Description

Thesis Summary

An under-the-radar power producer in Alberta, Canada has been quietly investing in a clean energy technology that could prove to be revolutionary. Capital Power Corporation (TSX:CPX) is a C$4-billion market cap independent power producer with a strong, under-appreciated base business with a free option on a new technology that cost-effectively converts carbon dioxide into valuable carbon nanotubes. We believe Capital Power’s base business is worth C$43 per share and its budding clean-tech nanotube investment could be worth anywhere between C$4 and C$45 per share on a risk-adjusted basis. At the current share price of ~C$36, we believe the market undervalues the base business and also ascribes zero value to a tremendous opportunity that could more than double the Company’s share price.

An Attractive Base Business with Limited Downside

Capital Power is a growth-oriented North American power producer headquartered in Alberta, Canada. The company develops, acquires, owns and operates coal, gas and wind-based power generation facilities. In total, the company owns 6,400 megawatts (MW) of generation capacity across 25 well-situated facilities, with an average asset life of only 14 years.  

Management is currently executing on a diversification strategy that has considerably de-risked the company’s business profile over the past 5 years. By the end of 2021, the company will have transitioned from coal-fired power plants generating 55% of EBITDA in 2015 to only 30% of EBITDA being generated by dual-fuel plants capable of either coal or gas-based generation.  The remaining 70% of EBITDA will be derived from gas-only and wind power facilities. The company will also have reduced its concentration of Alberta-based power generation from 75% in 2015 to 50%. Management has accomplished this transformation while retaining an investment grade balance sheet, growing AFFO by a 13% CAGR and maintaining a strong contracted cash flow profile for the majority of the business. 

By the end of this year, approximately 2/3 of EBITDA will be locked-in under long-term wind and gas generation contracts, with a weighted average duration exceeding 10 years. Management is currently addressing two near-term contract expiries related to assets that are very favourably positioned in their respective jurisdictions – the Decatur Energy Center in Alabama and Island Generation in British Columbia. Once these contracts are renewed, the weighted average contract life for the contracted portfolio will increase to 11+ years. 

The remaining 1/3 of Capital Power’s EBITDA will be earned in the Alberta merchant power market, which is an oligopoly market with the forward power price curve indicating robust pricing in the C$53-$60 per MW range over the next 3 years. We expect improving free cash flow in the near term. With strong plant performance and a highly effective hedging strategy, management has consistently demonstrated realized prices in excess of spot market prices for its Alberta merchant portfolio. 

Longer term, power demand in Alberta is a legitimate risk if one is bearish on Alberta oil and gas investment. However, the risk of stranded assets is low, as Capital Power’s younger, lower-cost plants are much more efficient than those of competitors and therefore, operate at a higher load factor and are unlikely to be displaced in the event supply needs to exit the market due to lower than expected demand. Additionally, if new pipeline capacity isn’t built, and oil and gas development remains subdued, AECO (Alberta) gas prices are sure to remain lower for longer, providing a nice hedge in the form of lower input costs for Capital Power’s efficient gas-fired fleet. For context, AECO gas forward pricing is currently averaging only ~US$1.50/MMBtu for the next 3 years, making gas-fired power generation in Alberta very inexpensive, even under the Canadian federal government’s current carbon tax pricing regime. 

The current share price of ~C$36 implies an EV/EBITDA of 8.8x and a free cash flow yield of 14.5% on F21 consensus, which we believe is easily achievable. With 2/3 of the business underpinned by long-term contracts and the other 1/3 derived from well-positioned assets in a rational oligopoly market, we believe the current valuation is too punitive. A more reasonable valuation for the base business would be C$43, based on 9.5x EV/EBITDA and a 12% free cash flow yield. 

The Little-Known Clean Energy Technology that could be Revolutionary

In May 2018, Capital Power invested C$3mm in a little-known company by the name of C2CNT, a developer of innovative technology that captures and transforms carbon dioxide into a high-value product called carbon nanotubes. The company was founded by Dr. Stuart Licht, a Professor of Chemistry at George Washington University and expert in the field of electrochemistry. Its stated mission is to “save the planet from the ravages of climate change” by “removing anthropogenic carbon dioxide and pioneering a transformative carbon economy.”

Extracting carbon from smoke stacks is not a new idea; but using the captured carbon to produce carbon nanotubes (CNTs) cost effectively is potentially revolutionary. C2CNT’s patented process splits carbon dioxide molecules by molten electrolysis into CNT and oxygen components. The CNTs extracted from the process are a high-value material that, when added to materials such as concrete, steel or aluminum, forms composites with significantly enhanced structural properties. 

CNTs are considered by those that study the science to be the strongest material ever measured. Enhancing the strength of concrete, steel or aluminum opens the door to less material usage to achieve a desired application. Using round numbers as an example, according to C2CNT, a 3,000-tonne block of concrete can be replaced by an equally strong 2,000-tonne block of CNT-concrete composite through the addition of only 1 tonne of CNTs. This reduces the concrete that needs to be produced for an application by one-third, resulting in significant costs savings for a concrete producer. (i.e. adding 1 tonne of CNTs displaces 1,000 tonnes of concrete.)

