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Steven Li: Mergers Abound in Geothermal

Written by Karen Roche, Publisher

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Source: Interviewed by Karen Roche, Publisher, The Energy Report

Although the Copenhagen Climate Conference proved more a lesson in futility than a blueprint for a global energy shift, investors are already chasing green in 2010. But which alt energy source to invest in? One that runs 24/7, according to Steven Li, Senior VP of Technology & Clean Tech at Raymond James. "With geothermal it's always there, all the time," says Li, who examines key drivers for geothermal development and explains how small geothermal companies become "institutionally relevant" in this exclusive interview with The Energy Report.

The Energy Report: Steven, what do you think are the key drivers long term for the sector?

Steven Li: For most of the companies we cover in the alternative energy field, when you look longer term-say 10 to 15 years-we see an "energy gap" as one of the key drivers.

For example, as more and more coal plants are taken offline because of tougher pollution controls, they have to be replaced by something greener. And so we think that two geothermal companies that we've just launched coverage on, Ram Power Corp. (TSX: RPG) and Magma Energy Corp. (TSX:MXY), which have strong geothermal assets, are very well positioned to take advantage of this coming energy gap in the short term.

TER: The observations that I have heard about geothermal are that it's fairly regionally focused (i.e., only available in certain topographies) and would not be a national solution to coal power. What's your input on that?

SL: The way I look at it is if you drill deep enough anywhere you're going to get a lot of heat, but obviously, there are areas where it is easier and more economical to get the heat out. So, you're right, in the U.S., for example, California is one of the best places to find geothermal assets. There are assets like The Geysers and Imperial Valley where developers have been producing geothermal energy for the past 20, 30 years, and hundreds of production wells have been drilled successfully in these areas.

So, yes, there is some regional focus, but again at the end of it, we are only scratching the surface. The amount of geothermal energy that is available is huge; it's significant. And as you develop these geothermal assets, it can start to represent a bigger proportion of the energy supply globally.

TER: Both Ram and Magma are, in essence, roll-ups of smaller geothermal companies. What advantages does rolling these up have for geothermal? What advantages does it have for an investor in this sector?

SL: It's pretty simple. The bigger you are, the more institutionally relevant you become. It opens up doors to accessing the capital markets. In this case, let's use Ram. Ram was the result of the merger of four companies: GTO Resources Inc. (NEX:GTR.H), Western GeoPower Corp. (TSX-V:WGP), Polaris Geothermal Inc. (TSX:GEO), and Ram Power. I doubt that these four companies by themselves would have been able to raise the capital that is required to move their projects ahead. By merging, you have a company that has a market cap that is very institutionally relevant. And not only that, the other advantage is you get an increased pool of managerial expertise you can leverage across the different assets coming from the different firms.

From the investor's perspective, you have diversification; you're not confined to just one project. You now have multiple projects at multiple stages of development, and again, you know that you're investing in a company that can have access to capital in the future if they need to.

TER: Do you see investment opportunities in these smaller companies?

SL: Yes, but it's riskier, again, for the reasons we just highlighted. There are definitely a number of smaller geothermal resources out there. But a lot of them are single projects and are very small, and you are taking a bit of a chance in terms of "can they access capital?" Keep in mind, these geothermal projects require an enormous amount of capital to bring them to production. So that access to the capital markets is critical.

TER: Is there an investment opportunity for people to come into these smaller ones anticipating that a Ram or a Magma might acquire them?

SL: You know, that's an investment angle that has attracted some investors. You look at all the different small companies, and you make some bets as to who's going to get taken out, which is fine. But when I look at Ram or Magma, for example, I see companies that have very impressive management teams that have done it before, and I see great assets and a relatively very cheap valuation. So, yes, you can play the take-outs, but on the other hand, Ram and Magna would be the lower-risk plays. So, my preference would be to stick to Ram and Magma.

TER: Do you see in the future any potential similar to Ram and Magma as roll-up plays that are starting to develop?

SL: First of all, the market has seen Magma and Ram do this roll-up and come to the market and successfully raise capital. So, yes, I am pretty sure we're going to see a couple more next year. It's a very fragmented space, and you've got many companies out there with assets in different locations. And I could see a couple of them get together and maybe try what Ram or Magma has done. If you successfully put together a group of assets and a quality management team, you do create value.

TER: Do Ram and Magma get any "first mover" advantage of doing the roll-up as compared to those companies who might attempt it?

