Last Updated: February 17, 2020

Disclaimer: As of the date of this report, we have short positions in the stock of Ormat Technologies, Inc.  We stand to realize gains in the event that the price of the stock decreases. Following publication or dissemination, we may transact in the securities of the company.  All expressions of opinion are subject to change without notice, and we do not undertake to update this report or any information herein. Please read our full legal disclaimer at the end of this report.

Ormat Technologies, Inc. (NYSE:ORA)

Running Out of Steam

We are short shares of Ormat Technologies, Inc. (“ORA” or the “Company”), a vertically-integrated geothermal and recovered energy power plant developer, operator, and equipment manufacturer.  Shares of this under-the-radar firm in a niche segment of the power market have returned ~500% since the Company’s IPO in late 2004, culminating with a nearly 200% return over the last five years (more than 2x the S&P 500).  Today, ORA’s market capitalization exceeds $4 billion. 

We think that ORA’s earnings per share could be cut by more than 40%, which would result in a violation of the Company’s dividend payout ratio covenant.  A key partner appears increasingly likely to break what is almost certainly the Company’s most lucrative power purchase agreement (“PPA”). With shares trading at all-time highs, a 0.6% forward dividend yield, and 42x next-twelve month EPS, a re-rating could result in meaningful downside beyond any hit to earnings.

Current media headlines point to a potential geothermal “revival” in California that could double capacity by 2030 – two power purchase agreements have been signed recently at what will be the first new geothermal plants built in the state in nearly a decade, one of which belongs to ORA.  Management wants investors to believe that its U.S.-centric business is positioned to take advantage of these trends. On a 2019 investor call, while discussing the Electricity segment (nearly all of profits), management said: “obviously, the largest part is in the U.S., about two-thirds of our portfolio is in the U.S.”  However, upside from U.S. expansion is more than priced into the stock at current trading levels. The bigger problem – and what bulls are likely overlooking – is that while the statement is true based on megawatt capacity, ORA’s profits and risk profile skew internationally. In new disclosures in the 2018 10-K, ORA noted that 53% of EBITDA and 77% of net income are from the international operations of the Electricity segment and that Kenya contributes “disproportionately.” 

Fortunes in Kenya appear to be changing – ORA relies on a single, government-controlled utility customer, whose past due balance is growing.  The utility’s last annual report (for the year ended June 30, 2018) revealed a technical breach of covenants; a qualified opinion on its statements; and a negative cash balance net of overdrafts.  ORA’s lone plant in Kenya earns per unit pricing that appears to be substantially higher than the rate a larger, government-controlled producer earns for generation sold to the same customer. Using the local producer’s rates as a baseline for comparison, ORA has extracted as much as ~$310-$360 million, or ~120%-170%, in excess pre-tax profits during the utility’s 2012-2018 fiscal years alone.  In what appears to be a full court press, the Kenya Revenue Authority sent a letter to ORA in July 2019 demanding $77 million relating to taxes from 2013 to 2017. At the same time, ORA’s competitive position in Kenya has deteriorated. ORA’s local capacity declined from 35% of the local producer’s geothermal capacity in 2011 to less than 20% after a new 165 MW plant commenced operation in the second half of 2019.  

Management raises red flags.  ORA’s CEO and CFO both have past affiliations that shouldn’t be overlooked in the context of the Company’s international operations and Kenya’s contribution to profits.  The CEO’s last executive position at a public company ended with his resignation from VeriFone in 2008, one month after VeriFone announced financial restatements in the wake of its purchase of Lipman Electronics Engineering.  Before the deal, ORA’s CEO had been the CEO and President of Lipman, where operating expenses were improperly booked in subsidiaries’ inventory accounts. ORA’s CFO was previously CFO of Shikun & Binui, a large Israeli EPC firm being investigated for bribery, false reporting, and tax violations that occurred in Kenya (of all places) from 2008 to 2016.  ORA’s CFO’s tenure with S&B was 2009 to 2013. ORA itself has an unresolved material weakness, and restated reported EPS for 2016 and 2017. PWC resigned as auditor in 2018, and an Israeli affiliate took over. Executives and board members own a negligible $3.5 million of stock.

Outside of Kenya, we think that the core business earns low- or mid-single digit returns at best, below the Company’s cost of capital.  While revenue and EBITDA targets drive executive compensation, cash flows tell the real story. Since becoming a public company, ORA has burned over $1 billion dollars in free cash flow, yet paid out nearly $350 million in dividends to common stock holders and minority partners net of receipts of dividends on its own minority investments.  Net debt issuance and equity issuance of ~$600 million each, plus net divestitures of subsidiaries and minority stakes of ~$235 million, have plugged the $1.4 billion deficit over the past 15 years. While net leverage of ~3x appears reasonable on an EBITDA basis, the free cash flow profile and risks to the Kenya PPA mean that anything higher would probably be irresponsible.  Management has attempted to diversify the business, but the capital allocation decisions appear value destructive so far. After acquiring a venture-backed grid management business in 2017 and allocating 99% of the purchase price to intangibles and goodwill, the entire goodwill balance was written off less than two years later. ORA trades ~$11 million per day, short interest is only 1%, and borrow is general collateral. 

Contents

Executive Summary

Company Overview

Excess International Profits Are at Risk

Management History Raises Potential Red Flags

The Domestic (and Overall) Business has Mediocre Economics at Best

Efforts to Diversify Distract from Issues and are Likely Value Destructive

The Bull Case Comes Up Short

Valuation is Rich Across All Metrics

Conclusion – We Expect Shares to Run Out of Steam

Appendix

Disclosures

Executive Summary

Excess International Profits Are at Risk.  ORA’s international Electricity business contributes approximately half of consolidated EBITDA despite being less than 30% of revenue, and Kenya is a disproportionate contributor within international Electricity.  In Kenya, the Company has what appears to be a significantly above market power contract with the local monopoly and government-controlled utility Kenya Power and Lighting Company Limited (“KPLC”).  ORA earns far higher pricing selling to KPLC versus the much larger local champion, Kenya Electricity Generating Company plc (“KenGen” or “KEGN”). Using KenGen’s rates as a proxy, ORA’s existing agreement allowed the Company to extract as much as ~$310-$360 million, or ~120%-170%, in excess pre-tax profits during KPLC’s fiscal years 2012-2018 (the total could be as much as ~$400 million going back to 2004).  Lately, something in Kenya has changed. As of ORA’s September 30, 2019 10-Q the Company had an overdue balance from KPLC of $41 million, equal to 34% of LTM KPLC revenue and up meaningfully vs. the prior two quarters.  The Kenya Revenue Authority also notified the Company in July 2019 that it is seeking $77 million in payments related to taxes for 2013 to 2017.  While management points to the visibility of long-term contracts, especially those with payments tilted towards capacity fees like Kenya, a reset of ORA’s current KPLC rates to be comparable to KenGen’s rates could trigger a 40% hit to earnings per share.  Today KPLC and KenGen are effectively subsidizing ORA; and the current fact pattern suggests that the Kenyan government is tired of the arrangement, or its local state-owned enterprises are simply unable to pay the bills on time. Either explanation is a negative for ORA.

Management History Raises Potential Red Flags.  CEO Isaac Angel’s last managerial role at a public company prior to joining ORA in 2014 was at VeriFone in 2008, a six-year gap.  In 2008, VeriFone was in the midst of an accounting scandal in the wake of its November 2006 acquisition of Lipman Electronic Engineering.  Angel had been President and CEO of Lipman prior to the deal and became Vice President, Global Operations at VeriFone after the transaction closed.  The class action highlighted Lipman as a central part of VeriFone’s financial misstatements, including improper treatments of its in-transit inventory and overhead expenses improperly booked in Lipman subsidiaries’ inventory accounts.  Angel resigned in January 2008, a month after revelations of the accounting issues and a few months before VeriFone’s CFO resigned. Ultimately, VeriFone announced a final approval of a $95 million settlement in early 2014.  Angel took the job at ORA several months later. 

Before joining ORA in 2013, CFO Doron Blachar was the CFO of Israeli construction company Shikun & Binui (“S&B”) from 2009 to 2013.  In 2017, a former employee of a Kenyan subsidiary of S&B filed a suit against the Israeli parent that raised allegations related to bribery of foreign officials.  In May 2019, the Israeli police issued a notice regarding its investigation, which was carried out in conjunction with the Israeli Securities Authority.  The release said that sufficient evidence existed to support suspicions against S&B subsidiaries and executives, including “bribing of a foreign public official, obtaining by deception, false reporting in a corporation’s documents, disruption of the judicial process, money laundering, income tax violations, VAT violations and misreporting for the purpose of misleading a reasonable investor.”  The focus is “activity conducted in Africa and particularly Kenya in the years 2008-2016.” The entirety of Blachar’s time as CFO of S&B falls within the timeframe identified by the authorities as being at issue. The whistle blower reports being told to look the other way on bribes (among other things) and that behavior of this sort was normal in East Africa.  In fact, he claims to have been told that the practice reached all the way to S&B’s management and was “backed by the company’s internal auditor, board audit committee, the company’s legal department and even reaching Ofer Kotler [the former S&B CEO].”  S&B deposited NIS 250 million – more than $70 million and ~9% of company cash and equivalents and bank deposits at December 31, 2017 – with the Israeli police in February 2018 as an “interim arrangement.”

