Description

Polaris Infrastructure (PIF-T)

I was in the process of writing up PIF when the company announced the Union Energy Group acquisition – which I think is positive. Before the acquisition, I thought PIF’s upside/downside was fairly asymmetric given the fears over Nicaragua geopolitical risks and my investment thesis can be summarized as follows:

1. Starting with the downside, I think it is in the C$8.50 range given the current FCF generation, cash on the balance sheet, non-recourse balance sheet debt and the likelihood of some compensation should PIF’s geothermal asset be expropriated

2. My base case assumes PIF runs its asset for cash, allows production to decline over time and has its PPA not renewed in 2029. I get ~ C$18

3. Although it seems like a blue sky scenario now, assuming proper investment to maintain production and a PPA renewal post 2029 on similar terms, I get almost C$30

4. I think the opportunity exists because PIF’s predecessor Ram Power already restructured and wiped out previous equity holders, leaving an already narrow set of investors interested in PIF. Compounded by the Nicaragua situation, the interest in the name likely is pretty close to zero.

Background – Debt Load and Delays Led to First Wipe Out

PIF was formerly known as Ram Power who undertook the task to develop the San Jacinto field and build the San Jacinto (SJ) geothermal power plant. On paper, the project made a lot of sense as Nicaragua still relies on internal combustion engines burning bunker fuel or diesel to generate power – particularly with a PPA in place that goes until 2029 priced in USD with annual escalators and an initial 10 year tax holiday (3% first five years until 2023 and 1.5% thereafter, currently ~ US$126/Mwh). Unfortunately, Ram experienced ramp-up delays and had a high debt load, leading it to default on its debt and had to restructure in 2015, essentially wiping out equity holders (and yes, Antony Mitchell (see Emergent Capital VIC writeup) was the previous chairman of Ram).

With a right-sized balance sheet and better execution, PIF actually looked like an attractive investment given its FCF was fairly predictable and the company became ramping up its dividend over time. It would seem PIF just couldn’t catch a break as Nicaraguan protests broke out ~ April 2018 over President Ortega’s plan to increase income and payroll taxes while cutting pension benefits by 5%. Despite rescinding this, protests continued and the government took a hard line approach to violently cracking down on protests. Since April, PIF’s stock has been roughly cut in half despite maintaining its operations and PPA payments are largely unaffected.

San Jacinto Plant and Financial Overview

Being a one asset company, PIF’s financials are relatively easy to understand and model. The SJ geothermal plant has a 72 MW capacity and the associated PPA will pay up to 72 MW net. Currently, the plant is doing ~ 61 MW net and generating ~ 535,000 MWh. PIF gets US$126/MWh and their direct and other costs run at ~US$13.2/MWh and G&A runs at ~ US$3 mln per year. Putting it together, the math is real simple on this one, ~US$68 mln in revenues, EBITDA ~US$60 mln. The natural decline in production is in the 2-3% range and incremental drilling is required to counter this decline.

The Downside Scenario

I will spend a bit more time on the downside as the upside (no expropriation) is pretty self explanatory and does not require heroic assumptions. I think the main reason PIF is mispriced is because investors hear Nicaragua and think there has got to be better investment ideas than this. As well, the knee-jerk reaction is that the plant will be expropriated and hence the downside is zero. I think the downside is much more nuanced and involves handicapping how much FCF PIF can generate in the meantime and the possibility of compensation. In fact, I don’t think expropriation is the most likely outcome because:

1. Nicaragua practically does not (cannot) issue sovereign debt and relies on project financing (including the world bank) for its infrastructure projects. Any asset expropriation effectively cuts off external funding for the country

2. Electricity generation is an essential task that is unlikely at the top of the list for the government to interfere with.

3. The government is likely better off renegotiating the PPA agreement and/or not renewing the PPA when it expires

4. B2Gold’s El Limon mine is not too far from SJ. Just over a week ago, the company just announced plans to expand the mine and signed a 2 year collective agreement with labour unions. This does not sound  like imminent SJ expropriation

https://www.newswire.ca/news-releases/b2gold-corp-announces-positive-results-from-the-expansion-study-at-el-limon-mine-in-nicaragua-and-that-a-renewed-collective-agreement-has-been-signed-with-el-limon-labour-unions-698269301.html

5. Real time electricity generation shows SJ is running strong. The map will also give the reader a better sense of how unlikely the government is going to mess with this power plant given the lack of sizeable power generation in its vicinity.

http://www.cndc.org.ni/graficos/MapaSIN/index.php

Handicapping geopolitical risk is definitely not a precise or quantitative endeavor but here are the ways I would look at it:

Precedent Protests and Regime Changes – Start to Finish 50% drop in stock prices

I realize we can’t really look at “comps” to gauge the Nicaraguan situation but the Arab Spring in Egypt may serve as a bit of a guide as to how the market reacts to these developments.

