Oil Market–Tightness vs Strength There’s A Difference

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Oil bears? Anyone?

Maybe it’s just my feed, but the energy around energy on Twitter (excuse me, “X”) is as bulled up as I’ve seen since, well, the last oil run.

Of course, that run was all about “the war”, whereas this run is all about supply.

The lack there of.

Just last week we had J.P Morgan come out with the obligatory sell side piece titled: “Super Cycle Returns”.  Their case is all about supply, and the problems ahead.

J.P Morgan believes that there is upside for $150/bbl WTI over the medium term.  Their reasoning is 3-fold:

  1. Higher for longer rates driving up cost of funding for new projects.
  2. Companies returning cash to shareholders instead of investing in the ground.
  3. Peak demand and government policy discouraging investment.

These points all have a common theme: less investment leading to less supply.  Higher rates, reluctant boards and unfavorable macro will all contribute.

It is hard to argue with any of the points.  But all of these points were true when oil was languishing at $65/bbl back in June.

I am long oil (in a small way) but after such a big move in crude over a very short time, I feel the need to look at the other side.   We’re all bulled up.  A super-cycle beckons.  What is the bear case?

KEEP ON DRIVING

To me, the single, best summary of the bear case comes (unintentionally) from a tweet from Giovanni Staunovo (@staunovo on X).  Giovanni is a great follow on X for anyone looking for oil market information.  In the tweet below he’s not saying anything bearish, just giving us a chart that states the facts:

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Source: X.com

When I look at this chart of US gasoline demand I’ll tell you what I don’t see.   Growth.

Forget the last data-point (there is some debate whether its accurate and may still be revised up).  Instead, look at the trend.  In the first 8 months of 2023 we are still below 2019 levels, still below 2021 levels, and barely treading water with 2022.

But the US economy isn’t just strong, it’s on steroids.  We just heard that from Fed Chairman Jay Powell last week.   US GDP was 2% in Q1, 2.2% in Q2 and Q3 looks like it could be a barn-burner – with estimates of between 3% and 5%!

A walk around your local mall or a dinner out is all you need to see that the streets are bustling and people are spending.  There is no recession in sight.

Yet the US still can’t break out to new highs on gasoline demand.  Now of course, the US isn’t ALL of global demand, but I’ll touch on the international side in a minute.

THE CRACK BETWEEN THE SPREADS

There is a hint of this divergence in the crack spreads.  Crack spreads are what refiners pay for turning oil into gasoline, diesel, and jet fuel.  Spreads soared in late August and early September, taking most of the refining complex with it.  The crack spread got has high at $40/bbl.

But those spreads have come back down to earth.

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Source: RBN Energy

But that’s not the real story.  The story here has to do with the details.

Distillate (mainly diesel) spreads remain extremely healthy – about $46/bbl. Distillate=business.

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Source: Bank of America Global Research

Gasoline spreads?  Gasoline=consumer. Not so good.

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Source: Bank of America Global Research

Gasoline spreads have dropped precipitously as the summer driving season waned.  While some seasonality is expected, what we are seeing here is far more pronounced.

Is this because we are awash in gasoline?  Well, no.  Actually, the opposite.  Gasoline inventory is bouncing along the bottom of its 5-year range.

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Source: Bank of America Global Research

What gives?  If you have low supply, how come we have low prices?

Look, I don’t know what the market is telling us – or even if it is telling us anything at all.  Maybe we are just seeing extreme seasonality.

What I do wonder is–maybe inventories don’t matter as much as they used to–because the trend in US demand is down.

We are so accustomed to growing oil product demand.  Every year (when there isn’t a recession) demand goes up.

We are dialed into expecting inventories to trend toward the high end of the 5-year average.  You always need more inventory than in the past because demand is always higher.

What if that isn’t the case anymore?   It would be okay to bounce along the bottom of gasoline inventories because next year demand is going to be a little bit less.  The year after – less again.

“EMERGING” UNSCATHED

The bear case for oil is the developed world; OECD demand.  The bull case is emerging markets; non-OECD.

Back to the super-cycle.  The second leg of the J.P Morgan forecast is an expectation of an increase in oil demand of 5.5 million bbl/d by 2030.  That works out to about 0.8mmbbl/per year of growth.

