Friday, September 14, 2012

Ormat Under Fire

Ormat Technologies (ORA:  NYSE) produces electricity by tapping into the energy created by thermal properties of rocks deep within the earth.  However, it seems the company is in plenty of hot water above the earth as well.  At least that seems to be the view of readers who sent comments to an article I wrote about Ormat on September 11, 2012 entitled “Is Ormat Misunderstood?”  The article focused on the Ormat’s reported net loss and pointed out the noise in the company’s bottom line from income tax accounting treatments.  I suggested investors focus on cash from operations as a better gauge of operating.

This was apparently just a bit too bullish for some investors who wrote to point out Ormat’s various weaknesses.  For example, the article mentioned that cash flow from operations was vital to Ormat’s continued growth because the company has an ambitious capital spending program.  The article also indicated that Ormat’s internally generated resources are not sufficient to cover capex, i.e. free cash flow is negative, and that the gap must be filled by taking on new debt.  Each investor has a different tolerance for risk.  I was not particularly troubled by a debt-to-equity ratio near the utility industry average.  However, there is at least one Ormat follower out there who is convinced that since the most recent debt issuance to fund capacity expansion in Kenya, Ormat is on shaky ground and has no hope of repaying debt.

When is it appropriate for a utility to deleverage a balance sheet and rely exclusively on retained earnings to finance growth?  The answer is simple  -  when the cost of debt is higher than the cost of equity.  That could happen, say for example, if leverage were so high or cash flows so tenuous that creditors would be willing to lend only at high rates.  Ormat does not seem to be at that point yet. 

This blog presents an inadequate forum to do a "deep dive" into Ormat’s debt and interest obligations.  However, at a “thousand foot level” I note that interest rates on existing long-term debt are between 4.687% on recent issuances and 8.25% on notes issued in 2004.  At the beginning of the year the company estimated interest payment obligations on existing long-term debt, which was near $1.0 billion at the end of June 2012, would be near $59.0 million for the full year 2012.  Ormat’s EBITDA (earnings before interest depreciation and amortization) was $193.0 million in the most recently reported twelve months and it looks promising for EBITDA to top $200 million for the year 2012.  This represents an interest coverage ratio of 3.4 times the long-term debt interest obligation, well above limits set by any of the company’s disclosed debt covenants.  Total interest is covered 2.9 times, which is on par with the industry coverage ratio. 

If an investor is happy performance near industry averages then Ormat is doing fine and taking on new debt to finance new obligations should not present undue risk.  Perhaps a more important question is whether the capital structure of Ormat is in the way of a fatter dividend.  This is a point made by neither the bullish nor the bearish detractors of my Ormat article (Surprisingly, I heard criticism from both).

The average payout ratio in the utility industry is near 60%.  Ormat is plowing most of its money back into the company for the sake of building new geothermal facilities.  Operations generated $132.7 million in cash in 2011.  The company paid $5.9 million for dividends and used what was left over to finance part of the $269.7 million it invested in new plant and equipment.  Anyone considering a long-position in ORA should be clear on their investment objective.  If a strong cash flow in the form of dividends is a priority, it is probably best to keep looking. 

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.


1 comment:


Their may be a few companies out their in development stage energy technologies that have something. But for every gem theirs ten or twenty duds.