Description

‘ESG spacs’ (and warrants) 

The basic idea of this thesis is to profit from the ESG/Sustainable investing trend (hype) we have been and still are witnessing. I have to start by mentioning that I personally don’t believe that the trend towards ESG is adding much value. Please don’t get me wrong; I believe that every company should strive to make the world a better place through their products and services, though I’m sceptical regarding how much value is added with ESG/sustainable investing. To the contrary, I believe it makes the life of active managers in general more difficult. Some of my peers are now tied to Sustainalytics ratings to decide if they can or cannot take a new position in an interesting company. In addition, I find the literature about how ESG adds value generally weak. For those interested, I’ve added a very good post from Aswath Damodaran summarising the spurious relationship between ESG and company value.

http://aswathdamodaran.blogspot.com/2020/09/sounding-good-or-doing-good-skeptical.html

However, that does not mean we should not try to profit from this trend. 

A couple of general points regarding this write-up:

• ESG stands for Environmental, Social and Governance, and is basically a measure of the ‘goodness’ of a company, mainly to the environment and society. ESG proponents predicate that companies that improve their ‘goodness’ will become more profitable, valuable and make the world a better place for everybody. In my experience, companies that claim to be ESG-complaint generally focus on E and S, and less on G. The point here is that the company ‘does good’. Also, I see many peers not differentiating between ESG integration and sustainable investing (and Green for that matter) and putting them in the same bucket (as indeed many times there’s a big overlap). I will do the same and use the terms mixed together throughout this write-up (apologies to the purists).
• This write-up is not intended to discuss whether ESG is good, bad, hypocritical or whatever. This thesis is about playing a very significant trend.

Before presenting specific names, it is important to provide some context regarding the market and to keep this in mind when doing work on potential investments: 

Point 1. ESG is very real and is here to stay. Investors should not ignore this trend and its impact.

I would like to use an example of a friend fund manager who 4-5 years ago started to notice valuations of certain Scandinavian companies moving upwards, from expensive to extremely expensive - and staying at elevated levels. He called the company and several analysts and all gave the same answer; they were seeing lots of interest/flows given the ‘sustainable’ character of the company. Also, the company got even more expensive after Sustainalytics started to cover them (and give them a rating). Companies like Sustainalytics are already having a big impact on valuations and I believe this will only get worse. With respect to my friend he mentioned he would never become ‘sustainable’ and buy into such nonsensical valuations. You can guess what happened some time later; a couple of big clients told them they were changing their mandates and now need their investments to be branded ‘ESG-ok’ or else divest. 

Point 2. The US is strongly lagging Europe in the trend/flows towards sustainability. Investors should take this as a sign of things (flows) to come and as an opportunity as well.

We do not know whether US investors will move to sustainability as vigorously as their European counterparts, however we do know that the trend in Europe is not abating, and is actually accelerating. The conclusion is that even though the US might not reach the same level of AUM in ESG/sustainable funds, I believe the probability of accelerating US flows towards sustainable (or similar) funds in the near future to be very high.

Some interesting links related to the above:

https://expertinvestoreurope.com/global-sustainable-fund-assets-leap-to-all-time-high/

https://www.ft.com/content/fef1a4fc-8354-11e9-b592-5fe435b57a3b

Point 3. Another important point in the trend towards sustainability is the directionality of the flows. It is not similar to the divergence between large cap growth and small cap value where at some point one can expect a (very large) reversal of flows. I believe the fund flows towards ESG investing to be mainly one-directional. Today demand for companies with a sustainable character vastly outpaces supply. Though this will certainly cause excesses and bubbles here and there (and opportunities on the other side) it will not revert anytime soon, if ever. Asset managers will not go back to be ‘unsustainable’. Certainly the ESG hype can become less pronounced at some point (e.g. as ‘sustainable’ becomes the new normal), but that means less flows, not a reversal of the flows. In order to become ‘sustainable’ or branded ‘ESG-ok’, asset managers (and their clients) have to change their mandates, adjust prospectuses, (internal) guidelines, risk (monitoring) controls, etc. That is a process that will not be reversed easily. Think about the changes the gigantic but very slow moving Norwegian and Dutch pension funds have made to move towards ESG and sustainability. This is still ongoing and they will not revert anytime soon.