This is a lot less growth than we have seen in the past.  But it is still growth.  With supply looking tipsy, that may be all you need for higher prices.

Where is that growth going to come from?  Rather risky emerging markets.

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Source: J.P Morgan

Emerging markets will account for roughly 2x overall demand growth from 2023-2030 because OECD demand will be falling.

Unfortunately, I have not found a detailed breakdown of that demand growth.  What you can see from the report is that two countries, China and India, are expected to account for 65% of demand growth.

That makes sense and gives us some comfort in the forecast.  This is another one of those China and India stories—Asian industrialization has been happening for 40 years.  We are all familiar with that.

A closer look though leads to some questions.

The contribution from China and India is heavily weighted to 2023 and 2024.   In fact, most of the growth from 2025-2030 is from “other non-OECD” countries.

This is demand from the Middle East, from Asia-ex China (Thailand, Vietnam, Indonesia), from Latin America and from Africa.

That is a story I am less familiar with.

I’m not saying that won’t happen.  But relying on these emerging markets for the intermediate term bull-case is not without risk.

DIESEL KEEPS BURNING

Look, I am trying to point out the bearish factors that are out there.  But I’m not saying that I’m an oil bear.

While gasoline demand and gasoline crack spreads are hinting that some weakness is happening, diesel is roaring ahead.

Also, while the Chinese economy has not strengthened as everyone had hoped, oil demand continues to grow.

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Source: Morgan Stanley

OPEC’s latest estimates for global 2023 oil demand were revised up slightly month-over-month.

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Source: OPEC September 2023 Monthly Oil Market Report

OPEC’s own supply/demand balance is forecasting a 2.25 mmbbl/d increase in demand in 2024.

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Source: OPEC September 2023 Monthly Oil Market Report

This, while at the same time the cartel enforces reduced production levels and pays lip-service to their worries about demand!

HOPING FOR DISAPPOINTMENT

Which brings us to the last consideration: none of the demand concerns matter if supply disappoints us enough.

OPEC+ is focused on price.  Gone are the days where Saudi Arabia “enforced discipline” on the cartel and flooded the market with oil.

Instead, Saudi Arabia seems acutely aware that the good old days are numbered.  They need to make hay while they can.

It is all about supply management.  Keeping prices high enough for a windfall but low enough to keep demand strong.  This is really a bull market in supply management more than oil demand.

OPEC is helped by the shale struggles.

The EIA recently forecast that shale output may decline again in October – the third month in a row.  The US rig count is rolling over again.  And the global economy is proving far more resilient—so far—than anyone might have thought.

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Source: BofA Global Markets

It is easy to forget how helpful low interest rates were for shale in the late 2010’s.  Now interest rates are a headwind to more drilling.

Maybe this dearth of supply that is enough to drive prices higher.  A supply-side squeeze super-cycle?

Maybe.  Just don’t forget that you still need demand.  After all, it is demand that drives the bus.

Each Bear Market Seeds A New Bull Market It Just Needs A Little Sunlight to Grow

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Solar stocks have taken a beating this year.

The Invesco Solar ETF (TAN – NYSE) is down over 35% from its peak.

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Source: Stockcharts.com

Some of the worst performers have been former market darlings like Enphase (ENPH – NASDAQ) and SolarEdge (SEDG – NASDAQ).

Both sit at 52-week lows.  Enphase is down 60% since the beginning of 2023.  SolarEdge is down nearly 50% in the last month alone!

Looking at these charts you’d conclude that the whole solar business is taking it on the chin.  But a closer look reveals the move has had both winners and losers.

Outperforming this year have been stocks like Array Technologies (ARRY – NASDAQ) and NexTracker (NXT – NASDAQ), both of which are up significantly from their spring lows.

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Source: Stockcharts.com

What is the cause of such divergence?

Start with hedge funds.  The hedgies haven’t exited solar stocks entirely.  Instead, they have taken preference of some over others – in particular favoring those exposed to utility scale solar while shunning those that serve the residential solar market.  Some funds are almost certainly going long-short between the two.

