Description

Pinnacle Renewable Energy Inc. (PL)

Recommendation

Buy PL equity.  Based in Canada, PL is a private equity backed, growing renewable energy company that has experienced a challenging few months operationally which has led to its stock losing nearly half its value from the September highs.  The stock now trades 16% below last year’s IPO price even as the business is much larger and more valuable today. The Company reports its Q4 and full-year results later this week where they will likely provide investors an update on their operational issues and as a result, there might be additional short-term downside in the stock if I’ve underestimated the materiality of their problems. The operational challenges, some self-inflicted and others outside their control, appear to be fixable and should not derail the longer-term growth trajectory of the business.  With $5.0bn of contracted backlog (weighted average remaining life of 9+ years) with high quality customers and a favorable environment for additional high ROI growth initiatives, PL is poised to generate significant cash flow over the next decade.

With the stock currently trading at ~8.0x depressed FY19 EBITDA (and at a low-teens FCF yield), I believe the market is underpricing the Company’s prospects.  Even if you assume a one turn contraction in the multiple to 7.0x, the stock could be worth ~$13.65/sh (+45%) by the end of next year based on my FY21 EBITDA estimate.  Along the way, investors would also clip a healthy dividend yield, currently at 6.4%, which may grow as newer contracts in the backlog come online and start generating cash flow. Like it or not, this is a growth oriented company and with that comes execution risk (like the kind PL is experiencing right now) but also opportunity given the low transaction multiples (4.5 – 5.5x EBITDA) at which the Company can grow its backlog without equity dilution – any additional accretive acquisitions and/or expansion projects would provide upside optionality to the thesis.  

In addition to growth execution risks, there’s no shortage of regulatory/policy risk with a name like this.  Burning wood pellets for energy is super controversial and the massive subsidies allocated to it are even more so.  To be honest, the ongoing debate between the climate/environmental experts relating to this topic is way beyond my brain capacity and so the best I can do is focus on the current policies in place and actively monitor any potential changes to them.  While the policies are currently very favorable, you don’t need to be a rocket scientist to realize that any negative announcement from governments or customers that decreases the usage of wood pellets would be bad news for PL and its peers. What happens in 2027 with the U.K. subsidies expiring, and to a lesser extent with Brexit, is the major risk to the investment thesis.  Given the recent news flow, I think the base case has to be that the subsidies will not be renewed and that U.K. wood pellet imports will decline significantly. This would then suggest that pellet pricing would also take a hit taking down the profitability for the entire industry as they deal with excess capacity. What’s not clear to me is how much of the U.K. volume will be replaced by the Asian countries such as Japan and South Korea, which are aggressively growing their imports of wood pellets from North America and elsewhere.  I believe this risk of lower profitability post 2027 for the Company and industry is already baked into the valuation today.

Company/Business Overview

Founded in 1989 as one of the first wood pellet producers, PL is now the third largest in the world after Enviva and Graanul.  Industrial wood pellets are used as renewable fuel for electricity generation by utilities and large-scale power generators around the world to produce renewable and reliable baseload power.  They can be used in converted coal power plants, newly constructed dedicated biomass facilities and are also co-fired in coal power plants. Industrial wood pellets are handled much like coal by power plants – they are milled into powder, mixed with air and blown into a boiler for combustion to heat water, which produces steam to turn a turbine and generate electricity. Industrial wood pellets are a low-cost and green substitute for coal. Many believe that life-cycle greenhouse gas emissions from the use of industrial wood pellets are lower than that of coal, with approximately 75% less ash content and approximately 80% less sulfur.  PL operates nine production facilities with a combined run-rate production capacity of 2.2mm+ metric tons per annum (MPTA). The Company went public in February 2018 at $11.25/sh. Onex Corporation owns 31.6% of the Company.

