Tom Konrad CFA
Disclosure: I have long positions in MCQPF and AQUNF.
Capstone Infrastructure Corporation (TSX:CSE, OTC:MCQPF)
has been trading at a significant discount to its peers
because of a power supply agreement which expires at the end
of 2014. Capstone is seeking a new agreement with the
Ontario Power Authority for its Cardinal gas cogeneration
facility, a process which has taken much longer than management
expected.
The cardinal Cardinal plant currently accounts for about a third
of Capstone’s revenue and a quarter of earnings before interest,
taxes, and depreciation (EBITDA), but two-thirds of distributible
income. The high fraction of distributible income is because
Cardinal’s debt has been paid down over the term of the expiring
power supply agreement. This makes income from Cardinal (and
the terms of a new power supply agreement) crucial to maintaining
Capstone’s dividend.
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In the company’s third quarter conference call, we learned a few
tidbits which point to how and when the negotiations might be
resolved.
Timing
In terms of timing, the Ontario Power Authority (OPA) is expected
to release its new Long Term Energy Plan before the end of the
year. It seems unlikely that the OPA would announce a new
contract with Capstone before releasing the plan, so I expect that
investors will have to wait until 2014 before we have any news on
an actual contract.
The OPA did finalize a 20
year power supply agreement with TransAlta Corporation (TSX:
TA, NYSE:TAC) for that company’s similar gas cogeneration facility
in Ottawa. That facility’s previous agreement was expiring
at the end of 2013. If Capstone’s negotiations follow a
similar pattern, we would expect a new agreement for Cardinal in
the middle of next year.
Likely Terms
TransAlta’s Ottawa power supply agreement is interesting in terms
of its substance, in addition to its timing. Under that
deal, the plant “the plant will become dispatchable. This will
assist in reducing the incidents of surplus baseload generation in
the market, while maintaining the ability of the system to
reliably produce energy when it is needed.”
For similar reasons, the chance of Capstone and the OPA failing
to come to any agreement seems minuscule. The Ontario
government has committed to no new nuclear and an increasing
dependence on renewables and efficiency. No new nuclear
means lower overall supply, and more renewables means more
variable power supplies, adding to the value of flexible plants
such as Cardinal and Ottawa.
The Ottawa agreement provides for TransAltas’s plant to ramp up
and down in response to the needs of Ontario’s power system.
Dispatchable plants receive two types of revenues from the
utility: payment for energy produced, and a capacity payment based
on the plant’s ability to respond to system needs.
Cardinal is also a flexible facility, so it makes sense that
Cardinal’s power supply agreement would also provide for the plant
to become dispatchable. New capacity payments would go some
way to making up for the lost revenue when Cardinal no longer
operates as a baseload facility. In 2012 and 2013, Cardinal
has been generating power nearly flat-out, running at a capacity
factor equal to over 90% of its theoretical maximum.
The capacity factor of dispatchable facilities varies greatly.
”Peaker” plants tend to be relatively inefficient facilities
with high operating costs which operate for only a few hours or
days each year, when load is highest and all other facilities are
already operating. More efficient cogeneration plants such
as Cardinal and Ottawa are typically used to serve intermediate
load. Such plants are dispatched whenever demand is high or
moderate or when renewable power production is low. They are
switched off at times of low demand or high production from
renewables. Such plants usually operate at capacity factors
between 30% and 70%, with more efficient, low-cost facilities
operating at higher capacity factors. Cogeneration
facilities tend to be among the most efficient.
Estimates
I modeled three scenarios for Capstone’s 2015 earnings under a
new power supply agreement. For a worst case, I assumed that
Cardinal would operate at a very low 15% capacity factor. My
“expected” case would have Cardinal operating at a 55% capacity
factor, and my “high” case would have it operating at a 65%
capacity factor.
I then factored in moderate revenue and earnings growth from
Capstone’s many development projects and capital investments to
arrive at some rough estimates of Capstones future capacity to pay
dividends. The company measures this capacity with “Adjusted
Funds From Operations” or AFFO, and aims to pay out roughly 70% to
80% of AFFO as dividends.
Starting with Capstone’s recent share price of C$3.66, I assumed
that management would maintain the current C$0.075 quarterly
dividend through 2014, and pay out 80% of AFFO in 2015.
Although income and AFFO will drop with the new contract, the
market is already pricing in a dividend decrease. Capstone
currently trades at a dividend yield over 8%, while the closest
comparable, Algonquin Power and Utilities (TSX:AQN, OTC:AQUNF,)
yields 5.2%, so I assumed Capstone’s yield would fall to 6% in
2015, given the increased certainty embodied in a new contract.
In my expected scenario, this produced a C$4.70 stock price,
while my worst case scenario had the stock fall to C$3.08, and the
high case produced a stock price of C$5.06. The worst case
scenario produced only a tiny net loss (less than 1%) over the
next two years because of Capstone’s high dividend yield, while
the Expected and High scenarios produced 45% and 55% two-year
returns, respectively.
Conclusion
Ontario’s plans to meet its electricity needs without new nuclear
power, and with the increasing use of wind, solar, and energy
efficiency mean that the flexibility of Capstone’s Cardinal
cogeneration power plant is increasingly valuable. The
Ontario Power Authority is likely to reach a supply agreement with
Capstone to provide for Cardinal to be operated as a dispatchable
facility. Such an agreement is likely to be finalized well
in advance of the expiration of Cardinal’s current agreement at
the end of 2014.
Under such an agreement, Capstone’s income from Cardinal will
almost certainly decline. However, the market currently
seems to be pricing in a worst case scenario under which Cardinal
operates only a fifth of the time. Under a more likely
scenario, Capstone should be able to maintain its current C$0.30
annual dividend. If that happens, the stock should
appreciate for a two year total return of between 35% and 55%.
This article was first
published on the author's Forbes.com blog, Green Stocks on
November 15th.
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