ArcLight Clean Transition II (ACTDU) / Opal Fuels (OPL) is a pending SPAC deal sponsored by ArcLight Capital Partners and current owner Fortistar that offers a compelling opportunity in the fast-growing RNG market.  With units priced at $10.40, offering 1 share of common and ½ of a warrant with an $11.50 strike, callable by the company at $18/share, one gets what appears to be a cheap option on a compelling growth story.

This write-up follows up on cosecant95’s pitch on Archaea Energy, which provides an excellent primer on the current state of the emerging RNG market.  While Archaea’s strategic focus on selling to generators under long-term fixed contracts will likely make it a steady cash generator with little exposure to volatility in RIN/LCFS prices, ACTD/OPL’s vertically integrated structure offers an opportunity to benefit from the current elevated price deck for emissions credits.   

 I believe the additional political risk associated with greater exposure to D3 RIN/LCFS volatility is compensated by the attractive forward valuation, which offers downside protection even in significantly less favorable pricing environments.  If management can execute on their ambitious growth strategy, EBITDA is expected to reach around $500mm in 2024 and almost $650mm in 2025 on the current price deck, against a current EV of just under $2bn.  Should management execute on its current growth pipeline and D3 RIN prices remain at or near current levels, OPL could offer 40-50+% annualized returns over the next 2-3 years.

Opal Fuels was created by the consolidation of a number of Fortistar’s portfolio assets to create a vertically-integrated RNG platform.  Fortistar will be rolling over 100% of its equity into the new listed venture and committing $9mm to a PIPE, with sponsor ArcLight committing a further $20mm.  Strategic partner NextEra Energy will further support the transaction with a $25mm commitment to the PIPE and an additional $100mm in preferred equity.

Opal currently operates 20 biomethane assets, comprising 18 in renewable power service and 2 RNG facilities, estimated to have produced 107MW and 13mm GGE in 2021, respectively.  The current asset base is expected to print ~$34mm in 2021 EBITDA.  The company’s management have a long track record in the space, with decades of experience in acquiring, building, and operating dispensing & monetization and capture & conversion projects.  The company’s predecessor LFG entitles have been in operation since 1998, while its dispensing & monetization segment launched in 2012.  

Currently under construction are a further 8 projects, comprising a mix of landfill gas and dairy projects expected to produce a further 36.8mm GGE and ~$102mm in annual EBITDA by 2024.  Of this total, 14.4mm GGE of capacity representing ~$46mm in EBITDA is expected to be completed by or around deal close, with the remainder coming online in H2 2022 and 2023.  Total capex for the currently under construction projects is expected to be ~$245mm, implying highly attractive returns on capital. 

Under construction projects are dwarfed by the current development pipeline, comprising a further 16 directly controlled projects expected to come online starting EOY ’22 and continuing out into '25, and which management estimates will provide a further $202mm in annual EBITDA.  Production facilities use standardized equipment and designs, and much of the current pipeline comprises conversions of assets already operating in power service, which should help mitigate construction risk.  Management claims to have a further 18 projects in preliminary planning which provide further potential upside to these numbers, and also claim to have a pipeline of already-identified M&A targets that could further extend the development pipeline. 

Importantly, the entire current pipeline of under construction and under development projects will be fully funded upon deal close, with funding coming from a mix of the PIPE, preferred equity, TLA, and expected operating cash flow.  Management believes that they will be close to FCF breakeven by 2023 and FCF positive in 2024. 

Opal’s vertically-integrated strategy is enabled by its status as the #2 operator of RNG stations in the US, with 72 stations in operation at YE2020 dispensing 75mm GGEs, against 550 operated by Clean Energy Fuels, the market leader, who delivered some 382mm GGEs in 2020.  Opal began dispensing RNG in 2017 and currently counts UPS, Amazon, and Waste Management among its long-term contract customers, and offers a full cycle solution for RNG stations comprising design, project management, construction, and service, including a built-in O&M contract upon completion.  Management claim a representative contract duration of 10 years for dispensing customers, and that vertical integration allows them to offer customers more attractive terms than non-integrated distributors.

Opal plans to more than triple its dispensing footprint by 2025 so as to maintain a captive outlet for its production volumes.  If Opal is successful with this strategy, they will be able to capture a larger portion of RIN/LCFS revenues than non-integrated peers, which on the current price deck should lead to industry leading EBITDA margins of ~45% - management estimates that vertical integration should internalize $0.31-$1.52/GGE in marketing costs, which is potentially significant when considered against total unit operating costs expected to be in the $3.50/GGE range.  Opal’s track record of delivering and operating RNG stations mitigates execution risk on its ambitious growth pipeline, as the company has already been delivering fuel since 2017, serving key enterprise partners like UPS and Amazon.  However, the additional upside from vertical integration is partially offset by contract and operational risk in dispensing.

I believe that Opal could generate compelling returns over the next 9-12 months as the story gains traction post-close and the market begins to reward the company for its ambitious growth plans.  If management successfully executes on its under-construction projects between now and deal close, I expect that the new OPL equity will begin to re-rate towards peer multiples as perceptions of execution risk diminish and analysts gain confidence in the company’s ability to deliver on its pipeline.  Assuming the current project pipeline continues to move forward over the next ~6 months, the newly listed Opal will trade at a ~1.75bn EV, implying a ~7x multiple of 2023E EBITDA, against peers who currently trade at a median valuation of ~17x 2023E EBITDA, and a <4x multiple of 2024E EBITDA, against peers trading at ~14x.

Aside from execution risk, the 10,000 lb. elephant here is what will happen with Federal RVOs going forward; the market is, after all, almost entirely a creature of Federal policy.  RIN prices will make or break the company’s strategy over the next 4-5 years, and Federal policy has been anything but consistent over the years; EPA mandates have previously been successfully challenged in court, and the issuance of “final” EPA rules have been delayed by up to 2 years in some cases.  These risks are magnified by the sunsetting of statutory RVO volumes after 2022, which will give the EPA full authority to set RVOs at whatever level they please. 

On balance, I believe the current administration is likely to be strongly supportive of RNG – but what happens ultimately is anyone’s guess, as the end result will hinge on a unpredictable combination of political and lobbying pressures.  I believe these risks are mitigated by the current valuation, which offers some downside protection should RIN prices fail to meet management’s projections.  Using management’s cost assumptions, the following rough estimates suggest an attractive, asymmetric risk/reward scenario - potentially a very attractive one, if you're bullish on D4 RINS/LCFS:

Key Risks:

-       Current valuation is supported almost entirely by development projects coming online in ‘23/’24

-       Collapse in RIN/LCFS prices

-       Industry supply in booming market overshoots demand

-       Key dispensing customers move away from renewables / contract losses in dispensing