With the exception of the Alabama facility just recently acquired, the Company’s facilities are strategically located in highly concentrated forest products regions of B.C. and Alberta, adjacent to Canadian National Railway rail lines and on back-haul trucking routes in key wood fibre regions, providing access to wood fibre supply and enabling efficient, cost-effective transportation of renewable biomass fuel.  The Company’s plants process a variety of non-traditional forest product residuals (including bush grind, bark, and bio logs), in addition to traditional forest product residuals (including shavings, sawdust and chips). The majority of its wood fibre is sourced under long-term contracts with high quality forest products companies typically with exclusivity on residuals produced by their processing facilities near PL’s plants. The Company has secured wood fibre supply through 2021 for approximately 85% of its raw material needs.  Industrial wood pellets produced in its facilities (or purchased from third parties during shortages) are transported to one of two port terminals in B.C. that export industrial wood pellets: its wholly-owned Westview Terminal at the Port of Prince Rupert in Northern B.C. or the Fibreco Terminal at the Port of Vancouver. Ownership of Westview creates a competitive advantage by reducing rail, port and ocean demurrage costs for industrial wood pellets produced in its facilities. In summary, the operations are nicely vertically-integrated – wood fibre is procured under long-term contracts, then shipped under long-term contracts with reputable shippers that match the life of the supply contracts with large utility customers. This vertical integration and the ability to process all types of residuals provide PL a significant competitive advantage over smaller operations.  

Below is a map of the Company’s facility network:

Below is a quick overview of the Company’s production facilities in Canada:

PL has been one of the most active developers of industrial wood pellet production capacity and associated infrastructure in recent years.  In 2018 alone, the Company commenced operations or acquired three facilities, including one in the U.S., with total capacity of nearly 800k MTPA.  The Entwistle facility was developed at a cost of ~$95mm and commenced production in June 2018. When fully ramped, it will be the Company’s largest facility with capacity of 400k MTPA.  The Smithers facility was developed at a cost of ~$33mm and commenced production in late 2018. This facility is owned 70% by PL and 30% by West Fraser, its fibre supplier, and adds 125k MTPA of capacity.  The Aliceville facility was acquired for a total cost of ~US$44mm and has been ramping up production in 2018. This facility is owned 70% by PL and 30% by Westervelt, its fibre supplier, and adds 270k MTPA.  Management estimates that each of these transactions was consummated at 4.5 – 5.0x run-rate EBITDA though I suspect this might be aggressive in some cases.

The following shows the Company’s capacity growth progression over time:

The Company has entered into long-term take-or-pay contracts with a handful of utilities and large power generators in the U.K., continental Europe and Asia, such as Drax, RWE, and Mitsubishi (or their affiliates).  In 2017, the top 3 customers accounted for 89% of revenues, with Drax being the largest. Based on contracts signed to date and annual commitments, the top three customers will account for 78% of revenues by 2019. These customers have a firm obligation to purchase a fixed quantity of product at specific prices that represent 106% of production capacity through 2021 and nearly 98% of production capacity through 2026.  The contracts include annual price escalators that should offset any increases in the cost of production and distribution. As of September 2018, the total contracted backlog was $5.0bn.

Below is the Company’s current contracted production profile.  Note that the Company will have to add capacity over the next 36 months to meet the new additions to the backlog:

One of the main attractions of this investment opportunity for me is PL’s low cost position within the industry particularly as it relates to servicing customers in Asia.  According to industry analysts, it is the lowest-quartile cost supplier to markets in both Europe and Asia. Because all of PL’s Canadian facilities and ports are in Western Canada, it has a significant competitive advantage when it comes to winning new contracts in Asia. Additionally, the Company’s vertically integrated logistics network of production facilities, rail lines (766 leased railcars, contracts with CN, etc.), and export terminals allows it to control its costs better than many of its competitors. Given this backdrop, I think PL is strategically positioned to increase its business in the fast growing Japan and South Korea biomass markets.  

Below are supply cost curves for shipments to Europe and Japan:

Current Situation / Recent Events

PL has experienced some very unfortunate recent challenges.  The main one was self-inflicted and relates to its brand new Entwistle facility.  This facility will be its largest and projected to generate ~$20mm of EBITDA when fully ramped and so it’s not totally unexpected that the Company would experience commissioning challenges given the size and complexity of the project.  However, its safe to say that a lot has gone wrong over and above typical plant startup issues. The Company first ran into a number of issues in Q4 2018 during the development and ramp up of the facility. There were some production issues that management blamed on the supply of below standard quality fibre with excessive rocks.  Additionally, the Company experienced a delay in the completion of a storage silo at Entwistle that constrained its logistical efficiency resulting in higher costs and reduced production. The impact of all this was a production shortfall of 31k MT and ~$4mm in EBITDA loss in Q4. Only a couple of weeks ago, it appeared that these commissioning challenges were practically resolved with the completion of the silo which allowed logistics to run closer to normal.  Furthermore management had worked closely with suppliers to resolve the excessive rock issue with its fibre supply. Plant performance improved in November and December and Entwistle was on track to get to its targeted run rate production by 2H 2019. But unfortunately, all this momentum came to a screeching halt on February 11th.  

