Arise Valuation – 50% Target Reached, Now What?

In March I set a 50% year-end price target for the Swedish windpower company Arise and this has now been reached. So is now the time to sell?

In my opinion no. I estimate the risk/reward to be roughly the same as back in March when the price was 12.50 SEK/share (now 19 SEK). Granted, the risk has increased but the upside is also significantly higher now as my calculations further down will show.

And by the way these calculations are based on current market conditions and are not dependent on blue sky scenarios, which would only provide further upside not accounted for here.

The reason for the greater downside is that the price has further to fall in case the electricity market reverts back to the unprecedented slump that plagued it in the period from 2015-2017.

So how have market conditions changed? The basic drivers are:

• The project sales market is stronger than ever. For the last three years projects were generating 1.0 MSEK/MW of profits or less while recent sales ranged from 1.5 MSEK/MW for a project of average quality to 1.1 MSEK/MW for a project of below average quality. And I expect the hunger from institutional investors to result in increased sales of at least 100 MW per year – and more likely closer to 150 MW per year.
• Electricity prices are much higher. Short-term in part because of weather conditions (this effect is excluded from my calculations further down) but more importantly due to what I believe is a sustained trend in CO₂ emission quotas. The two electricity analysts I have spoken to believe this trend is set to continue because of rising environmental concerns.
• E-certificate prices have gone up dramatically. This impacts years 2018 and until 2020. Post 2021 is more of a question mark but in prior periods politicians have stepped up to secure a system that favors a continuation of the renewable build out.

As a result of the above I estimate EBITDA to more than double within the next couple of years from currently 135 MSEK to 275 MSEK. A word of caution though: Other analysts have much lower estimates in the 160-180 MSEK range. Not exactly sure why but I assume this is due to lack of updating to reflect the new reality.

Let me split up how I arrive at that much higher number:

1. 40 MSEK additional EBITDA from e-certificates. Here are my calculations for the years 2018-2020 (results in grey cells). Hedges are accounted for. Post 2021 the numbers are currently uncertain.
2. 40 MSEK additional EBITDA from electricty prices. This is based on current CO₂ quotas alone resulting in 140 MSEK/MWh higher prices (15 Euro higher * 0,9 Euro = price). Per 100 MSEK/MWh in price EBITDA increases/decreases by 34 MSEK. Lots of other factors influence electricity prices but most of those are weather dependent, and others are impossible to predict and model out due to their complexity so this and forward curves are all we can rely on in my opinion.
3. 60 MSEK additional EBITDA from project sales. (100 MW * 1.2 MSEK/MW vs. previously 60 MW * 1.0 MSEK/MW)

The above number is a conservative estimate in my view. I actually think they will sell closer to 150 MW on average per year but I have discounted the number to account for possible permitting/construction problems that may come about. Note though that in its short 10-year history Arise has not encountered construction problems before and only once, with Kölvallen in 2017, have run into permitting problems.

When will the effects kick in?

#1 and #2 have started to kick in but the full effect ought to be evident from the full year 2019. #3 will take effect from late 2019 and onwards and I expect EBITDA to gradually arrive at 275 MSEK for the full year 2020 and be in the range in the yeaers following.

Despite the above mentioned effects starting to kick in from now on my base case for 2018 is only 160 MSEK in EBITDA due to low winds in H1 – and as a kite surfer I know this spring to be an unusually disappointing season! In addition to this project sales that are being delivered this year were sold in 2016/2017 when they had a lower value than those that can be expected going forward.

Valuation and some key metrics

EBITDA 2017: 135 MSEK

Estimated EBITDA going forward: 275 MSEK

Current enterprise value: 1628 MSEK

Estimated EV/EBITDA: 5.92

Price-to-book: 0.82 (Asset-light competitor Eolus Wind: 1.58)

Since 2011 Arise has traded at an EV/EBITDA multiple in the 11-15 range. Companies trading near 5 are often takeover candidates.

As a result of the above estimates I believe the current fair value of Arise to be in the 30 SEK range +/- 5 SEK.

Note that the above is my base case scenario and all of the above numbers are based on current market conditions and prices. Be aware that the volatility has been quite extreme for all three factors historically and that the risk is significant. For that reason I have erred on the side of caution in my estimates, especially when it comes to project sales.

Post Mortem

Let’s say two years from now the above thesis has been proven wrong and the numbers above did not materialize. What killed the case?