The bottom line is that this space is very popular today and I expect it will continue to be so for some time. It has a massive tailwind and people are willing to pay up to own - and some even must.

‘ESG spacs'

Given the above, the question now is how to profit from the ESG hype. I have found spacs, and particularly spac-warrants, to be good vehicles to play trends/hypes (and one of the main reasons why they are so popular anno 2020):

• Spacs can move very quickly, closing a business combination in 2,3 months compared to >6 months for a regular IPO, and are thus able to play into trends more quickly.
• Regular IPO trajectories have a SEC mandated silent period prior to listing. In contrast, spacs able to sell their business combination before the closing of the business combination (and do so).
• Many funds cannot or will not buy into spacs prior to the closing of the business combination due to a variety of reasons, such as uncertainty regarding the closing of the business combination, low liquidity of the spac, or general antagonism/aversion towards spacs.
• As a consequence of the silent period, lock-up and the banks in the syndicate, regular IPOs have new analyst coverage only after a specific period, generally a month or so. Today, we are starting to see new analyst coverage of new spac business combinations even before closing of the business combination (NFIN as example).  

Below I present three ‘ESG’ spacs. It is not my intention to go much into the details of the products and the proposed business combinations and make this write-up overly lengthy. I will describe how I invest in these securities and what I’m mainly looking for in each. Full disclosure: I’m mainly long the warrants.

For each spac I try to assess how quickly the share price can reach $18 and how ‘easy it is to sell the particular ESG story’. The $18 is because that’s when there can be forced/cashless conversion of the warrants (then worth ~$6.5). If the shares price moves up strongly prior to say a month after closing the business combination, that’s just more upside; otherwise, the tendency is for the warrants to be called when the shares price reaches $18 (for a certain period of days within a month). Please keep in mind that a lot of (bad) things can happen with the warrants when the share price reaches $18; I’ve seen enough managements making it difficult for investors to convert their shares. With respect to how ‘easy it is to sell the story’, I mainly look at how ESG/sustainable/green the story is, the valuation (based on fully diluted shares) and comps.

Let’s look at three examples of ‘ESG spacs’ which I believe will do well. Please keep the previous discussion regarding the market trends in mind.

Live Oak Acquisition Corp. (LOAK, LOAK/WS)

LOAK recently announced a merger with Danimer Scientific. Danimer already produces PLA, but the company’s main product is PHA, “a 100% biodegradable, renewable and sustainable plastic feedstock alternative for usage in a wide variety of plastic applications...”. According to the company, its PHA polymer is the first commercially available PHA in the world to be certified as marine degradable. 

This is very interesting for the ‘easy to sell’ story. To give you an idea of the industry certifications of (bio)plastics:

1. Industrially compostable. First step above all that doesn’t go away. It is the easiest standard to achieve. Biodegradation takes place in an controlled, industrial facility to produce compost. The process requires very high temperatures.
2. Home compostable. More or less like 1, though the process of making it disappear requires less work (heat generally), but processed volumes are very low and it can take a long, long time.
3. Soil degradable. Here you start using (mainly) bacteria to process the plastics. Soil degradability can take a long time though. 
4. Fresh water degradable. Very difficult to achieve as less and less micro-organisms are present.
5. Marine degradable. The most difficult and highest standard to achieve. The cold sea water with a low population of micro-organisms makes it hard for materials to decompose. 

Danimer PHA products are certified as marine degradable.

What makes it more interesting compared to some of its peers is that Danimer appears to already have achieved some level of scale: Phase I of the Kentucky plant expansion was finished this year (20m pounds production capacity). The plan now is to move to phase II, which adds another 45m pounds, and break ground on the new greenfield facility (Q1 2022) that is expected to add an additional 125m pounds of finished product when finished (Q4 2023).

Most capex will be in the period 2021-2023 for phase II and the greenfield facility (~$400m). According to Danimer, after the business combination it will be fully financed for the entire project.