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Source: Bank of America Global Research

Hedge funds love Array Technologies and NexTracker, another utility solar play.  Most unloved are the laggards: Enphase and SolarEdge – which just happen to be the names most geared to residential solar installations.

BIG SOLAR UTILITY

The hedge fund preference hints at the market trend.  Utility solar remains strong while residential demand is slow with inventories swelling.

The slowdown in residential solar installs has happened in both the US and Europe.

In the US, residential solar growth has come to a halt due to rising interest rates, lower natural gas prices and California’s NEM 3.0 (NEM stands for net meter monitoring) legislation, which reduced the electricity export price paid to rooftop solar customers–by as much as 75%!!!

In Europe the picture is brighter, with underlying demand growth of 30-40% – but it was expected to be even better.

In Europe, energy shortages led to high prices last winter, which led to a big build in solar module inventory–everyone was expecting customers would flock to solar–maybe a big (60%+) growth year was coming.

When power prices backed off, European solar distributors were left holding the bag full of channel inventories far higher than normal.

With demand weak across the world, does this all mean that solar is dead?

More likely on pause.  Just this week Citigroup described the exhibition floor in Las Vegas at North America’s largest clean energy conference as “standing room only”.

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Source: Citigroup Research

The question of solar stocks bottoming is “when” not “if”.  But finding that bottom has proven extremely painful for investors.

WHEN WILL IT BOTTOM?

SolarEdge CFO Ronen Faier gave a sober assessment at an investor conference recently: we’re not there yet.

Faier said that Europe’s Q3 and Q4 would continue to be weak.  Europe’s inventory problems are being exaggerated by cash flow issues from distributors.  Distributors are delaying orders, even those “that they will need in Q4″ because of their cash crunch.

But this will pass.  By the end of Q4 or at latest Q1 next year Faier believes European inventory will stabilize – with as little as a month on hand.

Meanwhile the underlying market continues to grow at 30% to 40%.  That means the pickup could come quick – as growth asserts itself and distributors expand inventory-days once their cash crunch eases.  This dynamic applies to both inverters and batteries.

In the United States the picture is muddier.  Faier was blunt, saying that “underlying demand is not growing this year”, that it is “maybe even declining” and that the trend could continue into 2024.

That view is also held by Wells Fargo.  Wells expects a 13% decline in residential solar demand in 2024.  The reasons?

  1. Natural gas prices
  2. California NEM 3.0
  3. Interest rates.

The EIA is forecasting a decline in US electricity prices in the US in 2024 due to lower natural gas prices.

This would be the first decline since 2018.  While their forecast price decline is modest – only 1% – residential solar has had a big tailwind for the last 5-years as energy costs have done nothing but go up.

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Source: Wells Fargo

A second headwind comes from California’s new NEM 3.0 legislation, which was put into place April 15th, 2023.  California has been the biggest market for residential solar.

The changes enacted by the California Public Utilities Commission, significantly cut export rates for extra electricity generated by new installations.

NEM 3.0 slashed California’s export rate by about 75% – from a current average of around 30c/kWh to as low as 5c/kWh depending on the time of day.

The result has been a big decline in demand.  Permits for new installations have been declining since the change took effect.  Wells Fargo believes September permits will be down 23% YoY and that the number could increase to -40% YoY by November.

But there is a silver lining.  While California has lowered the average rate paid for solar produced, that rate varies with time of day.  During peak demand times (in the evening) the rate paid increases substantially – to the same level it was in the past.

This strengthens the case for storage.   Enphase is already on it, introducing a new next-gen battery product specifically designed to deliver power into a NEM 3.0 environment.

Also helping the case for storage, both in California and elsewhere in the US, is the Inflation Reduction Act (IRA).   The IRA extends already existing credits for residential solar to include stand-alone storage.

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Source: Solar Energy Industries Association

The other positive (well sort of) is that YoY comps can only last a year!

Wells Fargo believes that once we get past April, the numbers will improve.  In addition to easy comps they expect California installers to figure out how to sell into the new environment.  Wells sees permitting “improving significantly” beginning in April, with recovery to pre-NEM 3.0 levels by October 2024.