• Project sales volume was lower than expected due to institutional investors finding other ways of deploying their capital at a higher rate of return, perhaps helped by higher interest rates. The realized prices were lower than expected because the energy market went into a slump, perhaps as the result of an abundance of natural gas hitting the market from Russia and the US. Also, the politicians failed to move ahead to squeeze out coal via increased CO₂ emission quotas.
• The E-certificate system that was widely expected to get fixed was not fixed and as a result e-certificate prices post 2021 were too low to attract enough institutional investor resulting in lower sales.
• Permits for projects were delayed and/or not granted at all which created holes in the pipeline as happened with the Kölvallen-project in 2017.
• EBITDA Bear Case Scenario: 120 MSEK. If this happens two years out I think the effect on share price will be limited to a downside of approximately 15 SEK per share as debt repayment until then will have decreased the overall risk.

3+ years out:

• Grid connections are being planned to continential Europe and the UK. This will likely lead to Sweden being able to export electricity generated from wind and solar at higher prices.
• Arise may divest some or all of their own windfarms down the road. This would bring down debt dramatically and likely result in a repricing as I believe the debt level is the primary drag on the share price. While this is likely to boost the share price short term I am unsure whether it is the optimal move long term as these assets, especially those in the southern part of Sweden, are becoming increasingly valuable in the current pricing environment. Arise CEO have recently stated they believe their wind farms are likely to have a longer lifespan than the 25 years that are reported in the books.

Never time frame forecasts again!

And by the way let me end this post by apologizing for that 50% year-end target I made in March even though it panned out.

I believe all we can comment on is our estimate of fair value and not what the markets will do, especially short term like within nine months, and for that reason I will refrain from commenting on that going forward. I never do this in written form but on video it slipped out in a moment of uncertainty and regretably I didn’t bother with the editing.

Disclaimer: I do not accept responsibility for losses that are a result of buy/sell recommendations I make. I encourage you to do your own reserarch before making an investment decision. I own shares in Arise.

Arise Q2 – Higher Electricity Prices Appear Sustainable

Although the reported numbers were in the red (due to factors that were known and expected) the quarter was an exceptional one nonetheless as reflected by a 40% increase in the share price.

Electricity prices are booming both on the short and on the long end of the curve. On the short end due to water reservoir levels being low, and on the longer end, which is perhaps more significant, due to rising demand and carbon emission quotas increasing steeply because of an increasing focus on the environment from governments.

The impact of carbon emission quotas on electricity prices

To give an idea of the impact carbon emission quotas have had: Quotas have risen from 7 to 16 EUR since January 1st. For every 1 EUR in quotas the impact on the price of electricity is 90 cent. On a SEK/MWh basis this translates to about 85 SEK of sustained improvement. Given that the forward curve for 2020 indicated a price of 280 SEK/MWh one year ago (when large impairments were taken by Arise!), this now sits at 360 SEK/MWh – a significant boost upwards that is mostly the result of the carbon emission quotas move. The two electricity analysts I’ve been speaking to recently both expect the quotas to go higher still.

The impact on rising e-certificate prices on cash flow

On top of that we have had a boom in the forward prices of e-certificates for 2018-2020 since the start of the year.  I’ve created a spread sheet to calculate how much this means in terms of the net present value of the increased cash flows to equity holders when comparing to the outlook at the beginning of the year.

Given that my assumptions on their current hedging percentages are correct (and their slides today indicate it is in the right neighborhood) I estimate the value to be 80 MSEK. To put this in relation to equity and market cap those are 800 MSEK and 580 MSEK.

See the spread sheet here. Admittedly it is a bit messy (did it for myself initially) and so you may need to have looked at the case in some detail for this to make any sense at all.

Why is this important?

Because their debt level at 1,000 MSEK is relatively high in relation to their past cash flows and now that both e-certificate prices AND recently also electricity prices look to contribute much more cash the debt can be reduced at a much faster pace than previously believed which means the stock has started to reprice. This effect is what makes highly levered stocks go bananas, as has been the case for Arise these last few months. Note that the 80 MSEK number is for e-certificates only. Add to that the impact of the rising electricity prices as well as the increased capacity (and increased willingness of potential buyers) for project sales.

The pipeline is more robust than ever

On top of that the pipeline is looking more robust than ever. With projects of 180 MW, 150 MW, 45 MW and 35 MW ready or close to ready to be sold from now and until the end 2019 (potentially providing 1 MSEK/MW on the bottom line). The Kölvallen project, which initially failed to get environmental permissions, is another 150 MW that could potentially be brought online by 2020/2021.