Management’s historical proximity to accounting issues in international markets, as well as bribery and other serious charges in Kenya, do not inspire confidence that ORA will be transparent if issues exist today or arise in the future (whether in Kenya or another frontier market).  As discussed in the section on excess profits, management’s responses to questions about Kenya do not sufficiently address serious concerns about a key source of profits.

The Domestic (and Overall) Business has Mediocre Economics at Best.  The U.S. business (and ex-Kenya business generally) is not particularly attractive.  Since management has begun disclosing – or was forced to disclose – the mix of the Electricity segment between international and domestic, investors can make more informed calculations specific to each region.  U.S. Electricity segment returns on assets appear to be ~4% vs. a blended cost of debt for recourse corporate borrowings and U.S. project-level borrowings of ~4.6% as of September 30, 2019 (and clearly a weighted-average cost of capital in excess of this cost of debt).  The new regional mix disclosures also facilitate better estimates for domestic cash costs. These cash costs, combined with analyses on capex and recent PPA unit pricing, provide inputs for ORA-specific unit economic models. Without detailing all of the assumptions here, the calculations suggest unattractive low-single-digit unlevered returns, without assigning any probability for unplanned decline curves or poor well performance.  ORA itself has faced such issues at its North Brawley plant, which increased capital spending and ongoing operating expenses, prevented the complex from reaching its design capacity, and ultimately resulted in a write-off of $229 million in 2012. 

The low returns likely explain ORA’s significant consumption of capital on a consolidated basis since the Company’s initial public offering, despite the lucrative contract in Kenya contributing to cash flow.  From 2005, ORA’s first full year as a public company, through September 30, 2019, ORA has burned over $1 billion dollars in free cash flow (including an inflow of ~$270 million from cash grants found in the investing section of the cash flow statement), yet paid out nearly $350 million in dividends to common stock holders and minority partners net of receipts of dividends on its own minority investments.  Net debt issuance and equity issuance of ~$600 million each, plus net divestitures of subsidiaries and minority stakes of ~$235 million, have plugged the $1.4 billion deficit over the past 15 years. Consistent deviations between GAAP and non-GAAP EBITDA; an unresolved material weakness dating back to 2017 that resulted in a restatement of 2017 and 2016 reported EPS; the inclusion of investees in adjusted EBITDA, which optically raises margins; and the poor cash flow profile suggest that true economic earnings quality is low relative management’s preferred measure of adjusted EBITDA.

Efforts to Diversify Earnings Distract from Issues and Are Likely Value Destructive.  In March 2017, ORA closed the acquisition of Viridity Energy for initial consideration of $35 million and contingent consideration of $12 million.  The entire purchase price was allocated to intangibles and goodwill. In the fourth quarter of 2018, less than two years after the close of the deal, the Company wrote off all goodwill associated with the transaction.  Viridity’s vision as a venture-backed business was to aggregate and manage distributed energy virtually.  Under ORA ownership, that business continues; but the Other segment that houses Viridity is increasingly financing and developing utility scale battery energy storage systems, another capital-intense and competitive business.  The Company has also ventured outside of its core competency by adding solar to its portfolio mix – ORA recently began construction of its first geothermal and solar hybrid project in Tungsten. Overall, these non-core investments are relatively small, but are indicative of questionable capital allocation decisions. 

The Bull Case Comes Up Short.  The bull thesis includes 1) an opportunity to grow capacity, especially in California as the state plans to increase geothermal’s share of generation; 2) ORA’s increasing Electricity contribution to profits, which are viewed as more stable than the volatile Product segment’s earnings; 3) the stable, high margins of Electricity translating into a premium multiple; 4) a way to play ESG trends; and 5) call options on other businesses like battery storage, virtual grid management services, and the addition of solar to its portfolio.  The risks in Kenya, mediocre economics of the core geothermal business, poor cash generation, write-offs at Viridity, and competitive and capital-intensive dynamics of the adjacent businesses provide plenty of evidence to undermine the bull case.

Valuation is Rich Across All Metrics.  A reset of the Kenya contract could result in a 40% hit to earnings.  ORA trades at 42x NTM consensus EPS, a wide premium to the S&P 500 at 19.5x, despite increasing risks related to an important source of earnings and returns on capital and equity below the S&P 500.  A re-rating to ORA’s 10-year average multiple premium vs. the S&P (still a generous 80% spread) would contribute mid-teens additional downside. Replacement costs do not support the share price at current levels either.  We think that shares have 40% downside.

Company Overview

Exhibit 1: ORA Trading Overview

Source: ORA public filings, CapitalIQ.

Note: EBITDA and debt includes the proportionate share related to ORA’s 12.75% interest in the Sarulla project.

The Company’s history is convoluted and dates back to 1965, when Ormat Turbines Ltd. was founded by the Bronicki family in Yavne, Israel.  Ormat Turbines Ltd. was the predecessor of Ormat Technologies’ former parent company, Ormat Industries (the “Parent” or “ORMT”). As the name suggests, the Parent was originally known for turbine designs and was exclusively a manufacturer of power generation equipment.  In the 1970s the Parent expanded into remote power solutions for projects like the Trans-Alaska Pipeline project. However, the Parent increasingly focused its renewable efforts on geothermal in the 1980s and 1990s.[1] [2]  In 1991, the Parent listed its U.S. geothermal subsidiary, OESI Power Corp. (“OESI”) on the American Stock Exchange in an IPO that priced at $14 per share and raised over $30 million.  The Parent, listed on the Tel Aviv stock exchange under the ticker ORMT that same year. Shortly after its IPO, OESI ran into problems with delays at its Puna plant on the Big Island in Hawaii; and in 1993 GE Capital, a minority partner and lender on a project in Nevada, withdrew financing.  Ultimately, the first listing of Ormat Industries’ geothermal assets, OESI, ended with the Parent buying out the last remaining minority holders at $0.12 in December 1994.[3] 

Ormat Technologies’ IPO prospectus disclosed that the Company was formed in 1994 to invest in and hold interests in power projects, as well as develop and operate both owned and third-party plants.  The Company appears to have been born in a restructuring of the OESI assets (for example, ORA controls Puna today). The Company completed its IPO in 2004 on the New York Stock Exchange and began trading under the ticker ORA.  In the months leading up to the IPO, the Company continued its U.S. expansion with the acquisition of a number of power assets that are still part of the portfolio today. It also acquired the equipment and services business from the Parent.  The public listing reduced Ormat Industries’ ownership stake in Ormat Technologies to approximately 80%. The Bronicki’s began to lose control of the Parent over the ensuing years. In 2007, the family took on debt to buy Parent shares in an attempt to secure control when another Israeli firm disclosed a 12% ownership interest.  As the stock collapsed in the crisis, the Bronicki’s had to pledge their shares to Bank Hapoalim in January 2009 to ensure repayment of their loan, which was due in December 2011. The maturity of the loan coincided with other issues – the Bronicki’s learned the hard way that geothermal power plants are price takers in a falling natural gas price environment if not properly hedged, and the Israeli shekel appreciated vs. the dollar increasing the cost of their loan.[4]  Finally, in 2015, Ormat Technologies and Ormat Industries undertook a share exchange to eliminate the Parent, which left Ormat Technologies as the only publicly traded company in the group.[5]  Today ORA operates in three segments: Electricity, Product, and Other. 

Electricity.  In the Electricity segment the Company develops, builds, owns, and operates geothermal and recovered energy power plants.  ORA has a 900+ megawatt portfolio across 25 geothermal and recovered energy power plant sites on a consolidated basis and including the Company’s ~13% stake in the Sarulla project in Indonesia.  Expansion plans call for another 120-135 MW of organic capacity additions by 2021 based on existing prospects and plans. Electricity has been 60% of revenue and 65% of cumulative segment profits since 2005.  In 2018, with Product segment profits down 50%, Electricity contributed 84% of segment profits. Domestically, customers are usually private electric utilities or public cooperatives, including public utilities.  Internationally, customers are usually state-owned utilities or private entities; and the Company usually operates in these markets under rights granted by a government agency pursuant to a concession. In either case, high up front capital costs require the Company to enter into long-term contracts (PPAs) for the sale of electricity.  The agreements consist of energy payments and capacity payments, but ORA has said for multiple years now that new PPAs generally provide for energy payments only and often require compensation to customers for supply shortfalls. Investors expect high initial capital costs to be offset by the benefits of contract visibility and low operations and maintenance expenses.  Management’s measure of adjusted EBITDA margins for the segment was nearly 70% for the twelve months through September 30, 2019.

Product.  In the Product Segment the Company designs, manufactures, and sells products used in electricity generation and related services.  Products include power units for geothermal plants, power units for recovered energy-based power generation, and remote power units and other generators.  Geothermal power unit customers include contractors and plant developers, owners, and operators. Customers for the recovered energy units include natural gas pipeline owners and operators, gas processing plant owners and operators, cement plant owners and operators, and other companies with energy-intensive industrial processes.  The Company also acts as an EPC contractor for geothermal and recovered energy plants using its own power units. ORA says that being vertically integrated translates into higher quality, more control over timing and delivery, and better cost containment for customers. The Product segment has been 40% of revenue and 35% of cumulative segment profits since 2005.  The business is volatile – in 2018 segment profits were down 50% from 2016 and contributed 21% of segment profits. Management adjusted EBITDA margins for the segment were 20% for the twelve months through September 30, 2019.

