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Ormat Technologies Is An Unrecognized Alternative Energy Play

Summary Geothermal is a small but fast-growing and important part of the growing alternative electricity generating space. Ormat is an industry leader with significant new capacity coming online. The Ormat Energy Converter technology is a patent protected process that gives the company a competitive advantage in the space. We believe that ORA will eventually be valued like the high-yielding electric utilities as it boosts its dividend payout with strong free cash flow growth. Ormat Technologies (NYSE: ORA ) is a global leader in geothermal energy technology, which we think will be a net market share adder over the next half decade. The path towards expanded margins and stronger earnings growth has become more clear, which we think should re-rate the shares higher over the course of the next year. We think the company has completed a significant amount of strategic initiatives over the last year which is unlocking substantial shareholder value. Those key catalysts, which we believe should reward shareholders, include: Share exchange completion with Ormat acquiring parent company in order to get listed on the TA-25 Index. Underlying growth in the space should realize a double-digit CAGR through 2020, propelling earnings. Its patented Ormat Energy Converter technology provides a competitive advantage. Company Description The company is the leader in the geothermal and recovered energy power generation business. The company builds and operates environmentally-friendly geothermal and recovered energy-based power plants, typically using equipment that it designs and manufactures. Most of the operating portfolio is in the US, Kenya, and Guatemala. The firm has a ~80% market share in the geothermal binary power market segment. The company has two reporting segments: electricity revenues and product sales. Electricity revenue represents two-thirds of revenue and 63% of operating income. The company has 50 years of experience in the space and owns and operates approximately 650 MW of power generation. (click to enlarge) Source: Corporate Presentation Long-Term Opportunity Potential We think geothermal is an overlooked area of alternative energy investment that holds many of the strong properties that are sought after by both investors and power generation companies. The essential properties of geothermal technology tap the heat from the Earth that escapes through various fissures as gas or water. Hydrothermal geothermal-electricity generation is derived from naturally occurring reservoirs of heat that are formed when water comes in contact with hot rock or through “escaping” heat of 300 degrees or more. The heated water rises to the surface and is extracted through geothermal wells, typically located within a few miles of a power plant. The key is if natural ground water sources and reinjected, extracted geothermal liquids are adequate to continuously replenish the geothermal reservoir creating a long-term renewable energy source. Geothermal in the US currently generates approximately 13 GW of geothermal energy. This is enough electricity to power approximately 20 million US homes, but represents just 0.2% of global electricity generating capacity with very low penetration. In the last year, the globe added 700 MW of additional capacity in 2014. Third-party forecasts as well as the Geothermal Energy Association (GEA) predict 10%-12% annual growth through the end of 2020. Bloomberg predicts that by 2030, capacity will grow to 40 GW, representing 270% capacity growth over the next eighteen years. Even with that massive growth, the percentage of power generated from geothermal would still be less than half a percent. The reason for the growth is the base-load potential of the source, meaning that it has a long-life potential (~30 years) and is cost competitive with coal and gas. Source: Bloomberg Energy Finance 2013 Proprietary Technology In Binary Plants A Differentiator Binary power plants are operated using the Organic Rankine Cycle where heat is transferred to a fluid at constant pressure. The fluid is then vaporized and then expanded in a vapor turbine that drives a generator, producing electricity. The company has proprietary technology that can be used in binary power plants to recover energy generation to capture unused heat derived from the industrial processes. This can be converted into electricity using the Rankine system. Ormat has a proprietary system called the Ormat Energy Converter which fulfills this purpose in both binary and REG systems. The whole system has been designed by Ormat including the turbines, pumps, and heat exchangers, as well as formulation of organic motive fluids, all of which are environmentally friendly. The company also patented and developed GCCU power plants in which the steam first produces power