One of few downsides that I see is that the market could get ahead of itself believing that current electricity prices are likely to stay as high as they are now. While I do think we will see much higher prices than we’ve seen in the last 3-4 years the current 550 SEK/MWh (excl e-cert) in the warmest months of the year is perhaps at an extreme – and if not shareholders will have very nice ride going forward!

Another downside is that the forward prices for e-certificate prices are very low from 2021 and onwards due to the construction of the current system. There is some expectation from industry players that this will be fixed to ensure that the long term build out goals will be reached but this is in no way a certain outcome. There is also some chance that institutional players will invest even without the subsidy from e-certificates if the current electricity pricing environment trends continue via support from carbon emission quotas.

Take profits or  hold for the longer term?

I am personally retaining a core position for the longer term but I have been reducing my holding by about half this past week. I still see the stock as under valued but not by the same extreme amount as when I last wrote about it in my post of April 30th when the price was 12,30 SEK.  I tend to be quite aggressive in my sizing when opportunities like that come along and the risk appear low but the flip side is I am forced to reduce earlier than I would have had my position size been a more standard one.

So I think much of the upside has been realized but that there is still some way to go when having a two year+ time horizon. Given current fundamentals my estimate of fair value two years out is 22-24 SEK per share, equal to 0,9-1,0 of book value (the price is now 17,30 SEK). I arrive at that number partly because I see potential for a reversal of past impairments now that fundamentals have improved and partly because I think the chance of project sale success in the coming two years is high.

I’d appreciate any feedback on what your current view of the stock is and if I have overlooked anything!

Disclaimer
I do not accept responsibility for losses that are a result of buy/sell recommendations I make. I encourage you to do your own reserarch before making an investment decision.

Arise: Price Heads South, Fundamentals Head North – A Few Charts

The share price of the Swedish windpower company Arise indicates a struggling company.

However, the balance sheet is solid after the recent refinancing and the pricing fundamentals have improved significantly this last year, especially since the start of the year. The combination of electricity prices (first graph below) + e-certificate prices (next two graphs) are now consistently above the 500 SEK/MWh range. A level we haven’t seen for the last three years. Finally “in the money”-territory on an allin basis, not just on a cash flow basis as has been the case in recent years. I believe break-even (e-spot + e-certificates) is now around 400 SEK/MWh if we include the recent impairments.

March was particularly cold and was probably an outlier. The price has come down and settled at 400 SEK/MWh for April (still way above previous years: April 2017: 280 SEK/MWh, April 2016: 200 SEK/MWh, April 2015: 240 SEK/MWh).

E-certificate prices have risen sharply in the last few weeks:

Much of this has to do with rising coal prices (and CO2 emission pricing has an impact on this which is why I include a graph of that as well).

The story has changed but the price hasn’t reflected this change, yet!

Wind Power: The Fundamentals in Arise Have Improved

Cliff notes:

• Arise has refinanced their bond = less risk.
• Demand for wind power projects among institutional investors has risen.
• Valuation gap. Trades at half book value while competitor Eolus trades at book value. The size of their pipelines is the same.
• The forward price curve for electricity has improved. Probably a function of the price of coal and carbon emission quotas rising throughout 2017 and continuing in 2018 laying a floor under the price of electricity.

Summary: The fundamentals have improved while the price of the stock has fallen to 12,50 SEK. I expect a rerating to occur and see fair value in the 18-19 SEK range.

Macro Risks & Arise Sold

Macro view

A disclaimer is in order:

1. A broad macro view of the world in all of its beautiful complexity is a really, really dangerous and risky thing to have. Most people are best off simply buying whenever they have spare cash – as long as it doesn’t threaten their personal situation. Never taking chips off the table at anytime in one’s life except when needing it to buy something is almost always the most prudent thing to do in order to secure buying power as we get older and to fight the fact that inflation eats into the real value of our savings.
2. Whenever you or someone you listen to is having a negative and bearish macro view you should be particularly sceptical of that view. Being bearish is more interesting and intellectually stimulating so in that respect it can be rather seducing. The question is whether it is beneficial to the wallet because over the long haul being positive has won in the market by a huge margin historically. It does seem that humanity has a tendency to always overcome hardships. Many would argue though that recent decades have been aided artificially by mountains of debt, and that this is now a major source of our current problems.

