Arise Windpower – Traded at a Historically Large Discount, part 1

(Note to the reader: What follows is an analysis of Arise Windpower. Part 1 will contain a qualitative analysis – the why without a lot of numbers, while part 2 will focus more on the quantitative aspects of the case, ie. the numbers in the annual reports, discounted cash flows, etc. If it is too long winded for you there is a summary at the bottom of the page.)

As an investor I am always on the lookout for stocks that are traded at a discount to their intrinsic value. Bargains in other words. Those have become harder to find in the current market where optimism is running rampant and stocks have risen sharply the last five years in spite of a rather bleak world economy. So I have started looking in depressed sectors out of the spotlight of most investors. One such sector is the wind power industry in Sweden. This sector has been hit by low electricity prices the last few years as can be seen here:

2008 2009 2010 2011 2012 2013 2014
Elspot SEK/MWh 491 392 542 378 280 340 320
E-certificates SEK/MWh ? 317 255 187 167 196 180
Total SEK/MWh 709 797 565 447 536 500

The bolded numbers, Total SEK/MWh, are what renewable energy producers (such as wind power producers) receive per MWh and the Elspot prices are what conventional energy sources (such as nuclear power producers) receive per MWh. The prices change every day, so these are averages.

These are unsustainable levels if Sweden is to renew its energy base since very few producers of energy are willing to make the necessary investments in the sector at these prices since they are all bleeding money (except those that have hedged prices in advance when times were better, ie. 2009 and 2010). As a consequence stock prices in the sector have been hit hard since the summer of 2011. Some perhaps way too hard. I believe Arise Windpower, listed on Swedish Stock Exchange in the small cap category, is such a case. Below we can see the development of the Price to Book Value from 2010 when Arise was listed on the Stock Exchange to today, October 9th 2014.

2010 2011 2012 2013 2014
Equity per Share 38,99 37,18 34,46 37,09 34,91
Share Price (yearly average) 48,80 39,70 31,40 24,30 17,20 (cur)
Price to Book Value 1,25 1,07 0,91 0,66 0,49

At the time of writing, Oct 9th 2014, the share price was 17,20. 

“For the price of 49 SEK you are currently getting 100 SEK of value”

The market cap of the company is currently priced at 585 mio. SEK while the book value of equity is at 1,167 mio. SEK. Discounts this large are not unusual for companies in declining industries where the company shows deficits year after year slowly (or in some cases, quickly!) depleting its assets. However, Arise has actually shown a combined profit in the tough years from 2011 to 2013 of 60 mio. SEK. And the cash flows from operations are approximately +200 mio. SEK per year. This is mainly due to successful hedging of prices though and not results that can be expected longer term if electricity prices remain subdued at current levels for the long run.

So what gives? Well, before I get into possible reasons for the large discounts (and whether I think the heavy discount is warranted), let’s take a look at what Arise Windpower actually does…

Arise Windpower’s business model
This is their own brief description of their business model found on their website, http://www.arise.se/en: “Arise is a leading player in the Swedish wind power market. The company’s business idea is to operate as an integrated wind power company managing all stages of the value chain, from project development to sale of green electricity from company-owned onshore wind turbines. Arise´s target is to have completed construction of and manage 1,000 MW of onshore wind power by 2017, of which 500 MW is owned by the company.”

At present wind farms in operation are at 368 MW (of which 102 MW are co-owned), which is quite far from their 2017 goal. The original goal for 2014, set back in 2009 when electricity prices were significantly higher, was to have 700 MW in operation. However, new investment decisions were put on hold because of market conditions. When prices rise above 600 SEK/MWh the company has stated that the expansion plans will resume.

The developments in the energy sector in recent years and the political situation
As of 2013 the total electricity production in Sweden was 150 Terawatt hours (TWh). The power sources were as follows:
Nuclear power 42%
Hydro power 41%
Wind power 7% (9,9 TWh)
Other energy sources 10%

In only a few years wind power production has gone up quite dramatically from 2% to 7% of the total national production. This is due to decisions by the political establishment relying less on nuclear energy and instead shifting more towards renewable energy. The E-certificate system is the instrument the politicians have available to make investments in the sector more attractive.