The following link provides more background on C2CNT: https://www.c2cnt.com/

CNTs have been researched and tested extensively by the scientific community, but the application of the material has been very limited on account of the prohibitive cost to mass produce. Under currently-utilized methods, industrial-scale production of high-quality CNTs can suffer from from low yields, high material and energy costs, and purity and other quality control challenges.  Whereas industrial grade CNT production costs have typically been in excess of US$100,000 per tonne, C2CNT has measured its production cost in the US$1,000 per tonne range. For context, industrial grade CNTs sell for hundreds of thousands of dollars per tonne, implying a substantial margin opportunity for a low-cost producer. 

The following link provides examples of industrial grade CNT pricing, which are shown to be in excess of US$199 per kg ($199,000 per tonne):

https://www.cheaptubes.com/product-category/industrial-carbon-nanotubes-products/

The following are links to Dr. Licht’s research and technical papers, which provide additional background on C2CNT’s production process and relevant costs:

https://www.researchgate.net/publication/305780518_Co-Production_of_Cement_and_Carbon_Nanotubes_with_a_Carbon_Negative_Footprint

https://www.nature.com/articles/srep27760

https://cpb-us-e1.wpmucdn.com/blogs.gwu.edu/dist/d/73/files/2019/12/2019-Exploration-of-alkali-cation-variation-on-the-synthesis-of-carbon-nanotubes-by-electrolysis-of-CO2-in-molten-carbonates.pdf

https://arxiv.org/ftp/arxiv/papers/1710/1710.07246.pdf

Given C2CNT’s breakthrough in production costs, large global steel, aluminum and cement producers have shown a keen interest in Dr. Licht’s work. The potential to substantially reduce production costs for producers of structural material is certainly a strong motivator, but the significant reduction in CO2 emissions could be of equally compelling benefit. Investor scrutiny of major industrial CO2 emitters, such as cement producers, has intensified tremendously over the past few years. For example, CEMEX, one of the world’s largest cement producers, is acting on environmental initiatives aggressively, recently setting a target to reduce its CO2 emissions by 35% by 2030. C2CNT’s technology would allow a cement producer like CEMEX to significantly reduce its carbon footprint by cost-effectively capturing and converting the CO2 emitted from its production process into CNTs, which could then be sold or utilized internally, significantly offsetting the cost of cement production.

As presented at Capital Power’s investor day this past December, C2CNT is currently working closely with major North American cement producer Lehigh Hanson (a subsidiary of Heidelberg Cement) to establish a model for the mass production of CNT-enhanced cement. Although disclosures are limited at this point, we believe feasibility of the cement-CNT composite material has already been established and the companies are currently engaged in more of a “tweaking” exercise. 

Regarding the application of CNTs in the production of cement, Capital Power’s CEO  Brian Vaasjo stated the following at the Company’s December investor day:

The inhibition of having these technologies move a little bit further and actually into significant production is simply cost. It's just out and out cost. And when we look at whether this enterprise is going to be successful or not, I talked earlier about it being at least an order of magnitude reduction and have tested it against prices and so on. And certainly, it works in cement, and we believe it'll work in other products. And we've got that confirmation from the cement industry. The issue is then -- or what -- where your questions are going to is, are you going to achieve in the cost and the scale that's going to make it happen. And when you look forward at Genesee, I would say, when you look at the cost of production that Professor [Licht] is going through today at Shepard, you -- it is economic even if you don't scale that up. You just have a larger footprint, greater production area, and it's a little bit more labor-intensive than it probably could be ultimately. And so there's a lot of scaling that will certainly help the economics, help the production, but in terms of it being economic, I would say, at the state it is today, it's economic. Anything else is upside.

The above reference to “Shepard” relates to the Shepard Energy Centre, Alberta’s largest natural gas-fired power plant, which is 50% owned by Capital Power. Per the above, Brian Vaasjo is confirming, 1) C2CNT is already producing CNTs at Shepard on a small scale; 2) Capital Power has confirmed that the CNTs produced are “economic,” with an “order of magnitude reduction” in costs; and 3) CNTs do indeed “work” as a cement composite material. 

From the investor day discussion on the Lehigh Hanson partnership, it is also worth noting that the development of the CNT-enhanced cement is being conducted at the cost of Lehigh Hanson. In any business, it is obviously a good sign that you have something of value if your prospective customer is willing to front the cost of product development. 