For the rest of the US, the final headwind to demand has been rising interest rates.  When and if interest rates decline is anybody’s guess.  What I will say here is that even stabilizing interest rates should help demand.

I wrote about Sunlight Financial (SUNL – NASDAQ) in a blog post a few months ago.  Sunlight is a very beleaguered solar financing company.  They provide credit to homeowners installing residential solar.

Sunlight’s #1 problem has been interest rates.  Not so much the level of interest rates, but the rise of interest rates.

What do I mean?  Sunlight: A. makes loans to homeowners for solar, and B. packages them up into securities and then sells those securities off to investors.

A look at Sunlight’s stock price is all you need to see how that has gone.

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Source: Stockcharts.com

Sunlight got into trouble as rates rose through 2022 and then spreads widened in 2023.   Loans they made a few months before were suddenly worth less because of higher rates.  Sunlight was left holding the bag on loans that they couldn’t sell without taking a haircut.

While it may be too late for Sunlight, it would help lenders like Sunlight a lot if rates and spreads just did nothing for an extended period of time.

UTILITY SOLAR DOESN’T BLINK

The argument that it is the pace of change in interest rates and not the level of rates that matters most is supported by the utility solar market.

While residential solar growth has hit a snag, the utility solar market has kept trucking along.

Morgan Stanley put out a note just this week where they said “developers and EPCs nearly unanimously conveyed a sense of unwavering conviction… for utility scale solar”.

Why is utility solar continuing to fare so well?   Because these larger players still have access to capital and solar is still the cheapest new capacity around.

Power price agreement pricing for new utility solar is significantly better than what is needed to build a new gas co-gen plant.

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Source: Morgan Stanley

FALLING PRICES

Solar install demand and polysilicon pricing have fallen dramatically. Citi pointed out that their discussions with solar module manufacturers indicate that “residential module pricing is down ~50% Y/Y with pricing in the $0.25-0.30/W range for ~370-420W panels.”

Now that’s liquidation!  See this chart of polysilicon pricing, which is down 75% in the last 12 months.

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Source: Bloomberg

You can look at it two ways.  Either “oh my God the sky is falling” or “this is bound to spur more demand”.

Falling module pricing make solar more attractive.  That will set the base for a recovery.  Each bear market is the seed for the next bull run.

Much of the same could be said for the stocks of Enphase and SolarEdge, which have charts that are pretty similar to the module and polysilicon pricing charts above.

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Source: Stockcharts.com

Neither of these stocks has ever been “cheap”.  But after the recent swansong they are getting close.

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Source: Sentieo

Both stocks now trade at multiples below the market average.  In the case of SolarEdge, significantly below.

That doesn’t mean that they can’t get cheaper.  And the solar market has not bottomed just yet.  But it is likely getting close.  A bottom in Q1 2024 seems more likely than not.

If the typical performance of these stocks holds true, they should bottom ahead of that.  Which could be any day – if you can handle the pain.

The “Switch” Behind a Nearly 4X Stock Surge (Since March)

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Pioneer Power Solutions has seen its stock nearly quadruple since March, and investors can be forgiven if they think it’s because of their sexy, mobile EV-charging products.
 

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Source: Stockcharts.com

The stock went ballistic the day the company announced huge Q4 2022 financials—revenue up 172% to $9.5 million, with higher margins YoY.  Most importantly—they reported real profits!

In Q4 22 Pioneer had 10c EPS.  In Q1 EPS remained positive at 1c per share.  CEO Nathan Mazurek telegraphed that Q1 would likely be the weakest quarter for the year.

Pioneer is guiding to revenue of $42 million to $45 million for the full year 2023.  At the midpoint that is 61% year-over-year growth.

The US small cap broker HC Wainwright is forecasting 42c EPS for 2024.  That puts the stock at about 20x earnings.

But the catch here is—their EV product is still REALLY small, and not contributing to the profit story here.

Management has been talking up their new mobile EV charging products, called E-Boost, since mid-2021. 

Could this stock now be something that The Market has searched for—an EV charging company that’s growing AND showing profits?  Isn’t that a Holy Grail for investors?

There definitely is real growth here—but as yet, not so much from EV demand.
 