At ~2pm on February 11th, a fire and explosion occurred at Entwistle, causing damage to part of the facility. One employee was taken to the hospital with non-life threatening head injuries and several other employees sustained minor injuries.  The fire is currently being investigated by Alberta Health and Safety and so the Company doesn’t have full access to the site yet and is therefore unable to assess the true extent and cost of the damage. Based on my conversations with the Company, I’m told that the fire was localized to the dryer area which may suggest that the timeframe for repairs will be the shorter side.  In the meantime, all operations at this facility remain suspended dealing a major blow to the Company. There’s no way to tell how long the plant will remain closed or what it will cost for repairs but management will provide an update on the earnings call this week. There’s also the issue of how PL will meet customer production volumes without access to the Entwistle capacity.  If there’s anything positive to report here, it’s that the Company does have business interruption insurance that could potentially be tapped to recover some of the losses incurred.

Other Company challenges were outside its control.  B.C. experienced extensive forest fires in 2018. A total of 2,092 wildfires have burned 3.3mm acres of land in 2018 as of early November 2018.  This resulted in business disruption because of rail service interruption related to the fires. Supply of fibre was impacted because of the fires and active management of relationships and rail logistics were required to mitigate these challenges.  Fortunately, none of the facilities were damaged by the fires.

Canadian rail companies also experienced delivery delays because of the harsh winter weather. Canadian National Railway, one of PL’s key partners, was the worst culprit. CN had aggressively cut costs in 2015 to adjust to a downturn in demand in the then-struggling energy sector and with more than 1,000 employees laid off and about 200 locomotives placed in long-term storage, CN was unable to meet demand for shippers, including PL’s, when the energy sector recovered some.  The delays were so acute that Canada’s federal government asked CN and rival CP to submit a plan for clearing up backlogs. While service issues with CN have improved in recent months, Q4 performance is still below par and PL management remains concerned about future levels.

Finally, the epic collapse in lumber prices in 2018 forced many fibre suppliers to temporarily curtail production.  While the Company has supply contracts with fibre suppliers, they do not include minimum volume requirements. This obviously created a mismatch in the operations as the Company has contractual volume requirements to meet with its customer contracts.  In order to meet its obligations, PL management had to source non-sawmill residuals and purchase pellets from third parties. This has pressured margins as fibre from new suppliers has to be hauled over greater distances, more non-sawmill residuals need to be purchased in a tight market, and they have to spend more to process different types of residuals.  I have no idea where lumber prices go in the future but I imagine markets adjust to curtailments and price fluctuations and supply/demand will eventually be back to normal at some point in 2019.

Below is a partial list of curtailments:

As a result of all the issues prior to the fire, the Company cut guidance for FY18 from $61 – 65mm to $57 – 60mm.  It will be interesting to see if management provides guidance for FY19 later this week but obviously EBITDA will be sharply lower than the ~$80mm that I was expecting prior to the Entwistle fire.  

Wood Pellet Demand

2018 was one of the strongest years for the global wood pellet market in quite some time.  From 2014 to 2016 the growth in global wood pellet trade slowed to 7% per year, accompanied by a low pricing environment and limited capacity expansion. In 2017 market conditions improved and global trade increased 13% to 18.9mm MT. The strength continued through 2018 as the growth in global pellet trade accelerated to 26% to 23.8mm MT. This growth is primarily fueled by increased demand in the U.K., Denmark, South Korea and Japan.

Global demand for industrial wood pellets has been increasing because of the shift toward renewable, cleaner power generation.  Regulations at countries that set targets by providing financial incentives for reducing greenhouse gas emissions are clearly the main reason behind the increasing demand for wood pellets. While wind and solar are likely to be the future of renewable power, biomass powered plants are a more compelling alternative at the moment for many countries.  Wood pellets are used as a substitute for coal in both dedicated and co-fired power generation and combined heat and power plants. Unlike wind and solar, wood pellet-fired plants are capable of meeting electricity demand and are flexible in the sense that power output can be adjusted based on demand. Additionally, the expenditures required to switch a plant from coal to biomass are a fraction of the costs associated with implementing offshore wind and most other renewable technologies. Furthermore, the process of converting from coal to biomass is quicker which benefits power generators with mothballed plants that are no longer viable due to expiration of operating permits or the introduction of taxes or other restrictions.  