in a backpressure steam turbine and then is condensed into a binary power plant, producing additional power compared to conventional methods. We think ORA’s technology has a number of competitive advantages compared to its competition. Conventional steam plants can consume a substantial amount of water, causing depletion of aquifers. In the US, most of the natural geological geothermal energy plants and sources are in the West, namely Nevada, California, Arizona, Utah and Idaho. These are areas where water is a valuable commodity, meaning water-saving technology is far superior to conventional steam methods. ORA’s binary technology also has lower visual impact which can be aesthetically unappealing to residents in the localities. Traditional steam models have to have large cooling towers which emit exhaust plumes during cool weather. Ormat’s technology does not have emissions when using its geothermal fluid technologies. Other competitive strengths include the ease of operation and low maintenance. This is derived from the lack of contact between the turbine blade and geothermal fluids, which tends to have a corrosive effect. Instead, the company’s technology passes the fluids through a heat exchanger, which creates less friction and can withstand corrosive fluids better. We think its moat and competitive advantages are a strong positive on the shares. Between the focus on geothermal binary and recovered energy generation, ORA’s proprietary energy conversion technology and its global expertise separate it from the competition. Margin Expansion Story Underway The business lends itself to significant scale advantages with margins growing to 36.4% last year and 37.3% over the trailing twelve-month period. EBITDA margins are up to 47.8%, up 1,000 bps over fiscal 2013. We think margins should continue to expand bolstered by the electricity segment which has several natural advantages to scale. Some of that margin expansion will come from stronger pricing per MWh. We think the expansion of new capacity over the next two years along with increased utilization should help the segment achieve 40%+ gross margins on an annual basis. The product segment is also seeing much strong margins growing from 27% to the current 38.4%, a significant increase. The business can see more lumpy margin expansion and contraction depending on product mix and EPC service. We think it’s an important driver of the value-add in the business as it’s far superior to other alternative power companies like solar and wind. State And Federal Push Into Renewables Renewable portfolio goals have been set in 40 states which require state-based utilities to generate or import a certain percentage of their electricity from renewable energy or recovered heat sources. California, for instance, established one of the first renewable portfolio standards which requires 25% of electricity generation and usage by renewable, and 33% by 2020. Another state, Hawaii, has an ambitious goal of achieving 100% renewable energy generation by 2045. Hawaii has a significant amount of geothermal activity which can utilize Ormat’s technology, and we believe that it will be a significant contributor in the portfolio of renewable power generation. As costs of renewable energy generation continues to come down and when factoring in ancillary costs of CO2-emitting power generation, we think states will continue to raise renewable standards and goals towards at least 50%. Depending on the location, geothermal will likely be an important part of that renewables portfolio. Remember, geothermal power generation does not need to be the majority or even one of the top three sources for Ormat to see a significant boost in revenue. The Federal government does not have a set renewable portfolio goal, but through the EPA, has been pushing up renewable usage through the implementation of additional regulations onto CO2-emitting power generation, namely coal. This was done by the Obama administration in 2013 which directed the EPA to create new pollution standards for new and existing power plants. In this clean power plan, the goal is to cut carbon emission from the power sector by 30% below 2005 levels nationwide by 2030. Movement towards renewables, while not explicitly cited, is a key factor in achieving those ends. Valuation The shares amid the global sell-off trade at just 9.6x ttm EV/EBITDA, which we believe is a discount given the shift towards higher-margin electricity segment revenue generation. We used a sum-of-the-parts analysis of the business to more accurately assess the value of the shares. The electricity segment is similar to many of the publicly-traded utilities that are power generators. The only real difference is the source of the power generated coming from geothermal rather than coal or natural gas. Using the public utilities as comps, the shares are trading at a slight discount to others like