The optionality of cash and equivalents in a high-risk setting

The markets seem very sure that 1) giant stimulus packages will be approved by the US congress, and 2) that they will work where everything else has failed. That may happen but it is very far from a sure thing and it won’t happen tomorrow, more like 2+ years down the road. In the meantime we are entering into dangerous territory and the risks are mounting on multiple fronts in the coming years. I realize it is unfashionable to make macro calls – and perhaps rightly so – but I do think prudence is called for considering the following factors, many of which have reached proportions unseen for decades:

List of macro risks:

1. The geopolitical power balance is out of whack which has led to instability not seen since the late 70’s/early 80’s. Could turn out explosive.
2. Rapidly growing tensions within all developed societies. Is this strictly limited to the immigrant situation or is it also rooted in the enormous inequality divide which is stifling consumption and thereby economic growth?
3. Poor underlying demographics in the developed world, which may be a deeper and more fundamental cause for the slow growth of the last 10 years.
4. A possible bubble in the bond market. This is way more dangerous to the world economy than a stock market crash due to the sheer size of the debt market (this could actually be bullish for stocks if money from bonds retreat into stocks). Will haircuts be needed for bondholders? And if so, what happens to the balance sheets that are heavily exposed to that debt?
5. 0% interest rate for 10 years ought to lead to poor capital allocation, which in turn usually leads to recessions or outright depressions.
6. How will the steep mountains of sovereign debt all over the world be paid back? Will central banks continue to stimulate and thereby increase risks of a giant blow-off and/or runaway inflation somewhere down the line?
7. A global trade war seems increasingly likely (given administration picks). This could lead to a global recession.
8. Low capex globally and high share buyback (which is typically a late-cycle phenomenon) means there isn’t much belief in the future. If companies aren’t investing where will future growth come from?
9. Historically high margins. Is mean reversion inevitable or is it a sign of the IT economy being less capital intensive? If the former turns out to be true we are in for a multiple contraction.
10. US jobless claims has fallen to a 43-year low. This is often an early indicator of a downturn and a late-cycle phenomenon since it suggests the potential for further growth is low as there isn’t much slack left. On top of that, even now when unemployment is this low the economy is struggling, which is not exactly a sign of underlying strength.
11. AI could be here much sooner than expected. Some experts talk about a couple of years rather than 10 years. While this will provide opportunities in the long run – is our system adequately prepared for it in the short term?
12. How will the stimulus package get financed? More debt or will Trump find a way to let Chinese money invest in roads, airports, etc.? Perhaps in exchange for not imposing trade tariffs on Chinese goods? Win-win if possible but is strong-arm tactics viable in the longer run…?
13. High valuations among so-called ”safe” dividend stocks due to “reach for yield” desperation. Shiller PE of 28 and the non-manipulative Price/Sales ratio is through the roof at 2,6 (1,6 being the average). Warren Buffett’s favorite indicator Total market cap/GDP is also blinking red. This is currently at 127%. Based on historical averages a fair valued market would be at around 85-90%.
14. Trump being Trump.

The bullish arguments that I see:

1. A giant stimulus plan corresponding to 2,5% of GDP over a 10-year period in the US ought to move the needle IF it indeed is approved. And if Germany picks up the mantle and does the same if could have a big effect. It is also a huge gamble because if it doesn’t do much the debt situation will be even more dire as a result.
2. Deregulation and tax cuts may also add some umpph. However, the latter could have a negative effect on long-term growth if much of it is given to the top, which would not do much for consumption.
3. Bond weakness could transform into stock strength as the money leaving the bond market has to go somewhere. If I had to choose, I’d feel safer in the stock market than in the debt (bond) market right now.
4. The possibility of a Trump impeachment would reduce many of the outlier risks. I suspect there will be a huge number of Republicans that will leap at the opportunity to get rid of him if it arises now that they have secured power. And I suspect there will be ample opportunities as the guy is likely to confuse his own financial interests with those of the state at some point.
5. In general I think it is more prudent to move to the emerging world where there is growth potential due to low debt levels as well as lower valuations.

Conclusion

One can argue whether the risk/reward points to a bullish or a bearish view, but one cannot argue against the fact that the risks are high. As a consequence of my own cautious view I have set out to increase the cash position to at least 30% and I am currently looking into gold miners as a potential currency and market hedge. I will probably post something about my findings further down the line.

For Those About to Trump etc.

In my last post I had said I’d write in depth about the US election situation but decided I cannot do it without it quickly becoming a private issue, which isn’t of interest to anyone. So I’ll just quickly say it makes me boil with anger that people chose untruth and unchecked aggression and that they were willing to put on a big gamble that will undoubtedly cause a great deal of harm to living beings all over the globe. But one either gets this or one doesn’t and my words won’t make dent of difference.