In February 2014 the Swedish Energy Agency put forth a recommendation for the adjustment of the E-certificate system which would result in higher prices if an agreement is made among the parties in the Swedish Parliament. A decision will be made in 2015. There is usually agreement across the aisle to follow recommendations of the Swedish Energy Agency.

Since the Social Democratic Party and the Green Party came to power the pace toward renewable energy has become even more pronounced. Before the election last month Sweden’s stated goal was to reach 25 TWh from renewable energy (currently at 18 TWh) by 2020. Now the left leaning government has raised the bar and proposed a new goal of 30 TWh by 2020.

Nuclear power
At the same time there are proposals from the government for extra taxes on nuclear power making a shut down of one or two nuclear reactors (of a total of ten) within the next four years a possible outcome. This would increase the spot prices of electricity as there will be less supply.

There are lots of ifs and buts in the discussions so the overall picture is not entirely clear. The right wing parties, along with many industry associations, are sceptical of the pace of which the new government wants to phase out nuclear energy. They fear unstable energy supply and higher prices.

One key question is whether the Green Party can survive as a party and as a member of the government unless they get a win in this, for them, major issue. Before the election they promised voters that at least two nuclear reactors would be shut down if they came to power. Having followed the debate quite closely (from the outside, admittedly), it looks to me like an almost certainty that the E-certificate prices will be raised, possibly by double what it is now (ie. in the 350 SEK/MWh range) as a few independant energy experts have called for. Perhaps the right wing would accept this in exchange for a slower phasing out of the nuclear reactors than what has been proposed.

Being comfortable with uncertainty
A lot of guesstimates and uncertainty here but isn’t that what always comes along with the investment territory? Being comfortable with uncertainty and being able to perform unbiased, coolheaded calculations of different scenarios is what investing is all about after all. Perhaps the best sources of opportunities lie in the fact that most would rather steer clear of uncertainty even when the odds are stacked in their favor?

Back to Arise
Now let’s get back to Arise and the possible implications for the share price for each scenario.
I first became aware of Arise back in May of this year when I learned that Peter Gyllenhammar had bought a stake worth 13 million SEK in the company. I had read a great deal about him in the book Free Capital by Guy Thomas and he is someone who likes to go for deep value (there is an excellent portrait of him in Swedish by a fellow blogger here: http://vardebyran.wordpress.com/?s=peter+gyllenhammar).

However, I never got down and dirty with the annual reports figuring it would take too much time to really figure out the inner workings of this complex industry to be worth my while. Since then the Arise stock has plummeted a whopping 35% from 26,00 to now 17,20. I started reading more about the company in September when the price was around 18,50. At the time it looked like a certainty that the red/green side would win the election which would possibly be giving tailwind to the wind power industry and so I started digging for reasons that stock had tanked so heavily.

So far I have not found anything that could justify shaving off 285 mio. SEK from the market cap. Sure, the numbers in Q2 were a bit worse than expected mainly due to less wind in the quarter and the refinancing of loans might have been a tad more expensive than the market expected but again we are talking very small numbers in comparison to the dive.

No change in long term story
From my perspective the long term story has not changed in any significant way and so the 35% dive seems unjustified. After all, electricity is not a product that is ever unsellable. You don’t need a marketing department, and once wind turbines are erected there is little capex maintainance. So there is a certain safety attached to the investment.

The only major issue that I can see is the uncertainty of the price of electricity and while this is a huge one, and one that fluctuates quite wildly, electricity is tied to the survival of the nation. A bit like the too big to fail banking sector in 2008. If prices dip even further the long term supply of electricity is threatened. So when investments in the sector start to dry up, I believe the politicians will wake up and press a few buttons in order to make investments attractive again.

A few numbers
First, let’s take a look at the downside. I tend to focus on potential catastrophes first. Preservation of capital is vital in the long run and much more important than chasing that extra percentage here and there.

