Article (Globe and Mail) featuring a Goodwood Funds’ investment

This power company’s flatlining stock has considerable upside potential

Polaris Infrastructure Inc. could be one of the great turnaround stories of 2016. Fresh from a sweeping recapitalization that eliminated the company’s excessive debt burden, the shares now yield almost 8 per cent and have massive upside if management’s expansion plan pays off. So why is the stock flat-lining? The reason will likely make you want to buy the stock. But first, the background.

Formerly called Ram Power, Polaris built and now owns and operates a state-of-the-art geothermal power plant in Nicaragua. Geothermal power is created by tapping into superheated underground water reservoirs and piping steam to the surface, where it spins turbines that make electricity. The water, once cooled, is pumped back into the reservoir to be reheated by the Earth’s core and then reused, on a continuous basis. The technology is highly reliable and has been around for a long time because as long as you have steam to tap into, it’s a relatively cheap way to generate power.

The company’s former management overspent on both the power plant and the drilling program it engaged in to find wells, and much of the capital they used was debt, which ultimately crippled the company. Last year, Ram had to be recapitalized under new management, a new board and a new name – Polaris. Much of the corporate debt was converted into new shares while the old shares were pretty much wiped out. There are now only about 15 million shares outstanding, which is important for reasons I’ll get to soon.

Polaris’s plant, at San Jacinto, has a contract to sell up to 72 megawatts of power to the national grid operator for set prices (meaning it knows the price it will receive for its product, to the envy of every oil and gas company in the world). The contract includes a guaranteed price increase of 3 per cent a year. Payment is in U.S. dollars.

But the plant is currently producing only 52 megawatts, so there is room for tremendous upside. Polaris, with a cash hoard of $62-million (U.S.) at the start of the year, plans to increase production by drilling three new wells. One has been completed, and it looks to be an average well with an estimated four to five megawatts of output. (The range at the plant is from two to 14 MW.) The second is nearly completed, while the third will be started later this year.

Here’s what’s important to know: Polaris should do about $50-million of revenue this year excluding the impact of new wells. It will do about $40-million of EBITDA (earnings before interest, taxes, depreciation and amortization), and about $12-million of free cash flow. This base of earnings is already funding an annual dividend of 40 cents a share – and it’s paid in greenbacks, which is a nice hedge. These are obviously very attractive margins. But they actually get better.

Each additional megawatt of production represents about $1-million of EBITDA, most of which is free cash flow.

So let’s say Polaris’s drilling program adds 15 MW of incremental power. That’s about $15-million of additional free cash flow, for a total of $27-million, and again, that’s in U.S. dollars.

Polaris has the money to do all this expensive drilling. It also has enough cash in the bank to buy what’s called a binary unit – equipment that increases the efficiency of a geothermal plant – that would increase free cash flow to about $30-million, and the plan is to make that investment after the drilling is done.

So if Polaris were to pay out 70 per cent of its free cash flow in dividends, the stock, purchased today, would yield 25 per cent if these conservative assumptions prove correct.

The downside, meanwhile, seems very limited. In the highly unlikely event that the drilling program flops, I figure the stock goes to $6 (Canadian), compared with about $7 today. If the plan works as expected, the stock could double over the next 24 months. That’s the kind of asymmetry a value investor loves.

From there, I expect either more production growth – Polaris has the rights to another deposit and is in negotiations with lenders to develop it – or a sale of the company, as these assets are highly sought after.

Polaris is a cheap stock, with a market capitalization about $100-million lower than its hard book value. And while some will say the risk of doing business in Latin America is high, Nicaragua is one of the safest countries in the region, with a very stable and business-friendly government.

To circle back to the question of why the stock is stuck in the mud, the answer is that many of the former bondholders, who now own shares, are funds that can’t own equities, so they’re dumping aggressively. But with a small share count, once that selling is done, the stock will begin what I expect to be a sharp upward trajectory. Now is the time to buy it – not after this artificial selling is done.

Disclosure: The author owns shares of Polaris Infrastructure.