I hate what happened with uncontrollable anger. So this is my mistake for the year: In order to preserve mental health I will resort to shielding myself from the words of Trump and his lunatics to prevent that anger from taking over, preferring instead to read commentator’s analyses of the situation. As an investor you always want the naked source not other’s interpretations of it so this is a step backwards for me. Hopefully something will come in the way of this presidency so we can move on.

For the record: I was for Bush being elected in 2000 (and against in 2004) so this is not automated knee-jerk lefty speak. I have listened to tons of past interviews with Trump and figure I have a grasp of what the man is made of and it isn’t the material of a man with a grand and carefully thought out vision. His path is fraught with bankruptcies and court battles and there isn’t much else there except the ego’s will to express itself.

Portfolio update – Arise sold

I decided to sell my remaining stake in Arise. I took some chips off following the September spike and now I let go of the rest. The reason being the combination of 1) a collapse in e-certificate prices lately (143 SEK/MWh in October to 69 now) as well as what I regard as a surprising weakness in the electricity spot price (below 300 SEK/MWh for a full week). A combined price below 370 SEK/MWh in wintertime despite extremely low water reservoir levels (low capacity in the system ought to lead to higher electricity prices) while the share price is approaching a three-year high has made me decide to move to the sidelines.

In addition to this there is a bit of uncertainty about the fact that the Kölvallen-project (150-200 MW) has still not received the final permit. It was scheduled to happen in the fall of 2016 and now the decision is expected in Q1.

To be clear it was a close decision to sell and my cautious macro view and my wish to increase the cash position played a part. I still think the share price is a bit lower than fair value even given current circumstances but on the other hand it isn’t as much of a no-brainer proposition for me currently so I elected to monitor the situation from the sidelines and perhaps re-enter at a later time should the outlook as well as the margin of safety become more attractive again.

When I started writing about the stock in October 2014 the stock price was 17,10 (https://hammerinvesting.wordpress.com/2014/10/09/arise-windpower-traded-at-a-historically-large-discount-part-1/). Now it sits at 21,50 for a gain of 26%, which isn’t great for a two and a half year time frame but market beating nonetheless.

The Cat is Out of the Bag – Part 2 (Arise Windpower)

The electricity market in Sweden has been very soft in 2015 due to a number of factors. The biggest contributing factor has been an abnormally wet year increasing the hydropower supply. Other factors: more wind capacity added to the system, a rather slow overall economic recovery, warmer than average temperatures and more than average wind conditions (reflected in the good operating results). In other words, when it comes to electricity prices 2015 has been hit by a perfect storm in almost all respects. In a normalized setting, power prices ought to increase – especially given the fact that four nuclear reactors – 13% of the overall supply – is in the process of being taken out of the system from now until 2020.

As a result Arise Windpower decided to write down their assets by about 10%. In my opinion a bit on the cautious side to do so given that they still have nice hedges in place until mid next year and thus plenty of time to see how the price situation plays out but it is after all a technicality and the market has already discounted the depressed conditions in the price of the Arise shares, which even after the write-down trades at 50% of book value despite a flow of high margin project sales.

Important to note also that about 70% of the production from their co-owned windfarms in Jädraås (about 40% of their overall production) have hedges in the 630-640 SEK/MWh range until the end of 2017 (compared to market prices, including e-certificates, of around 400 SEK currently) thus providing a nice cushion should electricity prices continue to be depressed.

Eolus Wind had written down their assets on Oct. 16th – their write-down was 15%, but I believe their assets are also older on average and thus bought at a time when wind turbine prices were higher. Other wind farm operators have chosen not to write down their assets but they may be forced to do so in the future.

I recently wrote a longer post about the e-certificate situation, thoughts on the future for ocean-based wind farms and possible project sales in the coming years for subscribers on inrater.com and I plan to write a more in-depth post on the overall situation on there soon.

Meanwhile, let’s hope El Nino brings wrath to the Scandinavian winter… May we all suffer a cold and painful winter and may the winds blaze through our lands at violent speeds!

Arise Windpower – a Quantitative Analysis (Part 2)

Back in October I wrote a qualitative analysis on Arise Windpower (https://hammerinvesting.wordpress.com/2014/10/09/arise-windpower-traded-at-a-historically-large-discount-part-1/) – before reading this quantitative follow-up I recommend that you read part 1 first.

I have been hesitant making calls on future electricity prices due to political uncertainty regarding a possible re-election. Since it has now been cleared up that there will be no re-election I feel somewhat more comfortable making these estimates. However, it is important to realize that there still is a lot of uncertainty in the assumptions below.