PPL Corp. (NYSE: PPL ), NRG Yield, Inc. (NYSE: NYLD ), TerraForm Power (NASDAQ: TERP ), and NextEra (NYSE: NEE ), but ahead of some other peers like TransAlta (NYSE: TA ), AES Corp. (NYSE: AES ), and Abengoa (NASDAQ: ABGB ). The peer group comps have a median average of 8.9x, which is slightly ahead of the ntm EV/EBITDA ratio for Ormat at 8.5x. We think that the product segment is holding back the consolidated ratio, but given the growth in the business’s margins, we think that could be changing. In addition, we see the electricity segment as gaining scale which is expanding its margin significantly towards 40%. As such, we do think the consolidated multiple should expand towards 9.0x. We applied a 5.5x multiple to the product segment, which we think is fairly conservative, but given the size of the business, it’s not a significant driver to the consolidated multiple. On the electricity side, the margins should be at least in line with the comps. We could make the argument that the electricity segment should receive a premium valuation and that the product multiple is too conservative. We estimate $285 million in EBITDA net of the company’s Northleaf JV ownership. We think the shares are worth $42 using those fairly low multiples. Conclusion We believe Ormat is an ignored alternative energy company. While the market seems to cater towards the solar and wind companies, we think the geothermal space is actually superior to the economics of those two alternative energy segments. We think the shares are worth approximately $42 and that the long-term trends within the space are very strong. The company is bringing on significant new capacity over the next two years while it becomes more efficient and gains scale, boosting its margins and profitability. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Indicators Of A Good Business

By Quan Hoang I recently had a constructive debate with my friend about the return on invested capital (ROIC). I said that we don’t calculate ROIC for fun; we calculate it to know what return retained earnings can make. High return on retained earnings means good business. He shot back that See’s Candies has little volume growth and it’s still a good business. His point led me to the broader topic of what a good business is. In a nutshell, a good business can create value. In other words, it can generate more than 10 cents for each $ of earnings it retains – assuming a 10% hurdle rate. But there are special cases in which a company can make more profits by retaining zero or negative earnings. Exceptional Businesses Have Negative Invested Capital or Pricing Power One special case is negative invested capital. Omnicom (NYSE: OMC ) is a good example. It pays for advertising spaces slower than it bills clients. Working capital is about -20% of sales. The negative sign means that Omnicom gets 20 cents pre-funding from clients for each additional $ of sales. If growth is stable, a business with negative invested capital deserves a higher than average multiple of EBIT. Another special case is exceptional pricing power. See’s Candies has exceptional pricing power. From 1972 to 1998, See’s Candies raised price per pound by about 6.9% annually. Inflation over this period was about 5.4%. So, pricing power generates about 1.5% real growth each year. That leads to margin expansion. This magnitude of pricing power is rare because the product becomes more expensive relative to a customer’s purchasing power over time. That’s not sustainable in most cases. But See’s Candies has been able to do so for many years. Another good example of pricing power is luxury Swiss watches. Swiss watchmakers managed to reposition mechanical watches from a utility product to an emotional product. But after that repositioning, it’s difficult to raise price faster than inflation. To do so, a brand must move upmarket and become more exclusive. Omega, on the path to regain its past prestige, has raised price from Longines’s price range closer to Rolex’s price range. Without exceptional pricing power, value is normally created through volume growth. Volume growth normally requires additional investment in production/service capacity and working capital. Value is created only if return on investment is high. How to Calculate ROIC A practice that many analysts use is to say that a business is good if it consistently make a high ROIC. Joel Greenblatt’s formula for ROIC is EBIT/NTA. NTA is N et T angible A ssets, which is the sum of net fixed asset and net working capital. There are several versions of ROIC. But all versions use net fixed assets in calculating the denominator. And that creates some controversies. Joel Greenblatt explained why he uses net fixed asset: Why are we taking Net Fixed Assets (NFA)? It is not always right. Say we buy a hotel for $10 and it is going to last 10 years and we write it down over 5 years and now it is at $5. But if this