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Source: Pioneer Power Solutions Financial Statement

Look I get it–electrification / de-carbonisation is probably The Biggest Meme in the investing world right now—from carbon credits to Electric Vehicles to solar power—the scale of this, and the runway (years!) attracts a lot of interest.

And for the last 18 months, Pioneer has been issuing a lot of press releases on their EV charging products.

But as investors got excited about PPSI–other EV charging stories like Blink Charging (BLNK-NASD) and ChargePoint (CHPT-NASD) have been mired close to their 52-week lows. This is CHPT’s chart:
 

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In Q1 23, Blink took an operating loss of over $30 million.  CHPT had an operating loss of almost $90 million. Both of these companies have gross margins in the low 20%’s.  Their operating expenses are as large as their gross revenue.

Maybe Pioneer is somehow different?  Well, yes and no.  They do have an interesting niche in mobile EV charging—and it is growing. 

You see, Pioneer is a two-product story, with their EV charging solution, called the e-Boost, being one of them.

e-Boost is a “mobile, self-contained EV charger” fueled by propane.

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Source: Pioneer Power Solutions Investor Presentation

The key word here is mobile.  These are chargers intended to be used where renewable power sources are not available. And this is a very valid business model—with growth coming in several different niche verticals.

Pioneer launched e-Boost in the first half of 2021.  In Q1 22, they received their first orders.  At the Planet Microcap Showcase in April, CEO Nathan Mazurek said that they had between $1.5 million to $2 million worth of E-Boost units in 2022.

Those orders have continued to come in this year. 

  1. After announcing orders in January for two skid mounted and two trailer mounted units and
  2. then another order in April for a trailer unit purchased by a “major transportation agency”,
  3. Pioneer followed up with a June press release announcing “multiple units” ordered by a “major global automaker”
  4. and a July press release summarizing “several new customers” totalling orders of $6.2 million in the second quarter.

e-Boost seems to be gaining momentum.

Pioneer is expecting e-Boost to contribute to revenue in the second half.  CEO Nathan Mazurek said he is “shooting for $3-$5 million in revenue for 2023” and contribute between 10 to 20% of total revenue during the fiscal 2024.

So where is all this growth and profitability coming from?

 

SWITCHING GEARS HERE–
HAVE YOU HEARD OF WALMART?
 

 
Most of Pioneer’s revenue today comes from an offshoot of their legacy transmission and distribution business.  And this business does have some potentially HUGE growth in it, from some very big customers.

That business sells switchgears. What is a switchgear? 

You aren’t the only one.  I had to figure that out myself.

Think of a switchgear as a power control system.  It regulates power coming from the utility, it prevents surges, isolates it from damage and, if attached to battery solution, switches between primary and second power sources.

That service is becoming MUCH more important in the US, as both winter storms and summer heat stress the electrical grid.  And PPSI’s product suite has a bit of a unique twist in this market too.
 

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Source: Industrial Electric Manufacturing

Physically a switchgear is a box full of switches, fuses, relays circuit breakers and wiring.

Switchgears are not anything new.  Lots of industrial and commercial buildings use switchgears. 

Any business that consumes a lot of power may use a switchgear to manage that power.  Datacenters, shopping malls, office building all may use switchgears.

And hey, switchgears are also an important part of EV charging.  They sit between the transformer and the charger, regulating current and protecting against surges.
 

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Most switchgears are largely commodity products.  There are a ton of companies that make switchgears:
 

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Like I said,. Pioneer’s switchgear product, called E-Bloc, has a bit different spin.
 

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Source: Pioneer Investor Presentation

The E-Bloc is tailor made for the emerging renewable power grid.

E-Bloc is designed to manage complex (read: multiple) power sources.

As CEO Nathan Mazurek described it, “if you’re just a shopping mall or an office building and you’re getting your feed 100% from [a single power source] we have nothing to offer.”  Where Pioneer does have something to offer is if you are a large power consumer that relies on multiple power sources.

That could be a solar installation onsite, a back-up generator, or a battery storage backup.

The E-Bloc is not cheap.  Depending on the size, Pioneer sells them for between $125k and $250k a pop. 