Other.  The Other (or New Activity) Segment is almost entirely comprised of Viridity Energy, which ORA acquired for initial consideration of $35 million and contingent consideration of $12 million in March 2017.  The entire purchase price was allocated to intangibles and goodwill; and all of the goodwill was written off in the fourth quarter of 2018, less than two years after the close of the deal. Viridity’s vision as a venture-backed business was to aggregate and manage distributed energy virtually.  Under ORA ownership, the business continues to do that; but the subsidiary is increasingly focused on financing and developing utility scale battery energy storage systems. The Viridity acquisition appears to be an effort to diversify ORA’s legacy business. Other segment revenue was less than 2% of ORA’s consolidated total in the twelve months through September 30, 2019, and adjusted EBITDA was a loss of $4 million. 

Excess International Profits Are at Risk

Summary: ORA has Meaningfully Over-earned in Kenya, and its Key Partner is Increasingly Late Paying the Bills

KPLC is one of ORA’s most important customers – it is the sole partner in Kenya and is responsible for 16% of ORA’s consolidated trailing twelve month revenue, 23% of Electricity segment revenue, 59% of international electricity revenue, and a “disproportionate” amount of income.  Concerns with late payments from KPLC were first disclosed in the 2017 10-K without any specifics provided, but over the last three quarters ORA has revealed a growing overdue receivable balance from its Kenyan partner.  The overdue amount from KPLC at the end of Q3 2019 stood at $41 million, up from $29 million as of the end of Q1.  The $41 million total represents 34% of trailing twelve month revenue in Kenya and 10% of consolidated Company adjusted EBITDA.  Despite the fact that payment issues arose at least two years ago, ORA claims that it “has historically been able to collect on substantially all of its receivable balances” and “believes it will be able to collect all past due amounts.”  KPLC’s largest supplier is 70%-government-owned KenGen, the largest power producer in Kenya. Based on KPLC, KenGen, and ORA disclosures, ORA likely earned ~120%-170%, or ~$310-$360 million, in excess pre-tax profits under its existing PPA during KPLC’s fiscal years 2012-2018 relative to what the Company would have earned at rates paid by KPLC to KenGen for similar geothermal capacity/generation.  While management claims that the Company will be paid and “it’s okay,” the rising overdue balance, scale of over-earning vs. similar local government assets over an extended timeframe, ambiguous responses to questions about the issue on earnings calls, and new demands from Kenyan tax authorities suggest that the situation is deteriorating. A reset of the contract to market rates could result in a 40% hit to ORA’s net income.

Creeping, Incremental Disclosures Paint a Concerning Picture

The Company has been slowly adding piecemeal disclosures regarding its international operations, particularly as it relates to Kenya and KPLC (effectively one in the same given the Kenyan government’s controlling interest in KPLC).  First, in the 2017 10-K in the section on concentration of credit risk, ORA began flagging issues regarding the receipt of late payments from KPLC without any specifics:

We have historically been able to collect on substantially all of our receivable balances. Recently, we have been receiving late payments from KPLC in Kenya related to our Olkaria Complex and from ENNE in Honduras related to our Platanares power plant. As we believe we will be able to collect all past due amounts, no provision for doubtful accounts has been recorded. (2017 10-K, p. 137)

ORA has been saying that its overdue balances in Kenya will be collected since 2017!  In ORA’s 2018 10-K, the Company added new disclosure about the Electricity segment’s business mix, including the outsized profit contribution from the international business, which is driven to a large extent by Kenya:

In 2018, the international operations of the Electricity segment accounted for 28% of our revenues, but accounted for 53% of our gross profit, 77% of our net income and 53% of our EBITDA. A substantial portion of Electricity segment international revenues came from Kenya (which also contributed disproportionately to our gross profit and net income) and, to a lesser extent, from Guadeloupe, Guatemala and Honduras.  (2018 10-K, p. 79)

In the Q1 2019 10-Q, international Electricity business contribution disclosures continued; and ORA began disclosing amounts of overdue receivables from KPLC and ENNE (a Honduran partner):

Consequently, in 2019 the international operations of the segment accounted for 46% of our total gross profits, 44% of our net income and 44% of our EBITDA. (2019 Q1 10-Q, p. 31)

….

As of March 31, 2019, the amounts overdue are $29.4 million and $18.0 million related to KPLC and ENNE, respectively, of which $20.4 and $3.0 million, respectively, were paid during April 2019. As we believe we will be able to collect all past due amounts, no provision for doubtful accounts has been recorded. (2019 Q1 10-Q, p. 44)

ORA has continued to include the note on international contribution (though on a year-to-date basis) in the 10-Qs and has updated the outstanding overdue balances as well.  These disclosures are summarized in Exhibits 2 and 3 below. The percentage contribution disclosures for the international Electricity business appear to be using the consolidated financial metrics as the denominator.  To estimate international Electricity margins, one adjustment has to be made. Management’s EBITDA and adjusted EBITDA include equity income and an adjustment for its proportionate share of interest, tax, and depreciation and amortization in unconsolidated investments (more on this treatment in the valuation section).  This inclusion boosts margins, because the revenue from these investments is not consolidated (i.e, EBITDA rises without any addition to revenue). Even adjusting for these investments, the international portion of the Electricity business earns ~80%-87% EBITDA margins, ~1,700-3,300 basis points higher profitability than the ~54%-63% EBITDA margins earned in the domestic Electricity business.  Disclosures suggest that Kenya contributes disproportionately within international Electricity, and therefore most likely has even higher EBITDA margins than ~80%-87%. 

Exhibit 2: International vs. Domestic Electricity Segment Contribution

Source: ORA public filings.

Management calls out KPLC payments made after the end of the quarter in the 10-Q and reaffirms on calls that the Company is collecting payments; but even net of the payments received post the end of the quarter the overdue balance is growing.  In fact, net of post-quarter-end receipts disclosed by ORA, the outstanding balance is growing faster than before the receipts.

Exhibit 3: Overdue Amounts from KPLC

Source: ORA public filings.

Note: See Appendix for a similar analysis of ENNE in Honduras.  This section focuses on Kenya, but Honduras is concerning for similar reasons.

To summarize, the international operations of the Electricity segment earn outsized margins, 80%+ EBITDA margins vs. ~60% in the domestic business.  These assets contributed disproportionately to earnings at 53% of total Company EBITDA and 77% of total company net income in 2018 despite being the minority of capacity and only 28% of revenue.  A similar mix continued to exist in the first nine months of 2019. KPLC is nearly 60% of international Electricity revenue and contributes disproportionately to the profits of the international operations of the Electricity segment, although the extent of KPLC’s contribution to profits is not disclosed by ORA.  KPLC now has an overdue balance as of the latest quarter end of $41 million, equal to 34% of LTM Kenya revenue of $122 million, 20% of LTM international Electricity revenue of $209 million and 10% of LTM consolidated adjusted EBITDA of $395 million. The Company has been aware of these late payments for at least two years, but has not provisioned against the growing balance, which may only be the tip of the iceberg.

What do we know about KPLC, KenGen, and Power Purchase Economics in Kenya?

KPLC and KenGen are listed on the Nairobi Securities Exchange.

Exhibit 4: KPLC and KEGN Capitalizations

Source: KPLC and KEGN public filings, CapitalIQ.

Note: Balance sheets are as of 6/30/18 vs. EBITDA estimates for 6/30/19 for which actuals have not yet been published.

KPLC received a highly qualified opinion from PricewaterhouseCoopers in 2018 and was in technical breach of a covenant as of its last annual report.  KPLC’s cash balances net of overdrafts were shown to be negative at the time of the publication of its last annual report and as of a brief trading update for the fiscal half ended December 31, 2018.  Neither KPLC nor KenGen has released results for fiscal 2019, which ended eight and a half months ago.  Both companies issued a press release saying that the delay is due to the process of appointing a new Auditor General, which seems like a Kenyan bureaucratic hold up rather than a misstep by either company.

Exhibit 5: KPLC’s Last Annual Report Shows a Negative Cash Balance after Overdrafts

Source: KPLC 2018 Annual Report.

KPLC is a national utility operator that is 50.1% owned by the Government of Kenya.  In its fiscal year ended June 30, 2018, the utility bought 75% of its power units as measured in GWh from 69.99% government-owned KenGen.  The two Kenyan companies previously existed under the same corporate umbrella.  ORA notes in its 10-K that KPLC “is the major licensed public electricity supplier and has a virtual monopoly in the distribution of electricity in the country.”  KenGen had 504 MW of effective geothermal capacity in Kenya and 1,522 MW of total effective installed capacity across all generation types as of its last annual report.  Its geothermal portfolio includes the Olkaria I, I AU, II, IV, and V complexes, adjacent to ORA’s Kenyan Olkaria III complex in the Rift Valley (i.e., KenGen’s geothermal assets are in direct competition with ORA’s in the same region).  KenGen’s Olkaria V became operational in late 2019, adding 165 MW of additional geothermal capacity.[6] 

KPLC and KenGen disclosures are better than investors may expect for frontier market companies.  KPLC discloses aggregate non-fuel power purchase costs and gigawatt-hours purchased by supplier (Exhibit 6 below). 

