Geothermal equipment maker and electricity producer Ormat (ORA) announced 4th quarter and 2006 full year results. Based on the run up of the stock in the early week, investors were expecting big things from this report. On Tuesday Ormat was trading at a near 52 week high of $44 per share sporting a market capitalization of $1.5B.

After results were announced Wednesday morning, shares dipped into the $37 a share range shaving market cap to $1.3B. Friday, a modest rally ensued on an upgrade from HSBC securities sending shares back to the $39 range, pretty much where the shares have been trading for the last year. Interestingly, enterprise value for the company is pegged at $1.8B so even at $44 per share, the issue was trading at a discount of $6 per share from enterprise value.

Let’s take a look at the earnings to see what we can uncover about Ormat. For the 4th quarter, the company recorded revenue of $66.7M, up from $58.8 million a year ago. Net income was $4.2M up from a loss of $5.1M a year ago, that’s a $0.28 per share swing year over year. For the year, revenues were $268.9M up from $238M a year ago and net income was $34.4M up from $15.2M a year ago. The board of directors declared a $0.07 per share dividend as well. That’s pretty impressive performance, so why did the shares get hammered?

I think it comes back to two issues: debt levels and strategy implementation. The debt is pretty straight forward, Ormat has taken on $500M in debt to finance it’s electricity generation business. Geothermal plant construction is a capital intensive business that involves the expense and risk of petro-chemical like drilling with the infrastructure requirements of traditional power plant construction. Consequently, the debt tends to be more expensive than tradition power plant construction and there tends to be alot of it per megawatt of capacity. During 2006, Ormat added 51 MW of generation capacity, bringing its total output to 377 MW.

This is a nice segue into the second issue, strategy implementation. Ormat has traditionally been a product company producing the equipment necessary to harvest power from geothermal resources. In particular, Ormat has demonstrated leadership in organic rankine cycle or binary harvest in closed geothermal systems. A few years ago, Ormat decided to get into the geothermal electricity production business in addition to its equipment business. This decision had risk of alienating their equipment customers since Ormat was now a competitor as well as a supplier in the electricity generation business.

A look into the Q4 and full year results shows that Ormat recorded equipment revenues of $20.1M and $73.5M respectively. The electricity segment shows results for Q4 and full year of $46.6M and $195.5M respectively. In the forward looking statements management indicated that equipment sales were projected to drop in 2007 while electricity segment would continue to grow. The key question is will electricity grow faster than equipment shrinks? And can Ormat continue to take on debt to finance the growth of electricity segment to fuel that growth?

The beauty of this strategy is that electricity generation is a pretty predictable business. Ormat will enter into longterm power sale agreements with known pricing and will work to control and reduce operating costs to generate predictable results. The equipment business is and will continue to be “lumpy” – dictated by the number of projects underway at any given time and with Ormat’s entry into the generation business, new competitors will appear like United Technologies with their Pure Cycle organic rankine cycle generation units.

So, what’s Ormat worth? That’s a pretty good question. Taking their generation capacity of 377 MW with average sale price of $70 per megawatt hour multiplied by the industry average capacity factor of 90% multiplied by the number of hours in the year (8760,) I would predict revenues in the electricity segment of around $208M for the full year. Management projects that the equipment segment will produce around $68M for the year. This brings projected full year revenues to $276M without the benefit of new capacity impact brought online during the year and any upside in equipment sales. However, it also takes into account a 7.5% decrease year over year in the equipment segment which may not be sufficiently pessimistic given the competitive landscape.

Provided Ormat can sustain current expense levels commensurate with revenue levels, the revenue levels above would yield earnings in the $35.3M dollar range. With a valuation of 50x earnings, which is where Ormat has been trading, that would signal a price of $52.56 per share. However, the projected earnings growth rate of 3% won’t justify that multiple. I expect Ormat’s PE will be begin to fall back toward traditional power producer multiples in the 20x range as growth slows. At a 20x valuation, that indicates a price of $19.83 per share.

If Ormat can show growth in excess of 5%, then I would expect the shares to stay closer to the high side estimate. If Ormat delivers results with 3% or less growth, I would expect quick adjustment to the lower end of the range. My conclusion is that at $35 per share, Ormat is fairly valued given the projected growth rates, risks, debt level, and strategy implementation.


If you liked this entry, Digg It!
Tune: Cold Feet by Albert King
Technorati Tags: Energy | Geothermal | Ormat | Mike Harding Blog