Their customers come from a wide range of industries, from manufacturing businesses to big box stores to utilities.

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Source: Pioneer Investor Presentation

These customers tend to be large, warehouse style building that consume a lot of power, can’t tolerate downtime to the grid and are looking for a solution that can incorporate multiple power sources.

 

E-BLOC’S BIG CUSTOMER–UNVEILED
 

 
Pioneer has had one primary customer that has driven E-Bloc sales over the last few years.

In 2022, Enchanted Rock Electric was 45% of Pioneer’s sales for the full year.
 

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Source: Pioneer 10-K

That number increased as the year went on.  In Q4 2022, Enchanted Rock accounted for 75% of Pioneer’s sales.  In Q1 2023 Enchanted Rock made up 73% of revenue. 

Who is Enchanted Rock?  They are a provider of dual purpose microgrids.  These are essentially power solutions that provide redundancy – often through natural gas generated back-up power.  To manage their multiple power sources, they use e-Bloc.
 

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Source: Enchanted Rock Website

Going through Enchanted Rock’s blog and press releases, you quickly notice the overlap with Pioneer’s contracts.

For example, Enchanted Rock talks here about the RNG microgrid they built for Microsoft.   Microsoft appears to be the large data center customer that Pioneer has talked about. 

One of the first adopters of E-Bloc that Pioneer talked about was a large Texas Supermarket chain. 

The timing overlap suggests that this was another Enchanted Rock customer, the grocery chain H-E-B.

Enchanted Rock has had one particularly large customer.  They talk about that customer, a “National Superstore Retailer”, (though left unnamed) here.   But if you dig enough into articles about the project that Enchanted Rock completed, you learn that the customer was Walmart.

Enchanted Rock sold 60 microgrid ATS units to Walmart.

Those are almost certainly the same 62 store E-Bloc orders that Pioneer announced.
 

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Source: Pioneer Investor Presentation

Mazurek talked about these orders at the Sidoti conference last year:

“The end of December of ’21, we announced our largest order to date from one particular retailer with a targeted 62 stores to go completely to the system. And again, just one retailer is actually planning on taking up to 500 of their 5,000 stores over the next couple of years and developing new and even edgier technology and product with us for the balance of their stores as that continues to develop.

BUT…so far, those additional stores haven’t materialized.  From the Q1 2023 call:

The initial order we announced was for 63 stores, all of which we’ve delivered.  Internally they have released to me that they have designated 1,000 stores for this program.  400 to 500 or so in a more immediate way. 

Our backlog right now reflects 0 additional stores, they haven’t come out with any yet.”


If and when Walmart does come back to order more, it could be huge.

Is it a risk that Enchanted Rock makes up so much of Pioneer’s business?  Well, it certainly makes Pioneer dependent on Enchanted Rock’s success.   But that goes both ways – if Walmart comes back for more orders, it is not necessarily a bad thing.

Mazurek believes that Enchanted Rock will become a smaller part of their business this year and next, before coming back with a vengeance in 2025. 

I took that to mean that to mean that future orders from Walmart may still be some time off.

 

CONCLUSION:
INVESTORS ARE BUYING THE STEAK
NOT THE SIZZLE
 

 
I’m glad I researched this—because the sizzle (EV charging via E-Boost) is different than the steak (E-Bloc / microgrid resiliency).  But both can be growth drivers over time.  For now however, I am not long, but the stock is on my radar.

For now, it is Enchanted Rock and their E-Bloc orders that have driven Pioneer’s revenue growth.

Pioneer operates in two segments.  E-Bloc is part of the Transmission and Distribution (T&D) segment while E-Boost is part of the Critical Power Solutions (CPS) segment.

While both segments contribute to revenue, the largest contribution has come from T&D and E-Bloc.
 

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Source: Pioneer Investor Presentation

e-Boost has not contributed meaningfully to revenue yet.  Mazurek clarified that there was no Q1 revenue booked from e-Boost and they expect “a little bit” in Q2.

The backlog is similarly weighted to E-Bloc and T&D.  
 