Exhibit 6: KPLC Aggregate Power Purchase Costs and GWh Purchased by Supplier

Source: KPLC 2018 Annual Report.

The power purchase costs reported by KPLC for “OrPower 4 Inc,” ORA’s local subsidiary, line up with ORA’s reported revenue from KPLC for KPLC’s fiscal years 2012-2018.  Comparing OrPower4’s rate per MWh to KenGen’s shows that ORA earned $399 million more in revenue from 2004 to 2018 and $309 million more from 2012 to 2018, or 126% and 118% more, respectively, than the Company would have generated at KenGen’s rates (Exhibit 7 below).

Exhibit 7: Benchmarking ORA’s Kenya Revenue vs. KPLC Disclosures

Source: Company filings, CapitalIQ.

As shown above, KPLC publishes aggregates for power purchases and GWh.  The aggregate published by KPLC for ORA is the totality of ORA’s operations in Kenya – KPLC’s power purchase costs match ORA’s disclosures of Kenya revenue.  However, KenGen’s power production comes from a diversity of sources. Geothermal was ~50% of generation and power unit sales in 2018. Therefore, if KenGen sells from other lower cost sources, then those sales could influence the blended rates implied by the KPLC disclosures.  Luckily KenGen provides enough disclosure to isolate its geothermal revenue metrics, which provide the same conclusion as the one drawn from the KPLC disclosures (Exhibits 8-10 below).

Exhibit 8: KenGen Installed Capacity and Units Generated and Sold

Source: KEGN 2018 Annual Report.

Exhibit 9: KenGen Revenue Mix 

Source: KEGN 2018 Annual Report.

Exhibit 10: Benchmarking ORA’s Kenya Revenue vs. KenGen Disclosures

Source: KPLC and KEGN public filings, CapitalIQ.

Note: KenGen sells steam from third-party wells that it manages, most of which is a pass-through with 70% billed as costs.  KenGen steam revenue is included in the calculations, while third-party steam revenue is excluded. Even including, third-party steam, ORA over-earns relative to KenGen by a wide margin.

Based on the additional KenGen disclosures, ORA potentially earned $312-$361 million, or 121%-172%, in excess profits when benchmarked at the rates KenGen received from KPLC.  The key takeaway from the large discrepancy in the rates is that KPLC and KenGen, and the Kenyan government by virtue of its controlling ownership interest in both entities, are subsidizing excessive profits at ORA’s Olkaria III plant.

Kenya is Applying Pressure through the Kenya Revenue Authority as Well

The Kenya Revenue Authority has hounded ORA before – it previously conducted an audit on the Company’s Kenyan operations for the 2012 and 2013 fiscal years.  This audit resulted in a small settlement of $2.6 million.  In the fourth quarter of 2018, the KRA notified ORA of its intention to conduct an audit focused on related party transactions for the years 2014-2017.  In ORA’s Q2 2019 10-Q, the Company revealed that the KRA is demanding new payments of tens of millions of dollars:

On July 30, 2019, the Company received a Letter of Preliminary Findings from the Kenya Revenue Authority (“KRA”) relating to tax years 2013-2017 that were previously audited by the KRA. The letter sets forth a demand for approximately $77 million before any possible interest and penalties. Based on a preliminary review of the KRA letter, the company and its advisors believe it has strong arguments against the preliminary findings raised in the KRA letter. (2019 Q2 10-Q, p. 27)

The delayed payments from government-controlled customer KPLC, which also buys power from ORA competitor and government-controlled KenGen, are cause for concern independent of any other factors.  However, these late payments, combined with the new KRA efforts to collect millions of dollars in additional taxes for prior periods, provide a growing body of evidence that something is not right in Kenya.  The logical conclusion is that ORA’s excess rents in Kenya carry a much greater degree of risk than at any time in the past. Even if ORA is contractually owed the money for capacity and generation at Olkaria III, Kenya may be unwilling or unable to pay.  An emerging market making it impossible for a foreign operator to collects its fees is not unheard of.  

Management Responses to Questions on Kenya Seem Ambiguous at Best and Intentionally Misleading at Worst

The Q3 2019 call had the most revealing commentary about the concerns identified in this report regarding Kenya.  When asked about opportunities for engineering, procurement, and construction on a new 20-year KPLC / KenGen PPA, management shifted the conversation to other markets (emphasis added):

            Noah Duke Kaye Oppenheimer & Co.

Yes. You mentioned a number of geographies for growth opportunity in products. In addition to the ones you mentioned, I'd like to ask for Kenya KenGen, just published in our queue for an EPC contract for 140-megawatt project at Olkaria with a 20-year PPA with KPLC. I would assume it could be a significant EPC opportunity for your products pipeline, can you comment on this development in your appetite to do EPC work in Kenya?

Isaac Angel ORA CEO

Noah, alas we know each other for long time, you know that it is the [doublet] for us, which means that, in one hand, we are increasing the electricity revenue and then profitability not at the same rate, we are improving our product revenue and profit. But fortunately on upwards, let me there review the opportunity that you mentioned in Kenya, New Zealand, Philippines, and also in other countries. So I'm expecting that the product revenues in the upcoming year will be at least at the rate that they were before. And as you mentioned, the opportunities are numerous and we shouldn't also forget the Turkish market, which is beyond that 1 gigawatt and their expectation is to increase. If we double it, the problem over there are, I like to believe, only temporary and eventually, also the open economy will somehow rewind. So and the financial capabilities of the local invested will be in place.

The questions on EPC opportunities in Kenya went unanswered – should investors assume that the non-response and diversion to a discussion of other markets means that the Company can’t capitalize on Kenyan opportunities?  Why has ORA not developed or owned additional assets in Kenya after Olkaria III, even as KenGen’s projects imply strong demand for geothermal equipment and construction? Historically, 100% of ORA’s Kenya revenue has been tied to KPLC power and capacity payments from Olkaria III, which suggests that sufficient competition exists to provide equipment and EPC services and the Kenyan government doesn’t intend to allow ORA to expand in the country.  The Oppenheimer analyst followed up with questions regarding “curtailments” mentioned in ORA’s 10-Q and the late payments issues (emphasis added):

            Noah Duke Kaye Oppenheimer & Co.

Okay. That's helpful. I guess as a follow-up, you mentioned there was a curtailment at Olkaria. Can just explain what drove that? And then I get as a related, in the past quarters, you've disclosed receivables outstanding from some customers and international customers, so the receivables balance went up again sequentially. Can you just give us some color on, was that a continued headwind this quarter, can you help us make sense of this trend?

Isaac Angel ORA CEO

Okay. First we had a 150-megawatt facility operating in Kenya, which was gradually built in the last 10 years. The PPA calls for asset -- the energy; there is a trend in the last few months that we are beginning to tell on the energy part, especially as night. We understand that this is due to the fact that they are still missing transmission lines and which would be being built and when it gets to be operational, we expect that this curtailment will be finished. In any case, as I mentioned before, as the PPAs both for capacity and energy, with the larger part being capacity, at the end of the day it is a more, let's say, problem with the revenues. But it's not something severe and I believe it's only temporary. On the second part of your question, we mentioned that there are -- I don't recall that we talked about the payment issues. At the end of the day, we are operating in the (inaudible) and we are -- even if we are not exactly due on all payments, we don't have a payment issue over there, so far. And now I'd like to add, as you continue to the big part of the PPA capacity focus of (inaudible) obviously only the energy part, and not the capacity…

Operator

The next question comes from Jeff Osborne of Cowen and Company.

Jeffrey David Osborne Cowen and Company

Maybe just following up on Noah's question. I think it was the 10-Q that actually flagged that there were some late payments from Kenya and Honduras. Can you just talk about those? I believe the outstanding balance was given for both those countries as of August, when it was last published. I'm just asking, are things getting better or worse in those 2 countries?

Isaac Angel ORA CEO

Let me relate first again on Kenya. I don't recall the exact due today, but in Kenya we are being paid even if it's late, it's okay. And they are covered, as Doron in telling me now, and on Honduras, we had a serious issue until 2019 because, I don't know if you know, that there is a very large in Honduras that they are putting together today, not only to us, but to others. But since April, we are being paid current, and we expect all the payment that is, I don't know if we have the number on the 10-Q, but it's a significant number that we're expecting to be based through financing (inaudible).