Since October, there has been some interesting developments:
1) A project with a capacity of 46 MW was sold to BlackRock, one of the largest money managers in the world. The company will receive a healthy profit of SEK 46 million as well as management fees going forward.
2) Due to the current low electricity prices the company has decided to reduce risk by selling three wind parks with a total capacity of 25 MW (total portfolio is 266 MW). They expect to sell these wind parks at prices above book value. On December 3rd the first of those were sold at a price that was 15% above book value. It was the small Stjärnarp wind park with a capacity of 5,4 MW which was sold for SEK 83 million and which had a book value of SEK 72 million (cost 75 million, depreciation 3 million).

Projects sold above book value, while the stock is traded at a 48% discount
The above sales show that even in the current challenging environment where electricity prices are at historically low levels, customers are willing to buy at prices that are above book value. This is not reflected in the current stock price, which is selling at a 48% discount to book value. After these sales the risk in the stock has been reduced significantly and the upside ought to be apparent for investors.

Let’s now take a closer look at the net present value of future cash flows and convert the number to price per share. Below are my assumptions.

Discounted cash flow analysis – assumptions:
– The previous expansion strategy has been put on hold due to lower electricity prices and therefore I will assume no building of new farms. This means Arise will rely on the cash flows generated from existing wind farms as well as projects sold to external parties. Should total energy prices rise to above 700 SEK/MWh it can be expected Arise will again look into expansion. This is an added upside but also one that is impossible to quantify, and so for this analysis I will focus on the current strategy only.
– Arise has sold 5,4 MW recently and aims to sell 20 MW more at a price above book value. This will lower debt from SEK 1,6 billion to around SEK 1,2 billion. Whether or not these sales will materialize, it will not affect the intrinsic value of Arise Windpower by much. It might be slightly higher if these sales do not materialize, however, the investment will also be somewhat riskier.
– Yearly average production: 715 GWh (current) – 87 GWh (sale of 25 MW) = 628 GWh after sale of 25 MW.
– Life span of a wind farm is 25 years. E-certificates are received for 15 of those years. On average Arise’s total wind farm capacity has been in operation for 3 years. That means on average they have 12 years left to receive E-certificates. For the remaining 10 years only elspot prices will be collected.
– For 2015 we already know Arise will receive around 600 MSEK/MWh due to forward price hedging. Very little is hedged after 2015.

– From 2016 and onwards I make the following assumptions as to prices and the likelihood of them occurring:
Scenario 1: Total elspot + E-certificate prices from 2016 and onwards: 450 MSEK/MWh. 2% price increase per year. Probability: 15% (No e-certificate hike + prolonged lower e-spot prices)
Scenario 2: Total elspot + E-certificate prices from 2016 and onwards: 650 MSEK/MWh. 2% price increase per year. Probability: 60% (normalized e-certificate prices + slightly higher e-spot prices but still below historical average)
Scenario 3: Total elspot + E-certificate prices from 2016 and onwards: 800 MSEK/MWh. 2% price increase per year. Probability: 25% (global recovery above expectations)

In terms of free cash flows my estimates for a normal year are as follows – based on previous years and based on a price of 650 SEK/MWh:

– On top of revenue from own wind farms Arise expects project sales of 75 MW on average per year. After the BlackRock deal this seems a reasonable assumption. Total profit after tax for those sales is estimated to be SEK 35 million. Added to that approximately SEK 5 million in management fees per year per project. We don’t know for sure whether Arise will succeed in making these project sales, but due to the recent sales I estimate there is a 75% chance of this happening – so for the numbers I have discounted with this factor.

Given an 8% discount rate, I have calculated the intrinsic value per share to be as follows:

Scenario 1: 13,60
Scenario 2: 31,50
Scenario 3: 44,20

Weighing the different outcomes I arrive at the following numbers:
Intrinsic value: 13,6 x 0,15 + 31,5 x 0,60 + 44,2 x 0,25 = SEK 32,00 per share

The current share price is 16,90. And the current book value per share is 34,90. In other words, the above estimate is still below book value. Considering what recent customers have been willing to pay for Arise’s wind farms it is possible my guesstimates are too conservative. I’d be interested in hearing yours.

Note that when it comes to discounted cash flows it is a case of garbage in, garbage out. And since there is a lot of uncertainty in almost all of these numbers, take it for what it is: Lots of guesses as to possible future outcomes.

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/