Pattern Energy: Strong Tailwinds Going Forward

Pattern Energy Group (PEGI) reported first quarter 2018 earnings last Thursday, May 10, and the company’s results prompted pleasant surprise among investors as PEGI maintained its dividend and reported 10% Y/Y growth in revenues.

Generally, my interest in alternative energy pertains to solar companies, which I believe are positioned for growth due to advancing technology and increasing value to consumers. However, I’m interested in PEGI as a value play. I believe that the company is currently undervalued by the market, which has focused too much on negative aspects of the business and underestimated the positive factors. PEGI continues to steadily grow its renewable holdings, while investors have driven down the stock price due to misplaced concerns about the company’s curtailments and dividend dangers.

Introduction

Pattern Energy Group is an independent renewable energy company based in the United States that operates utility-scale renewable energy projects (primarily wind farms) in the US, Canada, Chile, and Japan. It typically develops renewable projects through its partner Pattern Development, in which it holds a minority ownership stake, subsequently purchasing these projects. The company, founded in 2009, is based in San Francisco and underwent an IPO in late 2013.

In its most recent earnings release, as I previously mentioned, PEGI maintained its quarterly dividend of $0.422 per share, in addition to maintaining its guidance for 2018 cash available for distribution (CAFD) of $151M-$181M.

Continued Growth Through Project Purchases

PEGI’s portfolio of wind farms has nearly tripled since late 2013, and the company’s revenues grew by 16% in 2017, more than doubling its 7% growth rate in 2016. Q1 revenues of $111 million represented a 10% Y/Y increase. The company is steadily growing its business, yet even still the stock is down roughly 85% since its mid-2014 highs. Adjusted for the quantity of shares outstanding of common stock, that means that investors were willing to pay just as much (in terms of market capitalization of ~$1.9 billion) for a company producing $265 million of revenues as one that last year produced over $400 million. Perhaps these 2014 prices were inflated, but I think the selloff has gone too far.

According to its investor relations website, PEGI management plans to double its production capacity by 2020 in terms of megawatt production potential, and I believe the company is set to achieve this goal. Cash reserves of $162 million are available to continue project purchases and capacity expansion, as well as $174 available in a revolving credit agreement that CFO Michael Lyon plans to draw upon in funding new projects. Management expressed a desire on the earnings call not to issue equity in order to fund this planned expansion; investors can rest assured that Pattern has the means to continue expanding and growing its business without diluting shareholders.

Factors Hampering Power Production Set to Ease

In 2016, transmission repair costs for PEGI totaled only $424 thousand. In 2017 transmission repairs totaled more than $19 million, and in 2018 these costs are on track to total almost $28 million. Much of these expenses are related to congested operations in the Panhandle of Texas and with the Electric Reliability Council of Texas (ERCOT), which determines electricity spot prices in the region, and with the restoration of the Santa Isabel project in Puerto Rico. The Santa Isabel project was fully repaired at the beginning of Q1 and is slowly increasing its output to reach full capacity, which should provide added revenues going forward.

On the other hand, CEO Mike Garland indicated that the situation in Texas would not resolve itself any time in the near future, though this reality is already factored into the company’s guidance. Even still, he expects the curtailment of Texas Panhandle power production to decrease as Pattern begins to resolve its issues with ERCOT and bring its projects back online. This should provide a small boost to revenues beyond management guidance in the near-term. In the long term, I expect these issues to be resolved and for Texas Panhandle production to provide a meaningful addition to company revenues not currently reflected by the share price.

In addition to curtailments and transmission repair costs, reduced wind has contributed to depressed revenues in recent quarters. Garland noted that wind production was 7% below PEGI’s long-term average during Q1. Seeking Alpha contributor Justin Law has covered this phenomenon in depth, and his research on US wind speed data allowed him to correctly predict revenues below expectations for the past two quarters.

It’s possible that wind production below the long-term average over a sustained period could be indicative of changing patterns due to emerging factors (read: climate change). However, I believe that a few quarters of underperformance is not sufficient evidence of such changing trends, and I find it safe to assume that wind production will return to normal in the coming quarters. Furthermore, Pattern’s efforts to diversify its holdings geographically will also mitigate wind speed risk. This past quarter the company acquired five projects in Japan, and management maintains long-term plans to begin development of projects in Mexico. The more geographically diverse the company’s holdings are, the less affected revenues will be by wind production variations in specific locations.

Projected Growth Sufficient to Sustain the Dividend

Generally, investors’ biggest concern with PEGI has been maintenance of the dividend and production of sufficient CAFD to avoid cutting the dividend. This quarter, investors showed confidence in Pattern because the company reported CAFD in line with 2018 guidance and did not cut the dividend. I believe that this should be of no concern to investors. The $166 million midpoint of 2018 guidance represents 14% Y/Y CAFD growth over 2017. Increased revenues from production expansion will assist in this growth, and as I discussed earlier Pattern can fund this expansion without dipping into CAFD.

PEGI boasts a dividend yield of roughly 9.25% given the current stock price of $18.21 per share. This incredibly high yield indicates, to me, an artificially depressed share price. Investors should not focus on dividend increases or decreases in the near-term, as management attempts to drive down the payout ratio, but instead focus on the steady growth that Pattern continues to exhibit.

Conclusion

Pattern Energy Group represents a strong value play for investors. The fall in share price over the last few years contradicts the stable growth that management has produced, and continues to produce, through project purchases. The factors depressing Pattern’s power production, such as transmission costs, production curtailments, and below average wind speeds, are likely to ease in the coming quarters. Finally, the company has the means to fund its continued growth without dipping into CAFD, and this stable growth will allow for the company to cover its dividend.

The high dividend yield indicates an undervalued share price. I believe that investors in PEGI should reinvest the dividend and let the company’s steady growth carry its share price higher.

Disclosure: I am/we are long PEGI.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.