Danimer expects all this to lead to the earnings picture below. PHA resins are expected to be the main revenue stream. The company claims high visibility as capacity has been fully sold-out through 2022 with the phase II capacity buildout; all contracts are take-or-pay with large customers such as Nestle and Pepsi. As demand is much higher than supply, Danimer expects to be quickly sold-out again in 2024 as the greenfield facility is expected to approach full utilization. Target ebitda margin is ca 30% upon the full utilization of the Kentucky facility in 2023 and are supposed to continue to expand thereafter given operating leverage from the greenfield facility ramp-up.

The bear case of this story is arguably an Avantium (AVTX NA) scenario: A company with a promising bioplastics technology, nice partnerships and JVs with big names and a conviction that it will be able to scale, but eventually fails to do so and as such the story is over. However I believe the story with Danimer to be less risky; the company has already achieved some non-negligible level of scale and revenue visibility seems indeed high until 2022 given their take-or-pay contracts. Also, growth financing seems secure after the deal. Delays are always a risk (and probable), but I don’t believe that to be an issue now to ‘sell the story’.

The bull case is the company being able to scale and ramp up properly (and on time). As demand is currently much, much higher than supply, the company will have no problems selling out its capacity early, which massively increases visibility (2027+). End markets are huge, and as the greenfield facility construction progresses, the company will start talking about additional greenfield opportunities. Given the extreme green character of the firm and the clear intention of selling itself as an ESG leader, I will not be surprised should multiples expand quickly.

Danimer mentioned the best direct peers to be private companies, some European and other Asian. Kaneka is apparently the only other company that's actually selling PHA, however according to the company there’s limited market overlap. In addition, Kaneka does not appear to have reached commercial scale in its PHA production. http://www.kaneka.be/documents/PHBH-brochure-11-2017.pdf

The slide deck mentions some public listed peers, which (obviously) trade at much lower multiples. Management claims Corbion (CRBN NA) as the most comparable public peer, though Corbion’s bioplastic quality is much inferior (with respect to Danimer’s PHA). However, I know Corbion as being sold as an ESG leader, which I believe is reflected in its multiples (~16x 2022e ebitda of EUR 180m, very little growth and margin expansion). So I understand why this comparison.

Not mentioned by management, I believe Quantafuel (QFUELME NO) to be relatively comparable with respect to the growth story. Quantafuel is active in waste management. The company has developed a technology with which it will convert plastic waste into low-carbon products. There are many planned facilities over the next years in various stages, together with big name partners. The company sells itself as “green to the core”. Nevertheless, the company currently has zero revenues, will need to raise equity (often) and trades at ~22x 2022e ebitda of $44m. All because of sustainability.

Assuming a $18 share price, 103m shares (89m + 11.5m warrants + 2.5m 1st earn-out at $15) and ~$500m net cash (incl. ‘cash’ warrant conversion), Danimer will trade at ~25x 2022e ebitda of $54m (for 63% 2022-2024 ebitda CAGR). I might be a bit off on the exact number of shares, nevertheless, given the very sustainable character of Danimer, its revenue visibility up 2022 and strong expected growth thereafter, I believe Danimer to be an easy sell and I’m betting LOAK/Danimer will reach $18 sooner rather than later. 

With LOAK warrants currently trading at $1.8, there’s plenty of room to $6.5 or more in the very near term. The business combination is expected to close “end of Q4, early Q1”.

https://static1.squarespace.com/static/5e67edbafdc6373947debe8f/t/5f7b125cb3c4145e8943d4bc/1601901160578/Danimer+Scientific+and+Live+Oak+Merger+Presentation+October+2020.pdf

B. Riley Merger Corp. II (BMRG, BMRG/WS)

BMRG is a bit of an odd one. BMRG recently merged with Eos Energy Storage, though while spacs generally tend to make a big (marketing) deal of their intended acquisition, BMRG kept very quiet – I can’t remember a spac m&a call lasting 11 minutes. In addition, as the acquisition was announced just a month after the spac listing, I believe this spac might have been set up just for the purpose of listing Eos.