Regarding curtailments, wouldn’t yet-to-be-built transmission lines explain a lack of growth in demand rather than a decline in demand?  Could the explanation instead be that KPLC is substituting ORA power with generation from KenGen’s 165 MW of new incremental capacity that is now live at Olkaria V?  Angel is quick to hedge by saying that capacity charges comprise a larger portion of revenue, but the ultimate impact on ORA remains unclear. The responses addressing the receivables were even more problematic.  In a surprising response to the Oppenheimer analyst’s question on late payments, Angel said “we don’t have a payment issue, so far,” which is in direct contradiction to the overdue receivables and is qualified by the subtle “so far.”  Does “so far” imply investors should expect issues in the future (not that payments are already past due or anything)? Good for the Cowen and Company analyst who was next in the queue for not letting that response fly. When the Cowen analyst pressed, Angel replied that the Company is being paid; but as shown above in Exhibit 3 above, even net of the post-quarter-end payments, the receivables balance is growing at a concerning rate.  When Angel follows up by saying “they are covered,” does he mean to imply that the Company received payments of at least $30 million and $20 million to cover the last net outstanding amounts disclosed for Kenya and Honduras? The quarterly call was held on November 7, 2019, the same day that the company filed its press release and 10-Q, which made no mention of any further payments received in November to date. This timeline of events would seemingly point to the conclusion that the payments were not “covered” at the time of the discussion on the earnings call.  Did Angel mislead listeners?

At the end of the day, why would the Company make new disclosures regarding international contributions and overdue amounts in the 10-Ks and 10-Qs unless those issues needed to be flagged?  The late “payments” are by definition a “payment issue.” If the situation in Kenya and Honduras was being resolved or improving, investors would expect management to directly address the question “are things getting better or worse in those 2 countries?” by saying something along the lines of “we have resolved the previously identified payment issues by collecting the outstanding amounts in full,” or “these balances are now shrinking, showing an improving trend for collections in these markets.”  Instead the Company said that it is being paid, which may be true but does not appear to be the complete truth (if ORA wasn’t being paid at all…that would be even more concerning). No matter how investors measure the past due balances based on currently available disclosures by ORA – either before or after payments received post the latest quarter-end – the trajectory is up.

Putting it All Together

ORA has generated outsized revenues over an extended period of time at its Olkaria III complex, and Kenya has every incentive to try to renegotiate by any means necessary.  Hypothetically, an orchestrated KPLC bankruptcy would be a smart move for the Kenyans if KPLC could then renegotiate its PPA with ORA as a result. KPLC’s market capitalization is only marginally bigger than the overdue payments owed to ORA.  Also, the government owns 70% of KenGen vs. 50% of KPLC, so making KPLC “overpay” KenGen to weaken KPLC’s financial position wouldn’t be the craziest idea from the Kenyans’ perspective. Alternatively, KPLC could delay payments to ORA until ORA pays the KRA the $77 million in taxes being sought. Even if the Kenyans don’t want to take such a rout, the recent commencement of operations at KenGen’s new Olkaria plant might be the perfect catalyst to force the issue.  At year-end 2018 Kenya had installed generation capacity of over 2,700 MW, which has increased further with large additions like the 165 MW Olkaria V complex in 2019.[7]  ORA’s Olkaria III complex declined from 35% of KenGen’s installed geothermal capacity in 2011 to less than 20% after KenGen’s Olkaria V went live in the second half of 2019 (ORA is less than 10% of KenGen’s total capacity).  Kenya has peak demand of ~1,800 MW and recently lowered targets for power output based on weak demand despite large recent additions to production.[8]  The grid can likely handle its load without Olkaria III, leaving ORA with little leverage. 

The questions investors should begin asking now are:

• How strong are ORA’s contracts? 

• Even if the contracts are ironclad, what is the probability that Kenya allows the current situation to persist for the next 10+ years (especially after KenGen has more than quadrupled its geothermal capacity since 2013)?

• Does the company have sufficient protection or recourse if Kenya decides to walk?

• Even if ORA has strong legal standing and a good insurance policy, will the Company incur meaningful legal costs, have to pay fines or fees, or be unable to recover lost amounts or overdue balances?

• Finally, will ORA have to accept a much lower, market-priced contract going forward; and what will that agreement look like if and when implemented? 

The Company wants investors to believe that the large capacity component of its Kenya revenues translate into great visibility, but the significant overearning appears highly unlikely to prevail.  Investors will likely begin to haircut estimates for Kenya, make estimates for additional costs, apply lower multiples to international assets, or do all of the above. A reduction in the pricing of the Kenya contract would flow through directly to the bottom line and could be as much as a 40% hit to net income.  Despite the elevated risks, ORA shares trade at all-time highs.

Exhibit 11: Earnings could Drop by 40% on a Reset of the KPLC PPA to KenGen’s Economics

Source: KPLC, KenGen, and ORA public filings.  Internal estimates.

1. Uses ORA Kenya revenue for twelve months ended June 30, 2018 to be consistent with KPLC filings, but LTM Kenya revenue is now $122 million.

2. Based on KPLC annual report for the fiscal year ended June 30, 2018.

3. Based on KPLC and KenGen disclosures.

4. International EBITDA margins are ~80%-87%; Kenya’s contribution to international profits is “disproportionate”.

5. A rate reset is a re-pricing; therefore, the effect would flow through at 100% at the EBITDA level.

Management History Raises Potential Red Flags

Both Isaac Angel, ORA’s CEO, and Doron Blachar, the Company’s CFO, have resumes that raise potential red flags.  Angel’s last executive / managerial role at a public company was at VeriFone, which was accused of financial misstatements immediately following the acquisition of Lipman Electronics Engineering, where Angel was President and CEO.  Blachar’s last executive position was as CFO at Shikun & Binui, which is under investigation for a litany of accusations related to business practices and accounting in Kenya during years that fully encompass his employment by the Israeli construction company.  These prior associations are not a smoking gun of any wrongdoing at ORA. However, management’s historical proximity to accounting issues in international markets, as well as bribery and other serious charges in Kenya, do not inspire confidence that ORA will be transparent if issues exist today or arise in the future.  As discussed in the preceding section on excess profits, management’s responses to questions about Kenya seem ambiguous at best. 

Isaac Angel, Chief Executive Officer

Prior to joining ORA in 2014, Angel had not held an executive role at a public company since he had resigned from VeriFone in early 2008 amid an accounting probe.[9]  VeriFone’s CFO Barry Zwarenstein was forced to resign a few months later.[10]  The allegations led to a drawn out legal case and eventually to a $95 million settlement for investors in early 2014.[11]  Angel’s LinkedIn profile says that from 2008 to 2014 he was a Managing Director of Five Angels Ltd., which appears to be some sort of personal vehicle (although we’re not entirely certain).  Did the open VeriFone case prevent him from having another executive role in the intervening six years? Angel’s LinkedIn page conveniently omits VeriFone but includes “Lipman Ltd,” which is ironic because the issues at VeriFone appear to have largely stemmed from the 2007 acquisition of Lipman, where Angel was then President and CEO. 

VeriFone announced the acquisition of Lipman at a value of $793 million on April 10, 2006; and the deal closed on November 1 of the same year, which was the first day of VeriFone’s fiscal year.  As mentioned above, Isaac Angel was Lipman’s President and CEO at the time of the transaction.  He became Vice President, Global Operations at VeriFone after the sale. Shares of VeriFone fell after the M&A announcement.  One possible explanation is that management had trained the Street to focus on its gross margins, which were normally lower in international markets where Lipman generated the bulk of its revenue.  However, in the time leading up to and immediately after the acquisition, VeriFone management (particularly CFO Zwarenstein and CEO Douglas Bergeron) guided to expanding gross margins and appeared to deliver on its promise, often giving credit to Lipman and the smooth integration[12]:

I have tell you that with Lipman’s manufacturing in-house and with this hybrid model that we are very cleverly putting together and getting the best of both worlds, there is going to be gross margin expansion in our future.

….

The integration of Lipman into VeriFone has been completed ahead of schedule and we have created a single-branded, unified company with tremendous scale advantages. Already, we are enjoying several supply chain efficiencies and earnings accretion.... As a result, we have increased our internal expectations for fiscal Q12007 net earnings per share....

Bergeron even went as far as to say that VeriFone was “getting supply chain efficiencies in Israel that we never experienced before.”  Israel was Lipman’s home base. On December 3, 2007, barely a year after the close of the acquisition, VeriFone announced a massive restatement that sent shares plummeting 45%.  VeriFone had recorded inter-company in-transit inventory that did not exist, double-booked manufacturing and distribution overhead costs in inventories at former Lipman subsidiaries, and failed to eliminate intercompany profits according to press releases and the class action cited earlier.  In April 2008, VeriFone disclosed that the aggregate adjustments to operating income for the nine months ending July 31, 2007 would be $36.9 million, 24% higher than the estimate management had provided just five months earlier.  The $36.9 million adjustment was against previously reported operating income of $66 million for the nine-month period, which showed that real operating income was $29 million and had been overstated by 130%. All measures of adjusted and GAAP gross, operating, and net profits were adjusted lower (see Exhibit 20 in the appendix for a summary of the VeriFone restatements).  While Angel appears to have only been mentioned in the class action for touting the deal, Lipman was clearly at the center of VeriFone’s operational and accounting issues. Angel resigned in January 2008, a month after the initial December press release on the restatements and a few months before Zwarenstein. In the following year’s proxy, VeriFone highlighted both of these executives’ separation agreements, which included indemnification and confidentiality arrangements that remained in full force.  VeriFone also entered into mutual releases of claims related to both executives’ employment. VeriFone was a roller coaster – the stock went from $33 at the time of the M&A announcement in April 2006, to a pre-restatement high of $50 in October 2007, to $10 after the second restatement announcement in April 2008, and finally to crisis low of $2.  VeriFone was ultimately acquired in 2018 for $23, or a third lower than when the Lipman deal was announced 12 years prior.