goes down to zero, I might have to invest another $10. This would give me ($5) a skewed return (being too high) because of not considering replacement and reinvestment into the fixed assets. Say you have 100 hotels and they are all on different cycles, then on average, you will be correct in using NFA. 10% of your hotels will be refurbished each year over a 10 year normal cycle. That is my quick and dirty for an ongoing business.” And, Denominator is NWC + NFA – why using net and not gross fixed assets? On average that is the right thing to do. Because in general what happens to your fixed assets, you buy something and you depreciate the assets so the value of your asset goes down, but to maintain your asset, there has to be on-going capex. Depreciation and Capex cancel out (assume Deprec = Maint. Capex). If capex is more than depreciation, then FA will increase accordingly and you will be updated. If you are in expansion mode, you build new stores and the FA balloon before you earn on those assets, so your ROC will decline – so you must normalize or adjust for that. Fixed Assets minus depreciation plus Maint. Capex is why I use a Net number.” There’s some logic in his argument. But he didn’t examine how accurate EBIT/NTA is as a measure of ROIC for an ongoing business. If we own the 100 hotels in his example, we get cash flow roughly equal to EBITDA each year (assuming no tax). 10 hotels are totally depreciated each year. We can choose not to make any refurbishment at all and let EBITDA decline by 10% next year. We can refurbish 10 hotels and maintain EBITDA. Or we can refurbish and build 10 more hotels to grow EBITDA by 10%. In either case, ROIC of each new build or refurbishment will be based on the $10 gross investment in each of these projects because that’s what we have to spend upfront. Let’s take another example. The Fresh Market (NASDAQ: TFM ) spends about $4 million in a new store, which generates about $10 million sales and $1 million EBITDA. TFM remodels its stores every 10 years. The remodel cost is lower than $4 million in real term, but let’s assume the remodel cost to be $4 million. So, annual depreciation is $0.4 million and EBIT is $0.6 million. A very optimistic assumption is that the store requires no remodel. So, the $4 million upfront investment results in $1 million annual cash flow forever. That translates into 25% annual return (25% = ¼). Realistically, there’s remodel cost every 10 years. So, 25% is the ceiling of ROIC. Generally, ROIC is always lower than EBITDA/Gross NTA. (Gross NTA = Gross fixed assets + Net working capital.) A very conservative assumption is that we set aside “DA” each year. In the TFM example, we set aside $0.4 million each year so that after 10 years we have $4 million to spend on remodeling. That way, we’ll have $0.6 million free earnings each year (the “free” part is borrowed from the term free cash flow). So, the $4 million upfront investment results in 15% annual return (15% = 0.6/4). Realistically, we don’t set aside $0.4 million each year but use that money to fund new store openings. So, 15% is the floor of ROIC. Generally, ROIC is always higher than EBIT/Gross NTA. If we open Excel and calculate IRR for various scenarios, we can see that IRR tends to be in the upper end of the range between EBIT/Gross NTA and EBITDA/Gross NTA. The midpoint of the range is quite a good estimate of ROIC. Using EBIT/NTA is dangerous when fixed assets are a big part of NTA. I made that mistake when I first looked at Town Sports International (NASDAQ: CLUB ). Median EBIT/NTA was 20%, which looks good. But median EBIT/Gross NTA was 9% and median EBITDA/Gross NTA was 19%. So, pre-tax ROIC is around 14% instead of 20%. That’s a mediocre return. We must be flexible when estimating return. We have to look at composition of NTA. It’s okay to use EBIT/NTA when PPE is a tiny part of NTA because the error is small. If PPE is a big part of NTA, using the midpoint of EBIT/Gross NTA and EBITDA/Gross NTA is preferable. If receivables are a big component, we should make adjustments. For example, America’s Car-Mart (NASDAQ: CRMT ) has $324 million receivables, $34 million inventories and $34 million PPE. However, Car-Mart doesn’t really lend money. Car-Mart lends cars. So we should adjust receivables to (1-gross margin) * receivables to estimate the total value of the cars it lend and use that number to calculate NTA. A better method to estimate ROIC is to look at the economics of each loan. Return on Incremental Invested Capital (ROIIC) What we really want to know is ROIIC rather than ROIC. We can calculate ROIIC by taking incremental EBIT or EBITDA over incremental invested capital over a 1- to 3-year period. That’s not a good approach. Sometimes a company has excess capacity, so growth doesn’t require fixed investment for a while. Or sometimes a company has excess working capital and it can take capital out. But these