment to the baseline FCF, and applying a 12x multiple would indicate a value in excess of C$10 per share.

Conclusion: At a recent unit price of C$2.30, Algonquin is trading at approximately 70%-80% discount to intrinsic value and pays a safe 10% distribution to boot.  Any unit buybacks at the currently distressed unit price could significantly boost intrinsic value per unit well above the above estimates.

Further evidence of Algonquin Power's compelling value: the current stock price indicates that Algonquin's equity is trading at a 50% discount to its net asset value.  On top of that, the long-lived nature of Algonquin's portfolio renewable energy assets is made more valuable over time.  With years of building cost inflation, this net asset value likely understates the true cost of replicating this business.  These assets would become even more valuable if additional economic benefits are provided to power producers deemed environmentally friendly.

Catalyst

Value is its own catalyst - the company just needs to keep operating steadily.  The market will be a "weighing machine" in the long run and recognize Algonquin as the epitome of a Buffett "toll road" company.  The investment thesis does not hinge on the favorable resolution of any issues.  However, the following could be considered as catalysts that might accelerate this realization:

• Distribution-oriented investors finish exiting the stock
• Company provides additional disclosure about the ROI of its growth project pipeline
• Potential spinoff of water treatment business may provide clear visibility to core power generation business