Lipman and VeriFone are the most serious professional experience on Angel’s resume prior to ORA, but he also held a few board positions over the years.  From 2012 to 2013 Angel was a director at Retalix, which was acquired by NCR for $650 million in 2012.  The deal got mixed reviews from the investment community.  From 2008 to 2016, he was a Director of Frutarom, whose stock was a big winner during his time on the board.  He was appointed the Executive Chairman of Leadcom on August 25, 2008.[13]  Taking this job may have been an attempt to catch a falling knife, but Leadcom appears to have been an AIM-listed carcass of a pump and dump with a $20 million market capitalization when Angel showed up.  Leadcom listed in April 2005 at a $60 million market capitalization and rose 130% over the next year, at which point key shareholders cashed out. The company provided telecom integration services largely in frontier or emerging markets (Lipman was active in similar types of developing markets, as is ORA today).  Shares peaked at $0.90 and fell to $0.20 by the time Angel took the Executive Chairman position. Ultimately rapid growth, out of control expenses, and an inability to secure credit in the financial crisis sunk the company shortly after Angel joined.[14] [15] 

Doron Blachar, Chief Financial Officer

Blachar became ORA’s CFO in April 2013.  Prior to ORA, he was a Director of A.D.O. Group from 2011 to 2013 and the CFO at Israel’s largest construction company, Shikun & Binui, from 2009 to 2013.  Previously, he was VP, Finance at Teva Pharmaceuticals from 2005 to 2009 and held multiple positions at Amdocs Limited from 1998 to 2005.

In 2017, Shai Skaf, a former employee of a Kenyan subsidiary of S&B filed a suit against the Israeli parent that raised allegations related to bribery of foreign officials.  Skaf was an accountant, who claims to have been shown a second set of books that were considered to be top-secret and included bribes to officials. He says that he was unwilling to cooperate and as a result was berated by his local manager, Dan Shaham, and was then told “when in Africa, be African. They all give and take bribes…Why do you think profitability here [Kenya] runs at 40% and in Nigeria, 65% and in Israel, 4%?”  Skaf claims to have voiced his concerns to the BDO CPA Ruby Lazarov responsible for the Kenyan subsidiary’s books.  Lazarov said he had known about the issues in Kenya for years and mentioned a number of other countries where S&B had operations to suggest that the graft in Kenya was minor in comparison.  In 2016, Skaf was reportedly threatened by unidentified parties, beaten within an inch of his life, and returned to Israel.[16]  Lazarov, S&B’s internal auditor, and senior executives and board members of S&B have been placed under various forms of arrest and house arrest or detained for questioning since the allegations surfaced.

According to S&B’s 2019 Q3 financial report, in May 2019, Israeli police issued a notice saying that sufficient evidence existed to support suspicions against S&B subsidiaries and executives, including “bribing of a foreign public official, obtaining by deception, false reporting in a corporation’s documents, disruption of the judicial process, money laundering, income tax violations, VAT violations and misreporting for the purpose of misleading a reasonable investor.”  The focus is “activity conducted in Africa and particularly Kenya in the years 2008-2016.” The entirety of Blachar’s time as CFO of S&B falls within the timeframe identified by the authorities as being at issue. In news coverage of the allegations, Skaf reports that not only was he told bribes were normal in East Africa, but also that “the company’s internal auditor, board audit committee, the company’s legal department and even…Ofer Kotler [S&B’s CEO from 2008 to 2015]” were aware of and backed the practices.[17]  S&B deposited NIS 250 million – more than $70 million and ~9% of company cash and equivalents and bank deposits at December 31, 2017 – with the Israeli police in February 2018 as an “interim arrangement.”  Given that the internal auditor, audit committee, legal department, and CEO appear to have known of the Kenya issues, what is the probability that Blachar, then CFO, was unaware of the problems? To be fair, Blachar’s relatively short tenure of four years at S&B vs. seven years at Amdocs and currently seven years at ORA could be interpreted as a mark in his favor if he quickly jumped ship upon learning of the Kenya situation.

The Domestic (and Overall) Business has Mediocre Economics at Best

ORA’s consolidated financials follow a pattern that is common in today’s Ponzi economy – substantial cash burn, continual dividend payments despite negative free cash flow, and ongoing capital markets access in the form of both increasing net debt and equity issuance.  While dollars are fungible, and the Company would probably say that dividends are paid from cash flows at mature plants, either the current dividend or ongoing investments in capacity have would been impossible without the help of the capital markets. From 2005, ORA’s first full year as a public company, through September 30, 2019, ORA has burned over $1 billion dollars in free cash flow yet paid out nearly $350 million in dividends to common stock holders and minority partners (net of receipts of dividends on its own minority investments).  Net debt issuance and equity issuance of ~$600 million each, plus net divestitures of subsidiaries and minority stakes of $235 million, have plugged the $1.4 billion deficit over the past 15 years. What the cumulative cash flows suggest is that, despite a highly profitable Kenyan PPA that contributes meaningfully to the ORA’s financial position, substantial capital requirements outweigh the benefits of high EBITDA margins and long-term visibility in the U.S. (and elsewhere).

Unit Level Returns are Likely Below the Cost of Capital

The new disclosures regarding geographic profit mix not only reveal the risks related to the international Electricity business, but also give increased visibility into ORA’s domestic unit economics.  The U.S. geothermal business appears to earn middling returns that likely fall short of the Company’s cost of capital. Power purchase economic models can be extremely detailed – and to many people, incredibly boring – so the analysis that follows attempts to stick to basics and keep the outputs as simple as possible (we have run more granular calculations if further discussion is warranted). 

The key ingredients are upfront capital costs for exploration and construction of a plant, the capacity of the plant, the utilization of that capacity and the resulting generation, the pricing per unit of generation, and the cash costs to operate and maintain the plant.  When Guggenheim Securities initiated research coverage on ORA, the firm included as simple of a model as could be built.

Exhibit 12: Guggenheim Unit Economic Model

Source: Guggenheim Securities report dated January 8, 2018.

The inputs for the model conveniently produce an 8% project return, which translates into higher returns for equity investors with the use of leverage.  The only problem is that the inputs are sensitive to small changes and do not appear to be reflective of the economics at ORA. Below is a review of the assumptions (more detail is provided in the appendix).

Capex. $4.5 million of capital expenditures per MW of capacity looks low.  Lazard’s 2019 publication of its annual Levelized Cost of Energy Analysis shows that total capital costs for geothermal are typically $3.95-$6.60 million per MW.  A recent publication by the International Renewable Energy Agency (“IRENA”) noted that binary plants (ORA’s technology) are normally more expensive than direct dry steam and flash plants.  In looking at ORA’s annual capex budgets, the mix of MW capacity expansion in the U.S. vs. internationally (where capitalized labor is much less expensive), and disclosures on the costs of Olkaria V as a proxy for Kenya, blended domestic capital costs per MW could reach ~$5.2-$5.6 million before maintenance, or 15%-25% higher than Guggenheim’s model.  If binary is indeed more expensive than alternative technologies, then being above the midpoint of the Lazard range ($5.275 million) would make sense. ORA appears to exclude exploration from announced new development capital budgets. 

Capacity Factor / Generation.  Capacity factors for geothermal are usually higher than other forms of renewable energy, but fluctuate on a number of factors. Disruptions at ORA’s Puna facility as a result of the volcanic activity in Hawaii temporarily depressed the Company’s domestic geothermal capacity factor to 82%, but in prior years the average was ~86%.  The 85% assumption used by Guggenheim seems reasonable. 

Revenue.  The revenue situation is more variable.  ORA revenue per MWh in the U.S. in 2018 was ~$79 by our calculation.  Year-to-date through September 2019, our revenue per unit estimate is ~$72.  New capacity, such as the third phase of McGinness Hills that operates under the Ormat Northern Nevada Geothermal Portfolio Power Purchase Agreement, has a PPA price of $75.50 per MWh.  In Hawaii, the recent extension of the Puna PPA has a fixed price of $70.00 per MWh with “no escalation, regardless of changes in fossil fuel prices.”  An agreement for Mammoth Lakes capacity in early 2019 priced at $68.00 per MWh.  The Guggenheim assumption may be reasonable but $80.00 looks high based on current data points, and the low natural gas price environment could potentially result in compressed pricing on new projects.  New PPA pricing appears to be below existing pricing, which likely means tighter margins and lower returns as existing contracts roll off.

Cash Cost.  Like capex, cash costs in the Guggenheim model seem light.  The new geographic disclosures allow investors to estimate domestic Electricity segment revenue and adjusted EBITDA.  Subtracting the latter from the former provides an estimate for cash costs that can be divided by MWh to estimate the per unit costs, which by our estimate netted out to ~$33 in 2018.  Year-to-date through September 2019, our cash costs per unit estimate is ~$29. Our estimates include the net benefit of production tax credits, which ORA includes in its adjusted EBITDA, and gives the company the benefit of the doubt for all its EBITDA add-backs.  Adding back $30 million of assumed centralized operating expenses (needed to run the business) but adjusting for the tax benefits would put cash costs at ~$27-$28. Our calculations imply that real cash costs at ORA are 20%-70% higher than Guggenheim models and are in line with Lazard’s estimate of $30-$40 in its annual energy cost publication.