Basically, it looks like protests erupted in Egypt in Jan 2011, President Mubarak resigns in a month, unrest continues until President Morsi sworn in in June 2012 and unrest continues and Morsi gets overthrown in July 2013. Egypt gets a new president in June 2014.

The Egyptian market (EGX30) bottoms about 11 months since the start of protests and lost ~ 50% of its value.

For reference, we are 7 months in since the start of Nicaraguan protests and PIF is already down 50%.

https://www.researchgate.net/publication/272758702_The_Impact_of_Arab_Spring_on_Stock_Market_Performance

Actual Expropriation Experience and Recoveries

The other critique I hear about PIF with respect to its geopolitical risk is that the asset will be expropriated and when it does, PIF is a zero. This is actually false, there are many cases where Latin American countries expropriated assets and compensated companies within a few years.

Renationalization of YPF – Compensation at 2x book value or 45% of undisturbed market cap

A somewhat recent example is the renationalization of YPF under President Kirchner in April 2012. Repsol had a 54% stake in YPF. Apparently, the undisturbed market cap of YPF is thought to be closer to $20 bln and hence Repsol was asking for $10 bln in compensation. Book value for YPF was $4.4 bln at the time.

It took until February 2014 for the Repsol board to agree to the $5 bln settlement to be paid in bonds (so that should be discounted versus cash). Rough numbers the settlement works out to ~ 45% of the pre-expropriation affected market cap and 2x book value.

Peruvian Expropriation Settlements in the 1970’s – Roughly 40% of company’s claim of loss

In Peru in the 1970’s, there was a military revolution that led for a left leaning new President, Velasco. He proceeded to expropriate entire industries. Even under these circumstances, private companies still got compensated on average about 40% of the “asking” price of compensation (see below).

Venezuela Expropriation of Conoco – Compensation at ~45% of book, 2.5x “earnings”

Even the 2007 Hugo Chavez led expropriations resulted in compensation agreements after 10 years. For instance, Conoco in 2007 took a write-down of $4.5 bln (taking that to approximate book value) and Conoco noted their Venezuelan operations was generating $800 mln in “earnings”. At face value, compensation in this case took just over 10 years and would approximate 45% book value and 2.5x “earnings” (most likely cashflow before G&A and capex given how E&P companies call segment earnings and netbacks)

Handicapping the Downside for PIF - $8.50

Obviously, there are many different ways to handicap the downside in an expropriation scenario and no approach would be precisely correct. Here is how I would frame the downside by being reasonably punitive:

1. PIF operates and generates FCF until the end of 2019 or so

2. Asset gets expropriated and receives compensation based on book value in 5 years

3. The non-recourse debt accrues interest and gets repaid in 5 years

4. 15% discount rate

Based on the above assumptions, I get a PIF value of ~$8.50 per share.

Non Expropriation Scenarios C$18-C$30

Given the single asset nature of PIF’s business and the PPA in place, I am not going to spend a lot of time on PIF’s upside. Practically speaking, I think if PIF were to limit capital expenditures and allow production to decline 2% per annum and the PPA gets terminated in 2029, I get PIF equity value at C$18. If renewed on similar terms, I get C$30.

Alternatively, assuming the Nicaragua government reneges on the PPA and negotiates a power price close to prevailing wholesale prices (i.e. US$80/Mwh), I get a PIF value in the C$12 range using a 15% discount rate.

Capital Allocation Risk/Opportunity

Prior to this week’s Union Energy Group announcement, the biggest question mark for PIF is how management would allocate capital to help protect the downside – i.e. my scenarios could be much worse if management decided to increase capital spending to raise output only to have the asset expropriated. From my conversation with management, it didn’t seem like they were going to increase the dividend payout or buyback shares (I thought buybacks would add a lot of value). They seemed to be open to acquisitions to “diversify” their asset base and I was also concerned that would mean diversification for the sake of doing so at a premium price – particularly when their share price was already depressed, making it harder for acquisitions to make sense.

Union Energy Group Acquisition

Earlier this week, PIF announced the acquisition of Union Energy Group which includes a few Peru Hydro Projects all with PPA’s in place. I don’t have any special insight into the deal but think it’s a positive one in terms of the way its structured (contingent consideration), all have PPA’s in place and appears to be an intelligent way to deploy capital without making a very large and/or expensive acquisition.

With some moving parts, assuming all consideration is paid, it appears PIF would be paying ~ US$60 mln for US$11 mln in EBITDA plus some unknown upside at the Karpa project. Paying an implied 5.5x EBITDA with difficult to quantify upside on Karpa seems like a reasonable capital allocation decision.

To sum it up, I think the UEG deal removed some of the (poor) capital allocation risk of PIF. While the stock is up ~20% from the lows, I think the downside/upside of $8.50/$20 seems pretty attractive. I think the opportunity exists due to: 1) previous negative experience with Ram power and 2) not many investors willing to look past the Nicaragua expropriation = 0 risk.

Catalyst

Time

Execute on UEG acquisition