Regarding Eos’ products, the company brands itself as “a leading manufacturer of safe, sustainable, low-cost, and long-duration zinc hybrid cathode (‘Znyth’) battery energy storage systems”. The target market of Eos is large scale energy storage solutions, a market which is expected to grow extremely fast as a consequence of the fast transition to renewables. According to Eos, their flagship product (Znyth battery system) is commercially available and already scalable. However, the main selling points are:

• Their core product requires only five core commodity materials that are derived from non-rare earth and non-conflict minerals (read: independency from China).
• The batteries are fully recyclable. 
• The batteries are supposedly very safe, non-flammable and easy to maintain.
• Fully manufactured in the US. 

In addition, the company is further developing its technology and is expecting to introduce new, more efficient batteries as of 2021. Management was changed completely over the last couple of years and now consists of mainly ex GE-employees.

Eos has some production agreements in place and has since the announcement of the proposed business combination announced additional deals. The pipeline appears to be full. Since the above presentation (September), Eos announced additional deals. Eos is (obviously) very positive about the future, mainly given the strong expected demand from the shift to renewables.

I believe the bear/bull case here to be a bit more tricky compared to Danimer. The market demand for energy storage solutions is indeed growing very fast, and demand is expected to outpace supply for years. Also, the company claims visibility up to 2021 given the current pipeline. However, scaling the technology might prove difficult and we still have few signs of that potential given the little available capacity at the moment. Furthermore, there is much competition in this market, mainly from the ‘classic’ lithium-ion batteries. With respect to the technology, I understand that the potential is great, but total cost of ownership is not always better. Also, given Eos’ main product specs, the battery is efficient in specific environments (e.g. specific charge/discharge needs).

Again, assuming a $18 share target price, 68m shares (55m + 9.1m warrants + 3.8m earn-out shares) and ~$300m net cash (incl. ‘cash’ warrant conversion), Eos will trade at ~3.4x 2022e revenue of $270m* (2022e ebitda break-even). Eos expects revenues to almost quadruple in the period, which is quite a lot, though I believe there to be more uncertainty with Eos compared to Danimer. 

Nonetheless, I believe the story to be an easy sell to ESG investors and 3.4x 2022 revenue not a stretch, keeping in mind the market back-drop where Eos will trade in and (again) the very sustainable character of the company. The marginal ESG investor today is willing to pay some premium multiples to own growth stories in the ESG/sustainability space with much worse operating models. In addition, there aren’t many pure play sustainable battery storage solution companies in the market. As BMRG warrants are trading at $1.23 and shares at ~$10, I believe I’m not paying much to have exposure. The transaction is expected to close end of this month.

(*I have to mention that I’m a bit confused regarding what the company claims about pro-forma EV and implied market cap; both are mentioned to be ~$550m, though they’ll have ~$200m cash for growth. So either they have 200m debt, which I very much doubt or there’s some confusion in the nomenclature.) 

https://www.sec.gov/Archives/edgar/data/1805077/000121390020025523/ea126529ex99-2_briley.htm

Pivotal Investment Corp. II (PIC, PIC/WS)

The last one is Pivotal, and I can be short on this one. Pivotal will merge with XL Fleet, a provider of EV powertrains. This is basically their sales pitch:

We know how the other companies have performed. To say the market anything related to EV is hyped is an understatement. Even Nikola, which admitted lying and massively inflating its (hydrogen) potential, is still trading at ~30x 2022e revenues. XL Fleet claims it will sell “existing products to existing customers through existing channels” and basically differentiate itself this way from peers. 

Of the three, this has my lowest conviction. The EV powertrain market is crowded and becoming crowded by the day. Nonetheless, XL Fleet is a must to own if you want ‘sustainable’ exposure to the car market. At $18 share price and 152m shares, XL will be trading at ~8x 2022e revenue; a lot, though currently compared to listed peers still relatively cheap. Warrants are currently trading at ~$2.5, and I’m willing to bet these things will move up once the deal approaches closing.

https://xlfleet.com/assets/Uploads/PDF/Updated-Investor-Presentation-9.21.20.pdf

Catalyst

Closing of business combinations

Continuation of ESG/sustainable investing flows