examples are short-term adjustments. In the long run, volume growth requires investment in new production/service capacity and in working capital. So, ROIC is a good starting point to estimate long-term ROIIC. Reinvestment in the same business tends to achieve returns similar to past ROIC. That’s why many businesses have ROIC within a certain range. However, we need to make some adjustments to ROIC to have a fair expectation of ROIIC. Margin expansion can make ROIIC higher than ROIC. Margin expansion is usually a result of volume growth that drives down unit cost. For example, when gross margin is high and SG&A is relatively fixed, volume growth will significantly increase EBIT margin. Tom Russo usually uses Brown-Forman to illustrate the concept of the capacity to suffer. Brown-Forman is willing to incur expenses today to build infrastructure for international growth tomorrow. And the next 50,000 bottles it sells will have better margin than the last 50,000 bottle. Frost (NYSE: CFR ) is another good example. Frost’s branches grow deposits faster than inflation. So, operating expenses per $ of deposit declines over time. Gross margin in the banking industry is net interest spread. Net interest spread is influenced by interest rates and demand for loans. It’s cyclical but very stable over a long period of time. So, lower operating expenses per $ of deposits improve ROA. Today, Frost makes lower ROA than it did in the past. But without the impact of low interest rates, Frost should be able to make much better ROA. We must be careful when volume growth is outside of current goodwill. In such case, high ROIC in the past doesn’t guarantee a high return on reinvestment. See’s Candies wasn’t able to grow profitably in other states because it failed to replicate the mindshare it had in California. TFM is a current example. TFM is a gourmet food chain. Consumers shop at traditional grocers most of the time. But in some special occasions, they may go to TFM for very good foods. Consumers on average go to TFM only once a month. TFM wants to be the first choice retailer for “special.” So, unlike other grocers, TFM relies on mindshare instead of habit. TFM is very strong in the Southeast. It got into trouble in recent years when it expanded into new markets. It’s very difficult to create mindshare in a totally new state. But perhaps it’s easier to open the next store in that state because the first store helped build some awareness and word of mouth. Conclusions The term “good business” is perhaps too broad. A firm that achieved high growth and great return but have little growth potential in the future isn’t as good as its past success suggests. Firms that barely made profit in the past might now be done with the investment phase and will enjoy great profitability in the future. What investors care about is perhaps more specific: a good business to buy. I propose 3 indicators of a good business to buy. The first is negative invested capital. The second is exceptional pricing power. The third is high ROIC. Past ROIC is a good benchmark for ROIIC. But to have a fair expectation, we need to consider other factors like whether margin of additional units will be higher and whether volume growth is inside current goodwill. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

Shorting Russia Now Is Not As Rewarding As In 2014

Summary Oil prices have dropped sharply again, similar to late 2014, yet this has been less rewarding for investors shorting Russia. FDI in Russia is projected to increase from its current level of $1.3 billion to $16.2 billion during the 2nd quarter of 2016. The IMF made the following statement: “The recovery in 2016 will be supported by the ruble’s more competitive exchange rate, increasing external demand and normalization of domestic financial conditions.”. Non-alignment in sanctions against Russia is another factor that could decrease the value associated with shorting Russia, even in a low oil price environment. Shorting Russia will not be as rewarding as late 2014. Since late 2014 I have been bullish and bearish on Russia, enjoying the thrill of the volatility of the Direxion Daily Russia Bear 3x ETF(NYSEARCA: RUSS ) and the Direxion Daily Russia Bull 3x ETF(NYSEARCA: RUSL ). With necessary and intensive due diligence and an appetite for risk, the past year has provided opportunity for substantial returns by strategically investing in these leveraged ETFs. The declining price of oil has presented an obvious opportunity to short Russia, although the recent return for investors has been significantly lower. Although sentiment towards Russia has become more bearish amidst low oil prices, I have decided to take a step back and sell the majority of my position in RUSS, only keep the profit invested. This was tough to do, as Citi has projected that oil may drop close to $30/barrel this year , producing an inevitable shock to Russia’s