SL: Absolutely. First of all, as you know, the window is never guaranteed. Ram and Magma seized the window that was open. Magma now has roughly $100 million in cash; Ram, after its raise, has about $130 million in cash. Cash is very critical for these companies. Everyone is still at the stage where they're proving up assets by drilling, so cash is king and that gives them a great first-mover advantage. If you're the next company trying to do the same thing, you can never predict if the investors are going to have a similar appetite. If you come in later, you get compared to Ram and Magma. Because these companies have fantastic assets, the bar is set quite high for the next few companies. Having said that, it can be done, and there are going to be a couple more next year.

TER: Geothermal as an alternative energy sector is relatively small right now. Do you see it growing in importance and, if so, how much will geothermal really represent of energy usage?

SL: It's very small, you're right. You're barely scratching the surface. As a percentage of overall demand it is probably a fraction of a percent. What's going to help geothermal is the fact that geothermal is base load, meaning it's there 24 hours a day, whereas, for example, if you compare it with solar, you only have so much solar power during a day, and with wind, it depends on when you're going to have the wind to drive the turbines.

So, with geothermal it's always there, all the time. When we talk about these coal plants getting closed down and these coal plants were supplying baseload power because they were up all the time, you can't really replace them with wind farms or solar farms. You have to look for another alternative for baseload power, and that's where geothermal is pretty unique.

TER: In the United States, most of the coal-powered plants are on the East Coast and most of the geothermal production is on the West Coast. Because the power can't be transported, how can this be a replacement for coal?

SL: I think over time we're going to start to see power move across states. We're already starting to see some of that between Nevada and California, but you're right, it's not from East to West. It's not going to happen tomorrow but over time, we think geothermal is bound to capture increasing mindshare given its positive attributes and that will drive further advancement in public policy.

And the other thing we really haven't touched on is the number of incentives that are available for geothermal developers. In one of our recent reports we actually looked at the impact incentives have. They amplify the internal rate of return, so it makes it really attractive to develop. So if you take the baseload capacity attributes and add the incentives, I think all of that combined is going to keep driving geothermal development.

TER: And what geothermal opportunities are there in Canada?

SL: Most of the attractive assets are on the West Coast of the U.S.

TER: Can you give us a quick rundown of the differences and similarities of Ram and Magma so our readers can understand those two opportunities?

SL: The way I would differentiate between them is you get more exploration with Magma in the sense that if you look at the land they've been able to accumulate, their land bank is five times the size of Ram's. Now, land bank doesn't guarantee you're going to find something, but what a land bank gives you is the exploration option. So, you have a lot of exploration potential with Magma.

On the other hand, I think Ram is more advanced in terms of development and most of their assets are in regions that are known for world-class geothermal projects. For example, construction has already started on their project in Nicaragua. They've got 70% of steam behind pipe already so it's going to be financed. The financing on the construction is going to be concluded very soon. The construction has started, and you've already proven up the asset and you've got the steam.

A lot of Magma's assets still have to be proven up. So there are different characteristics for the two companies-more exploration with Magma, but higher-quality, and more advanced, assets with Ram Power.

In terms of the cash-both of them are very strong financially because of the financing they just did. And management teams are comparable; Magma has very strong geologists, and Ram's management team is very highly regarded. Much of Ram's key senior management team came over from Ormat Technologies Inc. (NYSE: ORA), which as you know is the market leader in this space, so that bodes well for Ram.

TER: As we look at Magma with more exploration, as some of their properties prove up, is there more upside potential for a Magma than a Ram investment?

SL: Not necessarily. Obviously you create value when you prove an asset but it does not stop there. If you don't have a Power Purchase Agreement (PPA) for example, you don't have a project, right? So, you do need a number of things to come together to have a really valuable asset. You also need to negotiate your project financing so that you can move ahead on a project.

At each and every one of these milestones, the developer can create value-and both Magma and Ram have many of these milestones potentially happening in 2010-2011. At the end of the day, the maximum value is created when you have a producing asset with visible free cash flows. We think overall Ram has significant upside potential but with lower risk given the more advanced stage of its assets.

TER: Very good. Thanks.

Steven Li, CFA, Senior Vice President, Technology & Clean Tech, joined Raymond James Ltd.in July 2001 as an equity analyst. Before joining Raymond James, Steven spent a total of four years as a research associate at three other investment dealers. In StarMine's annual survey of analyst performance for Canada, Steven was the number one Stock Picker for Software and IT Services in 2007. He also ranked 8th in the Top 10 Overall Stock Pickers of 2009 for his coverage of IT Equipment, Software, and IT Services. Steven holds the Chartered Financial Analyst designation and earned a BA and MA from the University of Cambridge (England) and an MBA from York University.

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