Description

Polaris Infrastructure Inc. (the “Company,” “Polaris” or “PIF”) is an under-the-radar renewable power producer approaching an inflection point. The Company’s sole producing asset is a geothermal plant in Nicaragua that is six months away from optimization, at which point EBITDA will inflect significantly higher. The opportunity exists because lingering legacy issues have clouded the investment thesis and held back valuation. These issues will dissipate in the near term as free cash flow and dividends increase significantly. We believe Polaris’ shares are worth $34, implying ~100% upside to the current share price. Given rapid consolidation among Canadian and global renewable independent power producers (“IPPs”), we also believe Polaris represents a highly compelling acquisition target, which could drive further upside to the $39 per share range, implying ~130% upside.

Background

Polaris’ sole producing asset is comprised of the San Jacinto-Tizate (“SJT”) geothermal field and power plant, located in northwest Nicaragua. Its production is contracted until 2029 under a power purchase agreement (“PPA”) with the country’s largest electricity distributor, Disnorte-Dissur, which is partially owned by the Nicaraguan government. The PPA is contracted for 72 MW of production, with pricing currently fixed at $121 per MW and subject to a very favourable annual price escalator ranging between 1.5% and 3% until 2029.

The SJT geothermal field is considered one of the highest quality geothermal resources in all of the Americas. The field has had several owners and operators over its life, and its drilling history dates back to the mid-1990s. Polaris’ predecessor, Ram Power (“Ram”), undertook a major expansion of the SJT field and power plant approximately five years ago. However, cost overruns, too much leverage and financial mismanagement resulted in Ram’s equity holders getting wiped out upon recapitalization in May 2015.

Polaris’ recapitalization and events leading up to this event still linger in the minds of Canadian investors, who continue to view the company as a speculative investment. However, Polaris is comprised of a new management team (led by CEO Marc Murnaghan), a reconstituted board, a restructured and significantly reduced debt burden, and the SJT asset requires minimal incremental capital expenditures to optimize production. The SJT power plant already has the capacity to produce the 72 MW of output permitted under the PPA and the field’s 11 producing wells currently produce at a run rate of 60 MW. In other words, SJT is no longer an early stage asset – the “heavy lifting” is over and the asset is entering the cash generation phase.

At 60 MW of production, Polaris currently generates approximately $55mm in run-rate EBITDA and $26mm in free cash flow-to-equity (“FCF”). The Company’s cash flow more than supports its modest leverage, at 2.5x run-rate EBITDA, and its current minimal dividend obligation at $9mm per year. Polaris is currently engaged in a significant drilling program that will likely take production from the current 60 MW to at or near the 72 MW PPA maximum. Management has a drilling success rate of ~70% and each successful production well produces an average of 5 MW. Importantly, every 1 MW of incremental production equates to approximately $1mm in EBITDA – and due to Polaris’ special tax status, $1mm in FCF. At a sunk cost of only $7mm - $10mm per well, the current drill program will likely be a highly accretive exercise. We estimate that once the current drill program is complete and its PPA is maximized, Polaris’ EBITDA run rate will improve ~25%, from $55mm to $68mm and FCF will improve ~50%, from $26mm to $39mm. The increase in FCF represents significant potential upside for Polaris shareholders given the Company’s discounted valuation.

Investment Rationale

Despite being within 6-12 months from asset optimization, Polaris’ legacy lingers in the minds of investors. However, we believe sentiment will inflect positively as the asset approaches optimization. Once investors have a line of sight to a ~50% improvement in FCF and the substantial dividend increase that is expected to follow, Polaris’ valuation will re-rate meaningfully. Based on its prospective run-rate EBITDA and FCF, the market currently values PIF at 5.0x EV/EBITDA, implying a FCF yield of 19%. We believe PIF is worth $34, which is based on an 8.0x EBITDA multiple and 7.5% FCF yield. For reference, Canadian renewable IPPs with average PPA durations exceeding 10 years currently trade at a forward EV/EBITDA in the range of 9x – 14x.

We note that our valuation reflected above does not ascribe any value to Polaris’ ownership of the Casita San Cristobal geothermal concession (“Casita”). Not far geographically from SJT, the Casita geothermal field is regarded as a high quality geothermal resource. However, as the asset is not yet in development, we conservatively value the Casita concession at nil.

Most Canadian renewable IPPs are well-diversified, with producing assets in low-risk developed countries. Without a doubt, a single-asset IPP based in Nicaragua would have a higher risk profile that should be factored into its valuation. We believe that a valuation based on 8x EBITDA reflects an appropriate risk premium as compared to a peer group currently valued in the 9x – 14x EV/EBITDA range.

With respect to jurisdictional risk, it is important to note that Nicaragua is actually considered one of the most stable countries and fastest-growing economies in Latin America. The country has growing energy needs and the government is intent on breaking its dependence on expensive foreign oil by encouraging the development of Nicaragua’s vast geothermal reserves. In order to develop these resources, the government’s policies have encouraged the import of foreign know-how and capital. In fact, the World Bank and other international financial organizations are actively involved in the financing of a number of important projects in Nicaragua’s energy sector – including the Casita geothermal resource, which Polaris owns the concession rights to.

In addition to its compelling value on a stand-alone basis, we believe Polaris is a likely acquisition target. Due to intense competition and a very low cost of capital, it is no secret that returns are compressing rapidly for IPPs in most jurisdictions around the world. This dynamic has led to a wave of consolidation that will likely only accelerate looking forward. In our view, it is only a question of “when,” and not “if” smaller IPPs like Polaris with high quality projects and long-duration PPAs will be rolled-up into larger, diversified players.

Selling Polaris to a larger, more diversified entity with a materially lower cost of capital would unlock material value that could not be realized by Polaris shareholders as a stand-alone entity. Acquirers with diversified portfolios are willing to “pay up” in single-asset/single-country risk scenarios. Public company IPPs in particular can realize significant financial accretion benefits on valuation multiple arbitrage, not to mention the strategic value of diversifying their EBITDA and cash flow profile further. Simply put, rolled up into a diversified portfolio of renewable assets, Polaris’ cash flow is worth more than on a stand-alone basis.

We believe the list of potential suitors to acquire Polaris is long and diverse. Strategic acquirers include both public and private companies with investments in infrastructure assets – the most obvious being the larger public companies in the renewable IPP sub-sector. Financial buyers, such as pension funds, are also in the market to deploy their very low cost of capital to acquire optimized cash-flowing assets with long-term PPAs.

Valuation multiples for precedent transactions are much higher than peer valuations of 9x- 14x EBITDA. For example, the recent acquisition by Innergex Renewable Energy Inc. (“Innergex”) of Alterra Power Corp. (“Alterra”) on October 30, 2017, was announced at an implied valuation of 17x forward EV/EBITDA. Although Alterra is more diversified than Polaris, we would regard Alterra as Polaris’ closest public peer given that the two companies are approximately the same size (in terms of EBITDA) and ~40% of Alterra’s EBITDA is derived from geothermal assets in one jurisdiction (Iceland). In a take-out scenario, we believe PIF could be valued as high as $39, which is based on a 9x EBITDA multiple.

Catalyst

Despite being within 6-12 months from asset optimization, Polaris’ legacy lingers in the minds of investors. However, we believe sentiment will inflect positively as the asset approaches optimization. Once investors have a line of sight to a ~50% improvement in FCF and the substantial dividend increase that is expected to follow, Polaris’ valuation will re-rate meaningfully.