economy. My basis for this decision was a historical analysis of the impact of oil prices on the Direxion Daily Russia Bear 3X ETF. The plunging price of oil in late 2014 sent the Direxion Daily Russia Bear ETF near 200.00 in December of 2014. Now that oil has dropped to its 6.5 year low , the positive impact on the Direxion Daily Russia Bear 3X ETF has been drastically reduced. The fund currently trades at 44.59, a far cry from the high levels experienced earlier this year. RUSS data by YCharts Lower oil prices have been less rewarding for bears Oil prices have dropped sharply again, similar to late 2014, yet this has been less rewarding for investors shorting Russia. (click to enlarge) Source: Trading Economics It will certainly take $30/barrel oil for investors shorting Russia to receive a substantial return, similar to what investors who shorted Russia in late 2014 experienced. I do not deny the opportunity associated with continuing to short Russia in anticipation of lower oil prices, but still decided to step back and take a wait and see attitude, which will most likely result in me not shorting Russia again. Sanctions: Non-Alignment Non-alignment in sanctions against Russia is another factor that could decrease the value associated with shorting Russia, even in a low oil price environment. However, the effects of sanctions have thus far been substantial, as the IMF has projected that sanctions have resulted in Russia’s economy contracting at an additional 1 to 1.5%. In December of 2014, China’s foreign minister Wang Yi made the following statements edifying its non alignment with sanctions against Russia: “Russia has the capability and the wisdom to overcome the existing hardship in the economic situation. If the Russian side needs, we will provide necessary assistance within our capacity.” These supporting views of Russia are also shared by its counterparts Brazil, India, and South Africa. Economic Outlook (click to enlarge) Source: Trading Economics The recent contraction in annual GDP growth will be met with reconciliation, according to the following outlook of the IMF: Growth in Russia’s GDP is projected to contract by 3.6% in 2015, but is expected to recover in 2016. Weak GDP growth of 1.5% is expected. This statement sums up the IMF’s reasoning for the recovery of Russia’s economy. “The recovery in 2016 will be supported by the ruble’s more competitive exchange rate, increasing external demand and normalization of domestic financial conditions.” Increased FDI Inflow Projections My observation of the increased FDI projections for Russia was probably the strongest indicator for me to determine that shorting Russia was no longer as beneficial. (click to enlarge) Source: Trading Economics The projected increased flow of FDI into Russia verifies that the country now has increased investors confidence, unlike late 2014. Trading Economics projects a substantial increase in FDI during the next 12 months. FDI is projected to increase from its current level of $1.3 billion to $16.2 billion during the 2nd quarter of 2016. 3rd quarter of 2015: 167% QoQ growth in FDI projected. 4th quarter of 2015: 14.3% QoQ growth in FDI projected. 1st quarter of 2016: 231.9% QoQ growth in FDI projected. 2nd quarter of 2016: 22.3% QoQ growth in FDI projected. Valuation Case A glance at some Russian ADRS displays how many companies in Russia have been unfairly hurt by sanctions and low oil prices, making them extremely undervalued. I will be watching these companies, based on an initial glance at valuation, although I will need to wait until oil prices settle and the economy of Russia begins to experience moderate economic growth, before feeling confident value investing in Russia. Company P/E P/B Mobile Telesystems Public JSC(NYSE: MBT ) 4.63 1.39 Qiwi plc(NASDAQ: QIWI ) 7.2 4.06 JSC Irkutskenergo(OTCPK: IKSGY ) 6.78 0.51 Federal Hydro-Generating Company(OTCQX: RSHYY ) 3.77 0.14 Rostelecom(OTCQX: ROSYY ) 2.59 0.32 Conclusion Shorting Russia could be rewarding, but I have decided to sell my principal investment, only keeping the profits invested in the Direxion Russia Daily Bear 3X ETF; this is based on the consensus that oil should drop to $30/barrel, and that this provides further opportunity for profit. This decision is not based on my long term bearish view of Russia, but rather the inevitable and sensationalized effect that lower oil prices will have on Russia’s economy. However, I think that the days of shorting Russia and winning will soon be over. Besides, I prefer the simplicity of value investing in high growth countries in Southeast Asia, and do not wish to relegate the art of investing to gambling. Russia is a complicated case for investment, but based on my observation, I am not confident that shorting Russia is a wise endeavor, even though oil prices are sure to be lower in the future. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.