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Alternative & Renewable Energy Alternatives_Cover_2008:Layout 1 8/22/2008 11:13 AM Page 1 Equity Research Industry Report August 2008 Alternative & Renewable Energy The Choice of a New Generation Utilities – Ben Isaacson, MBA, CFA – (416) 945-5310 Alternative & Renewable Energy For Reg AC Certification and important disclosures see Appendix A of this report. The Choice of a New Generation August 2008 The Choice of a New Generation Alternative and renewable energy is not a fad. Nor is it like the dot-com bubble of the early 2000s. It will not disappear if oil and natural gas prices suddenly drop, or if a long-awaited peace deal throughout the Middle East lessens the need for energy security and independence. Rather, alternative and renewable energy is real. It is here to stay, forever. We believe there is no other option for energy-dependent societies and global economies to develop prosperously over the long term. Alternative and renewable energy has become big business, with billions of investment dollars pouring into the sector. In 2007, almost US$150 billion was invested in the sector, and we expect the acceleration to continue, likely surpassing US$175 billion this year alone. In this report, we focus specifically on renewable power generation (and not renewable fuels such as ethanol, biodiesel, or clean syngas). We think it is critical that investors are aware of the drivers impacting the phenomenal growth we expect the renewable power space to realize. We see these drivers of sector growth as strengthening, not weakening. We present outlooks as well as reviews of the market, investment, and technology trends for various renewable power generation fuel sources, including wind, solar, geothermal, run-of-river hydro, biomass, wave, tidal, and ocean power. The carbon challenge has arrived, even if federal, regional, and local carbon legislation has not been finalized. Many companies, including the five Canadian independent power producers on which we have transferred or initiated coverage, are attempting to provide profitable business solutions to this challenge. Not all will succeed. Globally, there are hundreds of emerging renewable power companies, both public and private. As an investor looking to play the theme, the thought of filtering through these companies can be daunting. Since the start of 2008, stock prices within our coverage universe are down over 30%, on average. In our opinion, these equities are mostly oversold, as investors have temporarily stepped back from high- growth/speculative names. On a company-specific level, we believe little has happened to even partially justify such a sell-off. While several renewable project cost-overruns and time delays have occurred, this should be expected, and is a normal part of project development. On a macro level, the global credit crunch has clearly increased future costs of capital for renewable power projects, but, in our opinion, not enough to justify the steep sector sell-off. Were stock prices too high to begin with? Maybe a little, but it appears the euphoria over brag-a-watts is now over. Our coverage universe is, for the most part, unaffected by economic cycles, and therein lies the current opportunity. In most industries, easily comparable financial metrics are both readily available as well as reliable. We find this not to be the case in the renewable power space, and understandably so. Many companies that we have observed in the sector are barely a few years old, typically with negative earnings for the next several years. Some companies won’t even receive one dollar of revenue for at least two to three years out. In this report, we offer clients both time-tested valuation methods as well as a more unique approach to valuing renewable power companies. In addition to providing our outlooks and specific stock recommendations, we trust this introductory report also presents the underlying knowledge, logic, and rationale to support our investment views. 1 Alternative & Renewable Energy August 2008 Contents The Choice of a New Generation 1 Launching Alternative & Renewable Energy Coverage 7 Investment Highlights 7 Short Term Æ Market Weight; Long Term Æ Overweight 8 Valuation Approach 9 Renewable Power Growth Drivers All Strengthening 10 Three Catalysts That Move IPP Stock Prices 10 Execution Is the Largest Risk Facing Independent Power Producers 11 Four “Must Knows” per Renewable Technology 11 Our Top Picks 13 Canadian Hydro Developers Inc. – 1-Sector Outperform, $7 One-Year Target 13 Boralex Inc. – 1-Sector Outperform, $18 One-Year Target 14 Our Top Sector Ideas – And How to Play Them 17 Get in on the BC Hydro Call for Power 17 The Alberta Merchant Power Market Is a Fairly Safe Bet 18 Two Small Hydro-Quebec Wind RFPs 18 Connecticut REC Prices Are Attractive 19 Pay for a Management Team’s Successful Track Record 19 Consider Geothermal Equity Exposure 20 Marine Technologies Are Still Speculative, For Now 20 Keep Solar Equity Exposure Upstream 20 Valuation Methodology 22 We Cannot Justify Using Current Multiples or