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Source: Pioneer Q1 10-Q

CPS backlog is growing.  But not all that CPS backlog comes from e-Boost.  The CPS segment also includes service revenue contracts for their engine generator services business.  In an interview we did with Mazurek, he said that most of the CPS backlog growth is from E-Boost.

But for the next couple years at least, this story will be all about E-Bloc.


Keith Schaefer

P.S. “Hidden gems” — great companies with major upside — aren’t easy to find.  But I’ve discovered one, and it’s now one of my highest-conviction trades in the Whisperer portfolio. Follow this link to learn more about this company, and how to get my full write-up on it — That’s 18 pages of my just-released research. Click here for details.

SOLAR ENERGY PAYS FOR INVESTORS…..This Junior Solar Developer Just Landed A MEGA SALE $200M++ (all cash!)

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I bought a lot of solar stocks back in January. I see solar as the big energy play of 2023, not hydrocarbons.
 
Junior solar developers are REALLY cheap–but not because of cash flow multiples. Multiples are much higher than oil & gas. But the take-out value of solar projects–because of their 25-40 year power contracts–is HUGE!
 
My largest position Westbridge Renewables (WEB-TSXv / WEGYF-OTC) proved that out this week.
 
This week management surprised shareholders by monetizing FIVE of its early-stage solar assets in southern Alberta, totalling 1.4 GW or 1400 MW for CAD$217 – $346 million. CASH. At the bottom of that range, it works out to roughly 15.5 cent per watt.
 
The Market had been expecting a sale of just ONE—its lead Georgetown asset. Alberta is a premium solar market not just for weather but also—it and Ontario are the only Canadian provinces to de-regulate power prices, and they are 3rd highest among the 10 provinces (see chart at bottom).
 
WEB location of solar farms

If you think that Westbridge has 100 M shares out, that’s a cash amount of $2.17 – $3.45 per share. Some of that could be a special dividend (the CEO Stefano Romanin owns 20 M shares) or internally fund growth–or BOTH!
 
This deal is announced but not closed.  The buyer is Greek conglomerate Mytilineos (OTC-MYTHY), a US$4 billion company. One of its main backers is Canadian Prem Watsa via Fairfax Financial (FFH-TSX; CAD$23 Billion market cap), a legendary investor.
 
I have TWO OTHER JUNIOR SOLAR STOCKS that I am very keen on right now–to get their name and trading symbols for $5, click HERE.
 
The stock may not come to trade for a few days, as the Canadian exchange people wrap their heads around such a new, small company getting such a big big deal so quickly. Closing of the purchase and sale of each asset is conditional upon
  1. obtaining approval of the purchase and sale by Westbridge shareholders
  2.  and the TSX Venture Exchange,
  3. and obtaining regulatory approvals from the Alberta Utilities Commission (AUC).
Understand that the company will not receive much money initially. There was a small downpayment, but Mytilineos won’t be paying for these assets until they hit NTP and get into production. 
 
Georgetown, their lead project has NTP–Notice-To-Proceed, which is a key milestone for production. Once an asset hits NTP–anywhere in North America–it is worth a lot of money.
 
SunnyNook likely will hit NTP later this year. As rough guidance, given that the first two assets could monetize this year, Westbridge could receive cash of just under $100 million this year and just over $100 million next year.
 
So there’s no big cash up front (so the stock will open higher but not close to $2 IMHO). But for sure WEB will never have to raise capital again if they don’t want to.
 
And they will now be able to be a BOOM company–Build Own Operate Maintain–and get all the long term cash flow from their next few solar projects–if that’s what they want to do. They can do so without ever raising capital again.
 
The final purchase price will be very complicated, as WEB has a trailer on the ITC credits that Canada is offering–which could total over $400 million.
 
I purchased my 100,000 shares in December at 57 cents. It closed Wednesday at $1.22—already a double, but it has a chance to double again.
 
WEB 1 yr chart Jun 1 23

 
WEB Mytilinios snapshot

It’s going to cost Mytilineos about CAD$1.7 B-B-B-billion to build these power plants, and they expect to have them all operating by 2027.
 
This deal was done with no commission to anyone. No M&A fees, no big lawyer bills. This team–Stefano Romanin and Scott Kelly–raised all their own money.  There was never any analyst coverage here by the sell side because they were never going to raise any money/make fees.
 
