Description

Thesis

·         Pinnacle Renewable Holdings (PL) is a low-cost producer in an oligopolistic and fast growing market. 100% of current production capacity and the majority of associated costs are contracted with high-quality counterparties through 2026

·         Pinnacle trades at under 9x cash flow with less than 2.5x leverage. Earnings are growing and there are significant opportunities for value-creating investment

·         Even in a worst-case scenario shareholders should see a positive return

Oligopolistic and Growing Market

Pinnacle Renewable (PL) provides biomass fuel for utilities in Europe and Asia. Biomass is a renewable, carbon neutral energy source used by world governments to meet their environmental goals. Pinnacle takes byproducts of lumber processing (sawdust and wood shavings) and produces wood pellets that are burned for fuel.  These pellets can be used in converted coal plants and thus often require minimal new infrastructure. Biomass is a cost-effective way to provide renewable baseload power since unlike wind and solar it does not require specific environmental conditions.

Figure 1: Renewable Energy Cost Comparison

The biomass market is expected to grow from 12.9 million tons in 2016 to 29 million in 2021 as new biomass projects come online. As shown below, the UK is currently the largest market followed by continental Europe and Asia. However, rapid growth in Asia should make this market a larger percentage of the industry going forward. Pinnacle is the only producer shipping from the west coast of North America and thus has some advantage in supplying the Asian market.

Figure 2: Market Growth

New biomass generation capacity requires a reliable fuel source and thus new projects are built only after signing fuel supply agreements.  There are only two firms able to economically supply new utility demand; Enviva (EVA) in the south eastern U.S. and Pinnacle in western Canada. Many customers want to have multiple suppliers and will thus award new contracts to both firms.  

Most of Pinnacle’s customers are investment-grade utilities. Contracts are generally 10-15 year take-or-pay agreements with annual escalators. Once contracts are signed, Pinnacle is then able to sign long-term agreements for raw materials and transportation thus creating a highly predictable and growing earnings stream.  

Figure 3: Market Share

Stock is Cheap on Current Earnings and Earnings are Growing

PL trades at 8.8x 2019E cash flow. 100% of 2019E sales and the majority of costs are contracted and thus we can have high conviction in these cash flows. Leverage is reasonable at 2.4x. Current cash flows are somewhat elevated by tax assets which will shield taxes for a couple years. However, even if you assume a normalized tax rate shares only trade at around 10.7x cash flow which is still cheap.

PL effectively has 100% of current production capacity contracted through 2026 (in presentations, a portion of the post-2021 backlog is shown as subject to option renewal. This relates to sales to RWE which has a policy against entering long-term contracts. RWE will almost certainly exercise their option however as they have few alternatives).  All contracts have annual price escalators which will grow earnings even if there is no increase in production. Management indicted that earnings growth from contract escalators alone should be around 2-3% per year.

Figure 4: Pinnacle is Cheap on Current Earnings (2019E)

Significant Opportunities for Value Creating Growth

PL and EVA are the only two low-cost producers able to service new utility contracts. As such, they should supply most of the industry’s growth. Given that all current capacity is fully contracted, any new demand will require new production capacity. Figure 5 below shows the new capacity economics based on Pinnacle’s most recently opened facility in Entwistle Alberta. The last 3 new projects have all been built at about 4.5-5x EBITDA and at these multiples it appears fairly clear that new capacity creates value for shareholders.

Figure 5: Growth Creates Value

Valuation

There are two components to Pinnacle’s value; the current production capacity and new capacity PL will build in the future. To value the current assets we assume a 2% gross profit increase from contract escalators in perpetuity. At a 9% discount rate these assets are worth approximately $663mm or $20 per share.

The amount of new capacity Pinnacle is able to add is of course hard to estimate. However, current industry projections call for total capacity of 36mm MT by 2026 which would imply an average of 1.875mm new tons per year. If Pinnacle were to build 350k tons per year this would be less than 20% of new industry capacity which seems conservative given the current market structure. We believe Pinnacle is able to at add this amount of new capacity in western Canada with minimal infrastructure costs. 350k tons per year with 55% debt financing implies an equity investment of 39mm per year. Using a 9% cost of equity, investing 39mm per year at a 22% ROE implies about $58mm in value created per year.  If you assume this level of investment through 2026 and $50mm in infrastructure costs it would produce an NPV of about $8.15/share. Adding this to the value of the current assets yield a fair value of approximately $28/share or 90% above the current price.

Figure 6: Valuation

Key Risks

There are really two key risks to this investment; regulation and technology.

Regulation – Most renewable energy projects are not cost competitive with fossil fuels and thus owe their existence to government mandates and subsidies. The biggest risk to the current regulatory environment is the expiration of U.K. subsidies in 2027. Biomass accounts for about 23% of the U.K’s renewable energy or 6% of total power. Industry contacts I spoke with expect the subsidies to be renewed in some form, but it is impossible to know for sure.

We are comfortable with this risk because even if the subsidies are not renewed and most of the U.K. market is eliminated, the stocks are not over-valued.  North American producers enjoy a significant cost advantage. As such, even if the market were to shrink dramatically Enviva and Pinnacle could still operate profitably.  Looking the supply curve below, if we assume 5 million tons of demand (almost all the U.K. market) disappeared entirely prices would fall by about $20.

Figure 7: Biomass Supply Curve

A $20 price decrease would decrease gross profit by about 40%. In a worst case scenario we assume that all production other than what is currently under contract is sold at a 40% lower gross margin. This scenario is shown in figure 8 below. Even in this worst case the stock would return a positive 4-5% IRR.

Figure 8: Pinnacle Worst-Case Scenario

Technology –It is possible that new technology could provide a better way to provide renewable baseload generation.  The most likely way this could happen is with new utility scale battery technology. Better batteries would allow wind and solar power to be stored for later use and could thus prove superior to Biomass.

Current battery technology is still far too expensive to compete with biomass. Optimistic forecasts do not project utility scale pricing to become competitive for many years.  Even if the technology does eventually become cost competitive, it will require building significant new wind and solar capacity to replace biomass. In most geographies that use biomass (northern Europe, Japan and Korea), solar power is limited during the winter months and as such requires supplemental generation during periods of seasonally low production.  As such we feel comfortable with this risk.

Catalyst

Contract wins. Earnings growth