Metrics to Value Our Coverage Universe 22 Our Approach to Valuing the Sector 22 Discounted Cash Flow (DCF) Analysis – Sum of the Projects 23 Net Asset Value (NAV) Calculation – Our Unique Approach 23 We Don’t Rely on Relative Valuation Metrics, But Here They Are 24 Renewable Energy Demand Drivers Suggest Industry Growth Acceleration Ahead 29 Equity Performance to Date 32 Cap-and-Trade or Carbon Tax? 35 Our Call on the B.C. Call 38 Follow Feed-In Tariff Legislation 42 We Are Bullish on Renewable Energy Certificates 43 Canadian Federal Incentives Support Renewable Growth 44 2 The Choice of a New Generation August 2008 Provinces Also Encourage Renewable Power Investment 45 North American Initiatives Highlight Growing Acceptance of Climate Change Action 51 Europe Leads the World in Renewable Energy Targets 55 Global Investment Trends Support Our Bullish View 59 Boralex Inc. – A Lean, Green, Cash Flow Machine 67 Summary & Investment Recommendation 68 Capital Markets Profile 69 When Will Boralex Need New Equity? 70 We Like Boralex’s Geographic, Technology, and Seasonal Diversification 71 Production Profile & Outlook 73 Getting to 1,000 MW by 2012 77 We’re Bullish on Connecticut’s REC Market 78 A Small Hedge to High French Natural Gas Costs 81 ISO-NE’s Forward Capacity Markets 82 Key Investment Risks 83 French Wind Power Is Booming 85 Upcoming Stock Catalysts & Events 86 Cascades Likely Won’t Divest Its 34% Stake in Boralex 88 What About the Fund? 88 Valuation & Sensitivity Analysis 89 Financial Forecast 92 Management & Directors 99 Canadian Hydro Developers Inc. – The Best Bang for Your Renewable Buck 101 Summary & Investment Recommendation 102 Capital Markets Profile 103 When Will Canadian Hydro Developers Need New Equity? 104 Production Profile & Outlook 106 Alberta Spot Power Price Volatility Increasing… 108 …But KHD’s Proportionate Exposure Should Decline 108 Mixed Reactions on KHD’s Recent Acquisitions 109 Key Investment Risks 110 Upcoming Stock Catalysts & Events 112 Construction Projects & Development Prospects 113 The Value of KHD’s RECs 115 Warming Up to Dunvegan 116 Valuation & Sensitivity Analyses 117 Financial Forecast 120 Management & Directors 126 3 Alternative & Renewable Energy August 2008 EarthFirst Canada Inc. – At Risk: Everything 127 Summary & Investment Recommendation 128 Capital Markets Profile 129 When Will EarthFirst Need More Equity? 130 Key Investment Risks 132 Upcoming Stock Catalysts & Events 135 EarthFirst’s Flagship 144 MW Dokie I Wind Farm 136 Grand Valley 140 EarthFirst’s Other Wind Projects 142 Valuation & Sensitivity Analyses 145 Financial Forecast 147 Management & Directors 152 Innergex Renewable Energy Inc. – PPAs in Hand – Now Execute! 155 Summary & Investment Recommendation 156 Capital Markets Profile 157 When Will Innergex Need New Equity? 158 Production Profile & Outlook 159 Innergex Power Income Fund 160 A Big Day for a Small Company 161 Overview of Projects 162 Key Investment Risks 166 Upcoming Stock Catalysts & Events 168 Our Best Guess on Innergex’s Future PPA Bids 169 Valuation & Sensitivity Analyses 170 Financial Forecast 172 Management & Directors 178 Plutonic Power Corporation – One Goal: Winning Its Next BC Hydro Bids 181 Summary & Investment Recommendation 182 Capital Markets Profile 184 When Will Plutonic Need More Equity? 187 Key Investment Risks 188 The Fall of Europa 189 Share Price Observations – A News-Driven Story 190 Upcoming Stock Catalysts & Events 192 Plutonic’s Flagship 196 MW Toba/Montrose Project 194 Plutonic’s Likely BC Hydro Clean Power Call Bids 196 Valuation & Sensitivity Analyses 198 Financial Forecast 201 Management & Directors 207 Wind Power – An Established & Mainstream Power Source 209 Overview 209 Investment Positives & Negatives 210 Wind Power Market Trends 210 4 The Choice of a New Generation August 2008 Project Economics to Improve, in a Couple of Years 213 Modelling & Sensitivity Analyses of a Wind Project 213 Canada – A Review and Outlook 217 Catalysts for the Canadian Wind Power Market 220 The European Union Is Far More Advanced in Wind Power Development Than North America 221 Wind M&A Activity and Capital Markets Trends 223 Emerging Wind Technologies 226 Offshore Wind Capital Costs Have Not Peaked Yet 228 The Turbine Manufacturer Oligopoly 229 Select Canadian Wind Developer Equities 231 Solar Photovoltaic Power – Shining Bright Post-2013 236 Overview 236 What We Like About the Potential for Utility-Scale Solar PV 238 PV’s Challenges: Cost Reductions Needed in Many Areas 239 Solar Equities: The Rise … 240 … And Fall 240 Testing Ontario’s Standard Offer Contract: Modelling & Sensitivity Analyses of a Solar Project 242 Canadian Content 245 Expect Solar PV Grid Parity in Five to Seven Years 246 Solar PV Trends & Observations 247 Solar Supply/Demand Outlook: Too Many (Silicon) Cooks Spoil the (Investment) Broth 248 Photovoltaics Science & Technology 101 249 Emerging Photovoltaic Technologies & Concepts 253 Select Canadian Solar Manufacturers 254 Run-of-River – Focus on B.C. 261 Overview 261 Terrific Outlook for B.C.
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