According to my calculations, the point at which cash flow from operations goes in the red occurs when the total price (elspot + E-certificates) falls below 400 SEK/MWh. Net income would be -100 mio. SEK. Even two years like that would spell trouble when it comes to refinancing their loans. Arise might have to liquidate some of their assets at discounts that are larger than the current price indicates. For that to happen two things would have to occur simultaneously. 1) No political agreement is reached on adjustments of the E-certificate system and 2) the economy enters into a recession. The chances of both happening at the same time is extremely low in my opinion.

The point at which Arise net income goes in the red occurs when prices are below 570 SEK/MWh. Still cash flow from operations would be +100 mio. SEK. Due to Arise’s current price hedges 2014 and possibly 2015 look like years in that price range. Not great years at all, and not ones that make Arise overly attractive as an investment. The reason to enter would be because of what, in my opinion, is almost bound to happen from 2016 and beyond.

Political decision in 2015
Parliament will have made energy decisions reaching well ahead into the future in 2015 and the new adjusted E-certificate prices will come into play from 2016 and onwards. I don’t see the combined prices falling below 650 SEK/MWh as that could jeopardize the overall investment plans. And it is quite possible that prices will be a lot higher than that. At 650 SEK/MWh cash flow from operations will be 140 mio. SEK and profit after tax around 40 mio. SEK. At 800 SEK/MWh cash flow from operations will be 220 mio. SEK and profit after tax around 120 mio. SEK.

I will dive deeper into the numbers from the reports and perform a cash flow analysis in part 2. I expect to post it shortly (probably within a week or two after the Q3 report).

Summary

The Bull Case
Significantly higher E-certificate prices on the horizon according to experts. Judging from the political debate it seems almost a done deal across the aisle. Arise, with its portfolio of projects, is well positioned for a quick expansion plan if this was to occur.

– It is difficult to imagine the price of electricity fall below what it is now if Sweden is to reach its long term renewable energy goals. Investments in the sector has come to a halt as a consequence. This cannot go on for much longer and judging from the political debates it won’t.
– 100 SEK of book value is currently selling at 49 SEK. This is historically low. If Price to Book increased modestly from 0,49 to 0,70 as is more normal in the sector currently, the Arise share price would be in the 25,00 area – an increase of 45%. If electricity prices were to rise to average levels a share price around book value seems within reach, which would double the price from current levels. The long term potential is much higher.
Insiders are buying. The CEO bought 60,000 shares (amounting to 1 mio. SEK) in September around the time of the election. Board member Peter Gyllenhammar added to his 500,000 shares position by buying another 250,000 shares on Oct. 2nd (4,3 mio. SEK).
– Will the Green Party survive as a party if nuclear reactors are not being shut down in the near future? If reactors are shut down, the price of electricity will be boosted.

– BlackRock, the world’s largest asset manager, recently entered into an agreement to purchase Bohult windpark (46 MW). This can prove to be very beneficial relationship for the years to come releasing capital to either lower debt, pay out dividends to shareholders or for new projects.

Less important and more short term, but factors nonetheless:
– The water supply for hydro power is below the historical mean currently. Short term this ought to support the elspot prices.
– Will Russia increase the pressure in Ukraine by cutting the gas supply when the winter comes? This could potentially raise elspot prices in Sweden.

The Bear Case
– Forward prices of E-certificates do not agree with my assessment that we will see significantly higher E-certificate prices going forward (www.skm.se/priceinfo/)- in which case the current price to book discount is fair.
– A worsening of the world economy would put pressure on the demand for electricity potentially driving elspot prices down even further. It is my belief though that E-certificate prices would provide a cushion, at least to some extent.
– A reversal in political sentiment towards nuclear power. I really don’t see that coming – the momentum away from it seems way too strong on both sides of the aisle. But perhaps the market sees this question differently than I do, hence the low stock price.
– Rising interest rates at or around the time the loans are to be refinanced. The flip side to that is that it would indicate a stronger world economy and thus almost certainly higher elspot prices.

Part 2 of my analysis can be found here: https://hammerinvesting.wordpress.com/2014/12/28/arise-windpower-a-quantitative-analysis-part-2/

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