I'd like to thank the analyst who took the time to offer some constructive comments to my article. I posted my responses (high lighted in gray) to his comments.
But first, I want to take the time to make 2 points regarding my valuation, which I did not make clear in my original article.
First, I did not use Present Value of the cash flows in my calculations. Since I was looking ahead roughly 3 years, discounting to present value would not make a material difference in my calculations.
Second, for financial reporting purposes, GAAP requires R&D costs to be treated as operating expenses. However, for the purpose of valuation, it would be more accurate to capitalize R&D costs over the useful life of the product that was a result of the R&D. To state that R&D expenses are opertating costs is to state that they do not create any assets. While I did not capitilize R&D in my calculations (admittedly, I forgot), the amount of R&D the company used has started to escalate in the recent couple of years, and management expects the trend to increase further. R&D in 2005 was less than $1million, but 2006 & 2007 accounted for almost $10.5 million. If that R&D is capitilized, which I think it should be, it would elevate the valuations for OPTT.
Mr. Berenshteyn:
I applaud you for tackling the analysis of Ocean Power Technologies (OPTT). It is difficult to gauge the prospects of a company still under development and by its own admission, still two years from profitability.
I have spent a significant amount of time analyzing this company and others in the alternative energy sector. Let me offer a few points:
1. You begin your analysis with the following assertion: "In order for management’s claims to have any weight, we will have to assume that the cost per kW/hour will be competitive with coal which, depending on the grade, costs between $0.048-$0.055 kW/hour."
You may want to reconsider this line of reasoning in future analyses. While I understand the logic, it misses some very significant points.
First, to an increasing degree, U.S. states are coming under mandates called Renewable Portfolio Standards, which require the utilities to increase their generation of electricity from renewable sources. In spite of the coal industry's efforts to modify its emissions, coal is not clean. Unless I am mistaken, in California, coal is not even an option. Utilities in California are barred from contracting for more power from coal. More states are following California’s lead. Just in case you think resistance to coal is only in California, search for a recent story on the Kansas governor who is blocking construction of new coal plants.
Therefore, using coal as a benchmark and asserting that OPTT's power generation must meet coal's generation costs to compete is an incorrect assumption.
To understand the new paradigm, search for a recent contract by which electric utility Southern California Edison will place 250 megawatts of solar power on distribution centers and warehouse roofs. I can assure you that the solar panels are not generating power at 5 cents per kwh. It is the mandate that the California utilities must generate power from a minimum of 20% renewables that is driving the solar investment.
Second, there is a growing momentum to recognize that the repeated quotation of electricity generation costs from coal at the current “$0.048-$0.055 kW/hour” understates the environmental damage. Add in carbon taxes. Add in carbon sequestration costs. Is generation still at 5 cents? I don’t think so.
Indeed, the increase in the regulation of the coal industry forces costs to increase. Other factors such as high or low BTU levels, sulfur content, and transportation costs would impact final costs of electricity. Forced regulation to adopt improved filter systems which are expensive to make and maintain, and the increase complexity of electricity generation as a result of these systems may add even more costs with the increased downtime if/when these systems fail. However, for the purpose of my analysis, I took a look at the most competitive numbers. If OPTT can approach those numbers, it would help ameliorate uncertainty regarding their ability to compete.
For all the costs coal may face from government regulation, coal power also has many cost saving advantages that Ocean Power Buoy systems do not. For instance, a point that's commonly overlooked is that the infrastructure for coal production already exists. Furthermore, coal does not have the geographical limits that are imposed on Ocean Power’s buoy system, which would rely on adequate sites for deployment (coastal areas conducive to buoys’ function, as well as being close enough to major population centers). This would undoubtedly limit their ability to grow. It should be also noted that energy creation from these buoys’ is a lot less predictable and less consistent than electricity derived from coal - and thus it can be argued that consistent energy creation, like coal, would have more value than comparably priced energy sources that are less consistent, especially in heavily populated areas.
While you are correct in pointing out that alternative energy may have competitive advantages in certain markets, like California, it is not competitive categorically against other energy sources like coal, and may also fall short when competing against other comparable alternative energy companies, which I'll address in more detail shortly.
As for your second point regarding the low energy costs of coal electicity production, I don't think that looking at a geocentric price of coal energy is accurate. While more government regulation would definately increase the cost of electricity generation from coal, many coal power plants around the world are not regulated. On a global basis, coal is a very cheap energy source. But unlike USA, regulation of coal power plants in countries like China is, at best, non-existent and, at worst, not enforced. Since Ocean Power Technologies will be offering their technology abroad, they do have price competition from unregulated coal power plants. This is why I looked at the lowest common denominator when evaluating the energy costs involved. I do think it's important to point out that America is the leading producer of coal (which also means fairly cheap coal for us). However, as a result of the ever-increasing exports to growing countries like India and China, coal prices may inch higher as a result of growing international demand.