For these reasons, utilities and power generators in Europe and Asia have been making long-term investments in plant conversions and newbuilds of generating assets that fire wood pellets with coal or dedicated wood pellet-fired plants.  As more power generation plants around the world shift away from coal to wood pellets, growth could remain strong for many years to come. Industry analysts believe that increased European and Asian support for carbon reduction regulations will result in end market demand growing at 18% CAGR through 2021.  If even more countries (such as China, for example) begin providing incentives to switch from coal to biomass, that would further accelerate the growth potential for PL and its competitors.

Below is the global industrial wood pellet demand forecast:

Below is a chart that shows historical global wood pellet imports by country. Note that this data includes industrial and non-industrial wood pellet imports:

The force behind growth in demand for industrial wood pellets in the U.K. is the Climate Change Act, where the government set legally binding carbon budgets and reductions in greenhouse gas emissions by at least 80% by 2050. To support growth in renewable technologies, the government introduced a number of reforms, including the introduction of a carbon tax and changes to its incentive system to encourage operators of coal plants to switch to low-carbon alternatives, such as industrial wood pellets. In effect, the government was essentially offering a subsidy where it would pay power generators 2.5x more for the electricity it produced from wood versus from coal.  In response to these changes, U.K. power generators made significant investments in projects that utilize industrial wood pellets. For example, Drax converted four of its six plants from coal to industrial wood pellets and now burns 7mm MT per year of pellets imported from the U.S. and Canada. The current subsidy regime for coal-to-biomass conversion projects comes to the end in 2027. The large subsidies have been very controversial and recent studies and policy recommendations coming out of the U.K. seem to suggest that this subsidy will not survive after it expires in 2027. In simple terms, the new studies recommend that higher priority be given to options that do not burn biomass which means that energy production from wood pellets will ultimately get phased out.  However, as of now, any change to existing policies would only apply to new plants commissioning in 2021 – 2026 and therefore Drax and the other grandfathered plants already in the pipeline will continue to receive subsidies through 2027. What happens to converted wood pellet fired plants in the U.K. after 2027? It’s hard to say but without subsidies, it would be difficult for these plants to continue to be economical. Having said that, by 2027, biomass power plants are expected to represent 7% of the U.K.’s power generating capacity and will be playing an important role in the region’s power grid and replacing this with other renewable alternatives will be challenging. This leads some to think that some percentage of wood pellet fired plant capacity will continue to operate beyond 2027.  

According to analysts, industrial wood pellet demand from the rest of Europe is expected to grow to 18.7mm MT by 2022, a 10% CAGR.  In June 2018, the European Commission announced the agreement of key policy terms of the Renewable Energy Directive II framework, including a binding EU-wide target share for renewables of 32% in the energy mix by 2030, up from the target of 20% by 2020. The agreement also reconfirmed that energy generated from biomass counts towards the renewable energy target and is eligible for support mechanisms.

Analysts expect industrial wood pellet demand from Asia to grow to 11.4mm MT by 2022, a 29% CAGR.  In Japan, long-term demand of imported wood pellets continues to grow as the government targets 6.0 to 7.5 GWs of biomass-fired capacity, which represents demand for 15 to 20mm MT of biomass, as part of its expected power source mix for 2030. Japanese wood pellet imports are on pace to exceed 1mm MT in 2018, approximately double the amount of imports from 2017. In addition to confirming renewable energy’s target share of 22 – 24% in Japan’s 2030 energy mix, the plan designated renewables, including biomass, as a main source of power generation, indicating a major shift in government policy that recognizes renewable energy’s role as a baseload power source.  While the Japanese market has captured most of the attention of North American producers and European buyers of wood pellets, South Korea has quietly become the 2nd or 3rd biggest wood pellet market in the world (after the UK and very close to Denmark). However, unlike Japanese buyers who look for stability and long-term contracts, most of the pellets currently being imported by South Korea are on a short-term or spot basis. South Korean utilities that co-fire wood pellets to help meet their renewable portfolio standards are much more price sensitive due to the nature of their business. South Korean demand is largely responsible for the rapid development of wood pellet production capacity in Southeast Asia. In 2018, South Korea’s wood pellet imports are projected to reach 3.4mm MT, with more than 95% of that volume coming from Southeast Asia.  Total potential demand in Japan could exceed 12mm MT per year by 2025, while South Korea could demand 9mm MT.

