Sunday, October 28, 2012

Opportunity In Oversold Capstone Infrastructure

If you look at the chart below, you would probably run and hide under the closest bed – especially if you own this stock:

However, to the speculative small-cap utility and income investor, this maybe just what you are looking for. Founded in 2004, Capstone Infrastructure (MCQPF.PK) is an ex-Canadian unit trust, formerly known as Macquarie Infrastructure and Power. Earlier this year, the company changed from a unit trust, adopting a new name and trading symbol.

Capstone is a merchant power producer with about 190 Mw of production fueled by natural gas, wind, biomass, and solar. The firm recently purchased a 70% interest in Bristol Water, a U.K. water utility, and owns a 17% interest in a Swedish District Heating utility. The following is a breakdown of electric generating capacity by fuel type:

  • Natural Gas – 67%
  • Wind – 12%
  • Biomass – 11%
  • Hydro – 10%

Capstone’s natural gas production is generated at one facility, Cardinal, in Quebec, and utilizes a Purchase Power Agreement with the government of Quebec to buy all the capacity. The current PPA expires in 2014, and negotiations are underway to renew the long-term PPA. The outcome of these negotiations will have a substantial impact on future profitability. There is the rub: A large percentage of capacity tied to this one contract and market conditions are not favorable to an outcome that will lead to higher profitability. Cardinal is expected to generate almost 21% of 2012 EBITDA.

In addition, on Dec. 6, management announced several negative operating. These include higher transportation fees for natural gas, higher capital expenditures for Bristol Water, and the pending recapitalization of the heating district that will shrink interest income. Combined, these are expected to reduce distributable cash flow in 2012. Management has reduced 2012 EBITDA forecast from its previous $140 million to a bit less than $120 million.

During the same announcement, management also made clear the dividend would be cut as a direct result of these factors. In addition, it is anticipated the company will need to raise between $60 and $100 million in capital during 2012, probably through issuance of convertible securities similar to its debentures and preferred shares. Strategically, management postponed final long-term financing for the Bristol Water investment and current capital markets do not seem as encouraging.

Slam! Bam! The stock price shrinks from about $6.50 to $3.10. Looking deeper into the company’s situation makes this sharp decline in price seem somewhat overdone.

Book value of the company is about $5.40 per share. Revised consensus estimates of distributable cash flow for 2012 is $0.68/shr (with a range of $0.50 to $0.93) and for 2013 is $1.12/shr (range $0.50 to $1.18). Adjusted EBITDA margins remain constant at between 30% and 33%. Revenues are expected to climb from $158 million in 2010 to $194 million this year and $343 million next, reflecting the addition of the Bristol Water acquisition. There are 74 million shares outstanding, and current net debt amounts to about $807 million. After a 50% haircut since last week, current market capitalization is $240 million.

Interest expense is forecast to increase from $28 million this year to $63 million in 2012, reflecting higher debt associated with asset purchases in 2011. However, higher depreciation more than offsets interest expense at an estimated $87 million.

The dividend is distributed monthly and is currently paying $0.66/shr annually. Estimates call for a dividend cut to between $0.33 and $0.45 a share by May or June 2012. At current share prices, worst-case estimates should generate an 18% current cash dividend yield until about May, then a 10% yield going forward.

The history of previous Canadian Unit Trusts conversions is playing out again at Capstone. Most all cut their distributions, experienced a sharp decline in share price, then slowly rebuilt investor confidence over the following few years. Of the five-brokerage houses that follow Capstone, three rate it as a “Buy” or “Outperform” and two rate it as “Hold” or “Sector Perform.”

For those who like to play the “what if” game, Capstone may be also be ripe as an acquisition target. After the Cardinal negotiations are complete, Capstone will have a portfolio of premium merchant power and water utility assets supported by long-term PPAs, along with a growing percentage of renewables. Due to the smaller asset base, management and overhead expenses are a higher percent of operating cash flow, and melding the Cardinal facility into a larger company network should reduce costs. More information about Capstone can be found at the company website and the latest investor presentation.

Since the final Cardinal negotiations will not be completed for several quarters, along with uncertainty in future distributions, there will be an overhang on share prices for the next few weeks or months. However, with the advent of tax-loss selling season upon us, and with Capstone a prime candidate ripe for portfolio harvesting of such, current share prices may offer an unusual opportunity. Buying below a $4 threshold could provide speculative utility investors an intriguing potential total stock return.

As always, investors should conduct their own due diligence, should develop their own understanding of these potential opportunities, and should determine how it may fit their current financial situation.

Disclosure: I am long MCQPF.PK.

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