2. You base your sales price for an OPTT buoy working backwards from this coal generation cost per kwh. I’ll leave that aside for a moment, to clarify a more important point. I believe you are mistaken that the company can achieve profitability only with production of the PB500 at a production rate of 300 per year. What the company was communicating was that at that rate of production, electricity generation is at 5 cents per kwh, including all costs and profits to OPTT. The company is showing that with the continued scaling of its buoys, it can achieve really low electricity generation costs without assuming an overly aggressive level of production. (Draw a parallel to the wind industry. Do you think the first wind turbines generated power at the current 6 cents per kwh?)
In fact, the company may be able to get to profitability building the earlier generation PB150. At 400 buoys per year, the company estimates an electricity generation cost of 15 cents per kwh. This is without subsidies, incentives, or the investment tax credits and includes a return to OPTT. I am willing to bet that Southern California Edison’s recent solar deal is at 15 cents per kwh or higher. Also understand that the PB150 is already in production.
To reassure myself of my estimates, I did take a look at a similar company to OPTT, which I mentioned in my original article, but I did not include a cost comparison. So, allow me to do so now.
The company I mentioned is Blue Energy Power Systems. They are a private company, so there is less third party information regarding the claims they make on their website. Nevertheless, the claim of Blue Energy is that their technology will approach $0.04 kW/h in costs within the next 6 years. Their approach to generating power is based on a turbine system that generates electricity from current flows, which applies to ocean currents and rivers. This appears to be more superior system to OPTT due to its sustainable power curves, predictable power output, less geographical restrictions, and a non reliance to magnitude and frequency of waves. They would also benefit from the same carbon credits that OPTT is eligible to receive, so comparing costs between these 2 companies would be easier.
Blue Energy Power System is expected to have a competitive capital cost of $1,200 per kWh for large scale facilities, and $3,000 for the mid range system. If we apply those costs to Ocean Power's 500kW buoy's, we'd get a per-buoy cost of $600,000-$1,500,000. My estimate of ~$700,000 in my original article seems to fall on the low end of that range. Of course, the two companies have different techonologies and it could mean that Blue Energy may have a much more expensive system, and that its greater efficiency to a buoy design may compensate those costs. However, if Blue Energy's numbers are accurate, and with the information (un)available at this time, I think my estimates for Ocean Power buoys seem reasonable.
I am not disputing whether or not this technology can be cost-effective – it certainly looks promising, and likely can be cost effective when scaled, assuming the reliability claims are accurate. My doubts come from whether this company can have a return on equity at current valuations, and there are a lot of variables that may prevent this company from being profitable even if its product is a cost-effective means for generating electricity.
3. Also understand that the company outsources production of the buoys with the exception of the control system. This is its standard operating model and therefore, the outsourcing costs are built into the cost assumptions. You made it sound as if the company needed to expand dramatically in order to increase production significantly. You may be overstating the expense required.
Correct, their expansion is not to manufacture all of these buoys themselves, but in addition to the expansion they are undertaking, Ocean Power Technologies will still have to incur the costs associated with more materials, part design and development, transportation, and on-site construction which will be passed onto them from their contractors.
4. Finally, consider that the equity market capitalization is currently less than the total net cash on the balance sheet. This means that the company’s enterprise value is less than zero. In other words, you’re buying the business for nothing, nada, zip. I can assure you that of all the alternative energy plays I have reviewed, this is rare indeed.
If this company is able to follow the development model of the wind industry, i.e. start with a small model then scale the basic technology to larger and larger versions of the initial model, Ocean Power Technologies will reward its investors handsomely.
Yes, it’s trading a book value. But with back log orders at $6.5 million as of last filing, with costs being much higher than revenues, I’d venture to say that at book values, this stock could still be considered trading at a premium. It would bode well for the valuation if there were some indications of future commitments to purchase large orders of their buoys. If that were the case, we could estimate partial payments on construction, and other commitments toward future cash flows. It would also be likely that new debt that they would issue would also be lower in interest, the stock price would probably be higher, etc. As of now, this has not happened. However, management has still re-affirmed their expansion and construction of the buoys. Because of that, I assumed a ‘make now, sell later’ policy when crunching the numbers. This means that OPTT would have to incur the costs (with or without more equity issues and debt) to construct their buoys. Until we can see real demand for their products, which already exist in a functional form, it would be hard to speculate on size of the increased cash flows from operations to adjust the valuation higher.
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