Note that I've relied heavily on FutureMetrics and Hawkins Wright wood pellet industry analysis for much of the country/region climate policy updates and demand forecasts.

Capitalization

The Company has a market cap of $330mm and a total enterprise value of $553mm.  There’s a $50mm revolver that has $3.5mm drawn on it. There’s a term loan outstanding with a $194mm balance with annual mandatory repayment schedule of $6mm.  The Company also has a $130mm delayed draw term loan facility meant to be used for acquisitions and growth capex. I’ve assumed that the Company drew on the DDTL in October 2018 in the amount of $49.3mm to fund the closing of the Aliceville transaction.  Total annual interest expense is ~$13mm. The Company has $7.3mm of cash on the books but the table below reflects the assumption that 1.98mm options outstanding are exercised at a weighted average price of $8.36/sh. Given what we know today, I’m projecting that the Company will end FY19 with leverage of ~3.3x, in line with its target of 3.25x.  

In terms of capital needs to meet the current backlog, I estimate that the Company needs to spend an additional $80 – 90mm to add capacity.  Of this, I expect the Company to spend ~$12mm in FY19 and the balance in FY20 – FY22. Between the availability on its credit facilities and the FCF it will generate, the current business plan is fully funded and I don’t expect the need for any additional debt or equity financing.  

Summary Financials

PL is a growth company as evidenced by the growth in production, revenues and EBITDA over the last five years.  The Company has invested heavily, particularly in FY17 and FY18 to grow capacity to the current run rate of 2.2mm MT.  The business is generating a healthy amount of FCF assuming maintenance capital expenditures of ~3% of revenues. The Company has significant NOLs and will not be a cash taxpayer for at least the next couple of years.   

For FY19, I’ve assumed lower volumes sold and higher expenses due to the Entwistle issues and this reduces EBITDA from ~$80mm to ~$68mm.  This still represents growth of ~15% Y/Y. With total capex spend of $25mm, including $11mm for growth, and interest expense of $13mm, the Company should generate ~$30mm in FCF for the year.  Obviously, my estimates could prove to be way off base depending on what management shares on the call this week and the eventual outcome of the Entwistle situation.

Valuation Thoughts

I think a 7.0 – 8.0x EBITDA multiple range is appropriate for a business like PL with a significant contractual backlog and (generally) very high visibility of cash flows.  Its larger competitor, Enviva, usually trades in the 8.0 – 9.0x range and should command a premium multiple given its longevity and track record. Obviously there’s a lot of uncertainty about PL’s growth at the moment given the issues at Entwistle.  But assuming Entwistle gets fixed, there’s no reason why PL can’t generate $100mm in EBITDA in FY21. Contracted production for FY21 is 112% of current capacity, which suggests pellet sales of ~2.5mm MT that year. Assuming EBITDA of $40 per MT (middle of their $35 – 40 target), PL should generate ~$100mm of EBITDA in FY21.  At 8.0x EBITDA, PL could be worth $16.50/sh by the end of next year.

However, Entwistle does present risks to the business.  Should the plant not get up and running quickly and PL misses volume commitments, its possible that they lose a customer contract (or more).  This might also make it harder for PL to compete for new business given reputational damage. Even in the low probability scenario that Entwistle is a total bust, I think its unlikely that the Company loses so much business that EBITDA falls below $70mm.  At 7.0x, I think the downside scenario for the stock is ~$7.50/sh.

Note that for simplicity, I’ve ignored cash generation as excess liquidity will be used to pay dividends and build out capacity ($80 – 90mm mentioned earlier) for the new contracts in the backlog that come online in FY21 and beyond.  Its possible my debt projections are a bit too low but I think even at $70mm EBITDA, there should be ~$25mm per year in excess cash flow to fund this capacity buildout over the next three years.

Catalyst

* A fast and cost effective solution for Entwistle in FY19

* Demonstrated ability to operate all of the facilities at full capacity at target margins

* Additional off-take agreements with European and Asian utilities

* Additional capacity growth investments at mid single digit EBITDA multiples

* Dividend increases once Company is running production at full capacity