Other.  Geothermal plants do require some amount of maintenance capital spending.  Turbines, pumps, and miscellaneous moving parts wear or break – that pesky depreciation expense!  ORA discloses a budget for maintenance capital requirements each year in the 10-K, which has averaged $35 million from 2009 to 2019.  Our estimates suggest that capital spending (ignored in Guggenheim's model) of ~$50,000 per MW is reasonable beyond standard ongoing cash operating expenses. The Guggenheim model is pre-tax, so after-tax returns to investors would be lower.  To be generous, our analysis below in Exhibit 13 includes the benefit of a 2.5 cent per KWh production tax credit, yet doesn’t tax the income stream. 

Exhibit 13: Re-Run Unit Economic Model

Source: Based on Guggenheim model, with internal adjustments.

The re-run model yields a negative unlevered return on the low end and a 5% return on the high end, which is still ~35% lower than the Guggenheim model.  Even at a $90 PPA price and $25 cash cost, the project IRR would be ~6.5%, approximately in line with ORA’s cost of capital. Additionally, other economic realities negatively impact the returns of the geothermal business that are not included in the above analysis.  For example, ORA had extensive issues at its North Brawley plant that required a $229 million impairment in 2013; and the recent volcanic activity in Hawaii affected the Puna facility. Assigning any non-zero probability for construction challenges or issues with the resource would lower average project returns across a portfolio.  Lazard points out that construction typically takes 36 months. If initial capital costs span multiple years in advance of generating revenue and cash flow, then the rates of return would be lower than shown above. As previously mentioned, corporate taxes have been omitted while the benefit of production tax credits has been included.  The output yields EBITDA margins of 65%, which are higher than ORA’s domestic adjusted EBITDA margins of ~54%-63% as calculated in Exhibit 2 based on the new geographic disclosures and suggests the assumptions are not overly punitive. Some of the negatives would be offset by an accelerated depreciation schedule, but even with this benefit project returns are low. 

Triangulating Domestic and Consolidated Returns using ORA’s Reported Metrics

Because unit economic models are sensitive to small changes, looking at ORA’s actual results is the most informative measure of returns for the Company’s shareholders.  Domestic returns on assets appear to be in the low-single-digits. Q4 has been ~30% of Electricity EBITDA for the last couple of years, so seasonality provides a slight benefit vs. the output in Exhibit 14 but not enough to change the conclusion of the analysis.

Exhibit 14: Domestic Electricity ROA Estimate

1. Total long-lived assets equal PPE plus construction in progress.  Geographic mix for Q1-Q3 is not disclosed and is assumed to be the same as 2018.

2.     As shown in Exhibit 2.

3.     Electricity segment D&A allocated to domestic based on U.S. percentage of long-lived assets.

4.     Assumes total amount of tax benefits on ORA’s income statement is related to U.S. tax benefits.

5.     SBC allocated based on domestic Electricity revenue as a percent of consolidated revenue.

6.     Long-lived assets are primarily related to the Electricity segment.

7. Total Electricity assets adjusted based on U.S. percentage of long-lived assets.

Backing out an estimate of the excess earnings in Kenya and ORA’s inclusion of the proportionate EBITDA from the Company’s unconsolidated investees implies returns on capital equal ~5%.

Exhibit 15: Consolidated ROIC Estimate Excluding Kenya

Cumulative Cash Flows Result in a Large Deficit

Since the beginning of 2014, the Company has only converted 61% of adjusted EBITDA to cash flow from operations, which ignores the fact that ongoing capital requirements lower real conversion to free cash flow further.  ORA’s older plants have declining MW capacity, which is as clear of a sign as any that depreciation is a real economic expense for a power plant operator. As mentioned at other points in this report, the cumulative cash burn since ORA’s IPO exceeds $1 billion.  Net debt and equity issuance have been required to maintain investment and payment of dividends. Growth is impossible without substantial capital investment.

Exhibit 16: Cumulative Cash Flow Summary Based on Re-arranged Cash Flow Statement

Miscellaneous Quality of Earnings Flags

Other factors worth noting that raise questions about earnings quality and cash flow but are not a focus of this report include:

• Consistent add-backs to arrive at the Company’s definition of non-GAAP EBITDA

• An unresolved material weakness dating back to 2017 that resulted in a restatement of 2017 and 2016 reported EPS from $3.06 to $2.61 and $1.87 to $1.77, respectively

• The inclusion of investees in adjusted EBITDA, which optically raises EBITDA dollars and margins.  An apples to apples calculation of enterprise value would require including proportionate debt mentioned in the footnotes of Company filings, an adjustment that third-party financial information providers are unlikely to make

At the end of the day, the economics in Kenya have likely hidden the reality of an otherwise low-return business.

Efforts to Diversify Distract from Issues and are Likely Value Destructive

The Other segment is too small to matter much to ORA’s overall story and valuation, and therefore to warrant much attention.  However, the recent acquisition of Viridity appears to be a desperate grab for a growth asset in an area where the Company is unlikely to have any advantages.  The move into battery electric storage systems seems similarly misguided. 

In March 2017, ORA acquired Viridity Energy for initial consideration of $35 million and contingent consideration of $12 million.  The entire purchase price was allocated to intangibles and goodwill. In the fourth quarter of 2018, less than two years after the close of the deal, the Company wrote off all goodwill associated with the transaction.  Viridity’s vision as a venture-backed business was to aggregate and manage distributed energy virtually. Under ORA ownership, Viridity continues to operate its existing business; but the Other segment, which houses Viridity, is increasingly financing and developing utility scale battery energy storage systems.  Multiple companies are competing aggressively in energy storage and management solutions – the industry seems commoditized and highly competitive. Like the legacy geothermal business, capital requirements are high and returns on capital will probably be low.

The Company has also ventured outside of its core competency by adding solar to its generation mix.  ORA begin construction of its first geothermal and solar hybrid project in Tungsten. However, in the latest 10-Q ORA said that the solar capacity at Tungsten would offset energy use at the geothermal facility.  Solar mentions and related buzzwords are probably a positive with ESG investors, but ORA’s solar efforts today are little more than experimental. Investors have little reason to believe that the Company will have an advantage vs. existing utility-scale solar developers.

Overall, these non-core operations and investments are relatively small, but the merits appear questionable.

The Bull Case Comes Up Short

While the majority of the issues with the business have been covered in detailed above, a few thoughts on the bulls’ talking points and how their thesis misses the mark are outlined below.

Bull: ORA is well-positioned to take advantage of increasing geothermal penetration in California, which provides a long runway for capacity expansion.

Bear: ORA is highly dependent on Kenya for profits, and those profits are at serious risk.  The returns on the U.S. business are unimpressive. Geothermal assets do not have infinite lives as evidenced by the declines across multiple mature complexes in the ORA portfolio, which means capacity expansion and maintenance requires significant capital commitments.  Those capital commitments earn mediocre returns at best while the stock trades at a sky-high multiple. One of the reasons the California grid has become so costly is because subsidies for solar expanded supply dramatically and undermined the prices originally contemplated in government planning.  Could a focus on baseload capacity expansions undermine geothermal economics? Levelized costs to earn appropriate equity returns are above recent PPA pricing of deals signed in California. The stock price already reflects optimism about the opportunity in California.

Bull: ORA is a way to play ESG investment flows.

Bear: Do substantial excess rents in a frontier market qualify as ESG investing?  Don’t the economics of the business still matter? At some point cash flow will be king – a reset of Kenya economics would likely send the stock much lower.  If serious business risks of operating in a place like Africa were to ever become a reality, ORA could even be precluded from ESG investment portfolios.

Bull: The business mix is shifting away from volatile equipment and towards stable electricity revenue streams, which means that the Company deserves a higher multiple.

Bear: Just how stable are those electricity revenue streams?  Where does electricity profitability come from? Are electricity earnings actually at the highest level of risk in ORA’s history as a public company?

Bull: Premium margins = a premium multiple.

Bear: Margins are inflated by the inclusion of the overpriced Kenya contract, the inclusion of the proportionate share of investees without the corresponding revenue, and ongoing EBITDA addbacks to arrive at management’s adjusted earnings metrics.

Bull: The addition of battery solutions and solar to the portfolio adds upside optionality to ORA shares.

Bear: Both solar and battery storage are capital-intensive and competitive industries.  The likelihood of ORA having any competitive advantage in either category is low.

Valuation is Rich Across All Metrics

ORA’s valuation has expanded to or near post-crisis highs across nearly all valuation multiples.  We don’t believe that ORA should trade at its historical premium to the S&P 500 given that today’s risk profile appears to be worse than in the past.  However, even applying the stock’s 10-year average P/E premium to the S&P’s multiple implies downside of nearly 50% in a low case when adjusting for the Company’s excess earnings in Kenya.  Shares could still have 30% downside if we were to cut our estimated Kenya EPS impact in half on the high end (to be conservative). At the S&P 500 utilities sector (XLU) multiple, which also trades at a premium to the S&P 500, ORA could face downside in excess of what we envision.