Cement enhanced with CNTs is not a “fishing expedition.” It has already been demonstrated on a small scale by the scientific community that the strength of cement (and concrete) can be enhanced with the use of CNTs and similar materials. Below are slides from the investor day illustrating that cement-CNT composites have been extensively studied and tested by the scientific community:

As summarized above, Dr. Licht estimates that for every tonne of CNTs mixed into concrete, the production of concrete could be reduced by 938 tonnes to achieve the same tensile strength as a concrete-only material. At a US$100 per tonne production cost for cement, a total of US$93,800 in savings would be generated for each tonne of CNT utilized. At the current cost of industrial grade CNTs in the US$200,000 per tonne range, substituting CNTs for concrete would be uneconomic and, hence, the principal reason why CNT-concrete composites have not historically been commercially viable. However, Dr. Licht’s breakthrough in CNT production costs would seem to change all that. At a production cost of only ~US$1,000 per tonne of CNT, one can see why C2CNT’s technology has the potential to be revolutionary.

If successful, C2CNT’s work with Lehigh Hanson could be only the “tip of the iceberg.” Consider the size of the global concrete market, as well as the potential to address the steel and aluminum markets.

Results of C2CNT’s work with Lehigh Hanson should be disclosed by Capital Power within the next several months. We believe results will be positive and Capital Power will exercise its option to increase its ownership interest in C2CNT to 40%. However, even if results are mixed or negative, future trials with alternate concrete producers may be successful and there is great potential for the use of CNTs with other structural materials, such as steel or aluminum. 

What Could C2CNT’s Technology Be Worth?

By investing in and deploying the C2CNT technology, Capital Power hopes to benefit from an improved ESG rating among investors. More importantly, if testing with Lehigh Hanson proves to be successful, Capital Power’s investments in the technology could be worth billions of dollars. We believe this potential upside remains completely unrecognized by investors and sell-side analysts.

Capital Power currently holds a 9% ownership interest in C2CNT. If testing is successful, Capital Power will exercise an option to increase its ownership to 40% at a nominal cost. The company would also build its own industrial-scale CNT production facility at the site of its Genesee power generating station in Alberta. This production facility and all associated profits would be wholly-owned by Capital Power. At this facility, management expects to produce commercially saleable CNTs at a rate of 2,500 tonnes per year, beginning in 2021, and eventually ramping to a rate of 7,500 tonnes.

C2CNT will target the cement industry first and operate under a licensing model. A cement producer that licenses the carbon conversion technology would incur the cost to construct its own CNT production facility and produce CNTs, but would pay a licensing fee to C2CNT. Capital Power’s CNT production facility would also be subject to a licensing fee, albeit likely at a discounted rate according to management. 

The below figures incorporate our worst, base and best case valuations for Capital Power’s investment in the CNT technology. 

Based on the above, and assuming development with Lehigh Hanson progresses as planned, we believe Capital Power’s CNT investments would be worth between C$8 and C$90 per share. After applying a discount of 50% to account for risk related to product development, time to ramp and execution, Capital Power’s investments would be worth between C$4 and C$45.

After considering the value of Capital Power’s base business and risk-adjusting the Company’s CNT investments by 50%, we believe shares should be valued at between C$42 and C$93, with a C$62 base case.

We believe the above illustrates that even if a significant discount is applied to the CNT investments value, Capital Power’s shares represent a highly compelling opportunity at the current ~C$36 price. At the current price, the base business is moderately under-valued and investors get a free call option on CNT investments that could be worth up to C$90 per share if the technology proves successful.

Why the Opportunity Exists

Here is why the value of Capital Power’s base business is under-appreciated and the market ascribes little-to-no value to the CNT investments:

1. Conservative management – Management has a “matter-of-fact” style, focusing on strong and steady execution, without setting lofty expectations. Anyone who has met CEO Brian Vaasjo knows that he is judicious and not promotional.  Management has expressed optimism regarding C2CNT, but it is not surprising to us that disclosure on the opportunity is limited and has always been heavily couched in one form or another.
2. Nobody is paying attention – CPX is a “yield stock,” with a heavy Canadian retail following and limited institutional ownership. It is a niche Canadian mid-cap with a complicated story, overshadowed by its Alberta concentration. Most of the Canadian sell-side has not performed the requisite in-depth due diligence either, as the smaller market cap and limited institutional interest make it an easy perpetual “hold” rating, and it’s not perceived to be worth the time investment to fully understand the complicated story. Most of the sell-side has been slow to see Capital Power’s changing story since 2015 and we think the current state of apathy is just more of the same. Pipeline and utility analysts are simply not wired to understand and value nascent technology opportunities with tremendous potential. 

Risks to Investment

• Significant supply or demand shocks that negatively impact power pricing in Alberta for a sustained period of time;

• Expiring power purchase agreements are not re-contracted on favourable terms, or at all; and

• CNT-concrete composite development with Lehigh Hanson fails and further attempts to monetize the technology also fail.

Catalyst

• Continuing to demonstrate strong free cash flow from Alberta merchant operations

• Positive developments regarding re-contracting of the Decatur Energy Center and Island Generation

• Positive updates regarding the CNT technology and specifically, confirmation of commercial feasability with Lehigh Hanson