Exhibit 16: ORA Shares have Substantial Downside on an Earnings-Based Valuation

Source: CapitalIQ, internal estimates.

1. Assumes that the Kenya EPS impact as shown in Exhibit 11 above is reduced by 50% on the high valuation case for the sake of being conservative (i.e., in favor of ORA).

As a sanity check on valuation, we looked at replacement costs.  Using our estimates of ORA’s capital spending per KW of new capacity and Lazard’s estimates of capital costs as a guide, the range of outcomes appears asymmetric for the short thesis.  ORA would be unlikely to get current levels of capital spend per KW for its existing plants because many of its facilities are declining in terms of productivity (construction cost estimates are associated with the commencement of operation at new plants).  Complexes that were collectively responsible for 63% of ORA domestic capacity in 2013 had a total five-year capacity CAGR of (5)% from 2013 to 2018 (or a cumulative decline of 20%) as shown in Exhibit 17. The Company only discloses capacity factors on a regional basis; but applying those regional metrics to these plants implies utilization declined ~200 bps from 2014 to 2018, which means generation declined more than capacity (the capacity factors were not included in the 2013 10-K).  These declines are clear reminder of why high ongoing capital expenditures are a fact of life in the geothermal plant business.  

Exhibit 17: Declining Capacity is Evidence that ORA Plant is not Worth Current Construction Costs

Source: ORA public filings.

Clearly ORA plants should receive a discount vs. new build costs.  Reasonable assumptions for replacement costs imply values well below current trading levels.  

Exhibit 18: ORA’s Share Price is Unsupported by a Generous Assessment of Replacement Costs

1.     The midpoint of Lazard’s capital cost estimates is $5,275 / KW.  As mentioned above, binary plants can be more expensive. Higher assumptions for capital requirements increase the valuation under a replacement cost analysis anyway.

2.     Internal assumption, which still implies replacement costs well in excess of book PPE.

3.     Internal assumption, which is based on the mix of domestic and international MW of capacity added at ORA and disclosures about maintenance and other expenditures.

Conclusion – We Expect Shares to Run Out of Steam

ORA continued to expand capacity at Olkaria III over the years knowing that additions would fall under the existing overpriced PPA.  The Company’s revenue (KPLC’s cost of goods) has grown to a point where KPLC can no longer ignore the issue. While KenGen is the largest supplier to KPLC, ORA is 3.6x bigger than the third largest supplier in terms of Kenyan shillings, which makes the Company the most logical target for KPLC to go after to rationalize costs.  While we can’t predict with certainty the exact course of events or timeline, the developing mosaic points to a higher and higher likelihood of a substantial reset. The Kenyans are most likely unwilling to continue to subsidize ORA via state-owned enterprises or may simply be unable to pay the bills on time – either explanation is a negative for ORA shareholders.  ORA’s incremental disclosures, growing overdue KPLC balances, KenGen’s expanded capacity, Kenya’s lowered expectations for electricity demand growth, and a strong USD (ORA’s dollar-based contract becomes increasingly onerous against shilling revenues) suggest that a tipping point could occur sooner rather than later. In the event that Kenya doesn’t hit the reset button on ORA, the stock is more than fully valued anyway, which limits upside to shares and risk to the short position.  Ultimately, we think that shares will fall at least 40% as the Kenya situation comes to a boil and investors acknowledge the risks of being so dependent on an overpriced contract in a frontier country.

Appendix

Exhibit 19: Overdue Amounts from ENEE (Honduras)

Source: ORA public filings.

Note: ORA does not disclose Honduras revenue.  However, Honduras revenue could not have exceeded $59 million in 2018 because the country is not identified individually in the 10-K.  Therefore, Honduras could not be more than the “Other Foreign Countries” category in geographic disclosures. The “Other Foreign Countries” category is not segment specific and therefore includes Product segment revenue, meaning that the past due balance is a meaningful portion of “Other Foreign Countries” Electricity segment revenue.

Exhibit 20: Summary of VeriFone Restatements

Source: VeriFone public filings.

Exhibit 21: Domestic Revenue and Cash Cost per MWh Details

Exhibit 22: Capital Expenditure per MW Estimates

Source: ORA public filings, Lazard annual Levelized Cost of Energy Analysis.

Disclosures

As of the publication of this report, we have a short position in the stock of Ormat Technologies, Inc. (NYSE:ORA, or “ORA”).  We stand to realize gains in the event that the price of the stock decreases. Following the publication or distribution of this report, we may transact in the securities of the company covered herein.  This report and all statements contained herein are our opinions and are not statements of fact. We, like everyone else, are entitled to our opinion and have the right to express such opinion in a public forum.  We have obtained all information herein from sources we believe to be accurate and reliable and hold our opinions in good faith. However, such information is presented “as is,” without warranty of any kind. We make no representation, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results obtained from its use.  All expressions of opinion are subject to change without notice, and we do not undertake to update or supplement this report or any information contained herein. This report is not a recommendation to short the shares of any company, including ORA, and is only a discussion of why we are short ORA.

This document is for informational purposes only and it is not intended as an official confirmation of any transaction.  All market prices, data and other information are not warranted as to completeness or accuracy and are subject to change without notice.  The information included in this document is based upon selected public market data and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change.  Our opinions and estimates constitute a best efforts judgment and should be regarded as indicative, preliminary and for illustrative purposes only.

This report should only be considered in its entirety. Each section should be read in the context of the entire report, and no section, paragraph, sentence or phrase is intended to stand alone or to be interpreted in isolation without reference to the rest of the report. The section headings contained in this report are for reference purposes only and may only be considered in conjunction with the detailed statements of opinion in their respective sections.

Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the potential complete loss of principal.  This report’s estimated fundamental value only represents a best efforts estimate of the potential fundamental valuation of a specific security, and is not expressed as, or implied as, assessments of the quality of a security, a summary of past performance, or an actionable investment strategy for an investor.

This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of our affiliates.  Also, this document does not in any way constitute an offer or solicitation of an offer to buy or sell any security in any jurisdiction in which such an offer would be unlawful under the securities laws of such jurisdiction.  To the best of our abilities and beliefs, all information contained herein is accurate and reliable. We reserve the right for our affiliates, officers, and related persons to hold cash or derivative positions in any company discussed in this document at any time.  As of the original publication date of this document, investors should assume that we are short shares of ORA and stand to potentially realize gains in the event that the market valuation of the company’s common equity is lower than prior to the original publication date.  We shall have no obligation to inform any investor or viewer of this report about our historical, current, and future trading activities. In addition, we may benefit from any change in the valuation of any other companies, securities, or commodities discussed in this document.  We earn fees based on the profitability of funds that we manage.

The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact.  Any or all of our forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. The forward-looking statements can be affected by inaccurate assumptions or by known of unknown risks, uncertainties and other factors, most of which are beyond our control.  The opinions expressed in this report are not investment advice nor should they be construed as investment advice or any recommendation of any kind. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and development a stand-alone judgment of the relevant markets prior to making any investment decisions.

[1] Sec.gov. November 2004 Prospectus

[2] Ormat.com. https://www.ormat.com/en/company/welcome/history/

[3] Encyclopedia.com. https://www.encyclopedia.com/books/politics-and-business-magazines/ormat-technologies-inc

[4] Haaretz.com. https://www.haaretz.com/israel-news/business/1.5206393

[5] Sec.gov. November 2014 PRE 14C

[6] Thinkgeoenergy.com. https://www.thinkgeoenergy.com/kenya-olkaria-v-units-1-and-2-geothermal-plant-reach-full-load-operation/

[7] Reuters.com. https://www.reuters.com/article/kenya-electricity/kenya-slashes-2030-power-production-targets-as-usage-still-low-media-idUSL5N22R2OO

[8] Reuters.com. https://www.reuters.com/article/kenya-electricity/kenyas-kengen-says-to-add-extra-1745-mw-to-grid-by-2025-idUSL8N1Q928Z

[9] Sec.gov. VeriFone 2009 Proxy. Angel resigned in January 2008 but his separation agreement was not mentioned in the 2008 proxy.  The 2009 proxy disclosed more information about his departure.

[10] Forbes.com. https://www.forbes.com/2008/04/02/verifone-cfo-investigation-markets-equity-cx_mlm_0402markets28.html#558e1c8610e5

[11] Rgrdlaw.com. https://www.rgrdlaw.com/cases-verifone-holdings-litigation.html

[12] VeriFone Class Action. First Amended Consolidated Complaint.

[13] Trustnet.com. https://www2.trustnet.com/Investments/Article.aspx?id=20081128084000Z3278

[14] Haaretz.com. https://www.haaretz.com/israel-news/business/1.4895227

[15] En.globes.co.il. https://en.globes.co.il/en/article-fortissimo-to-acquire-leadcom-for-23m-1000916925

[16] Haaretz.com. https://www.haaretz.com/israel-news/bribery-scandal-at-israeli-construction-giant-blows-cover-off-its-busi-1.5888180

[17] Haaretz.com. https://www.haaretz.com/israel-news/bribery-scandal-at-israeli-construction-giant-blows-cover-off-its-busi-1.5888180