There is a good story on Mytilineos (and the Westbridge deal) in Canada’s Globe and Mail newspaper today—you can read it here:
 
https://www.theglobeandmail.com/business/industry-news/energy-and-resources/article-canada-alberta-solar-farm-mytilineos/
 
The size of this deal I’m sure surprised everyone. But this transaction proves how much the industry is valuing these projects–WAY MORE than investors are. That’s the opportunity on my two other solar stocks–there is little competition for stock.
 
But this deal shows the Market is coming around. This is the way to play energy–and small caps. These two companies have proven teams who have already monetized solar assets. Both have less than 50 million shares out, and neither need funding this year.
 
Subscribe now and get these two picks for just $5– Click Here.

WE HAVE NEVER BEEN MORE RELIANT ON THE FED Belly-Up to the Fed Bar Boys!

0

 

 

Folks, a lot of the small banks in the US are–for now anyway—technically insolvent. 

That sounds scary.  And it could be.  But only maybe.  Because on the other hand the banks aren’t actually insolvent. Not in real life.  Most of them, any ways.  But The Street isn’t exactly sure which ones are and which ones are not.

That’s why the US banking index—symbol KRE-NYSE—has such a horrible chart.


1

 
Most banks are still going about their business – making loans, taking deposits.  In fact, most banks are still making a lot of money, just as their first quarter earnings showed.

As long as the banks collect on their loans, as long as there is no devastating recession, and maybe most important: as long as the banks can continue to hold their assets through to maturity and not be forced to sell, they will be just fine.

In other words, everything may work out.

Unless it doesn’t. 
 

BANKING MAKE BELIEVE

 

How can everything either be just fine or totally off the rails?  Talk about black and white!

Welcome to the world of banking.  It’s a true confidence game.

The difference between good and awful comes down to mark-to-market.

You might remember mark-to-market from its top billing in the Great Financial Crisis.  Back then it was the mark-to-market of mortgage loans that threatened the system.  Today it is…well, actually it is still largely the mark-to-market of mortgage loans.  But this time there are also other loans and securities as well.

Mark-to-market means just what it says: pricing the asset at what the market would pay for it TODAY (or whatever day it is).

We do this every day with our own portfolios.  We open our bank app and are greeted with the value of portfolio is at that minute.   That is mark-to-market.

But banks do not typically mark their assets to market—almost never with their loans and often not with their bonds.

Why?   Because banks have no intention of selling them.  Who cares what it is worth right now. 

It is literally the job of a bank to hold a loan until it comes due (with a few exceptions of course).

Most loans and securities on a banks balance sheet are priced at what they were made at, NOT at what the market would pay for them on any given day.
 


THE BIG, BAD FED

 
There’s really only one scenario where the mark-to-market value matters to a bank–if there is a sudden, massive change in interest rates that occurs over a very short period of time.

Which almost never happens—except last year, when it did!

When the US Federal Reserve raised interest rates it was not the most they have ever done, but it was probably the fastest since the 1970s.   And it was the first time they had raised them this fast from 0%, which had an outsized impact on the price of assets.

2

Source: St. Louis Fed Economic Data
 

KICKING THE CAN

 

The one thing that is on the side of the banks is time.

Every month that passes their loans and bonds get a little closer to coming due.  When a loan comes due, it will (God willing!) get paid back at par.  The bank that owns it is a little closer to being made whole.

The Fed knows this.  They are trying their best to kick the can down the road.

The Fed has now created a lending window that lets the banks park their underwater securities at par, while they wait for them to come due.

The Fed said that they would take any and all government and quasi-government bonds, stuff like Fannie Mae, Ginnie Mae securities, at par value, so even better.

What that means for the bank is–that they can take their $150 TLT-NYSE equivalent bond, give it to the Fed, and get $200 worth of credit.

It is effectively a way of artificially pumping reserves into banks.  Instead of holding an underwater bond they can hold cash – if they need it.  When you see/hear people talking about the $160 billion at The Fed Window and how it’s money printing–this is what they are talking about.

Is it money printing?  That might be a stretch.   But it certainly is giving the banks a lifeline when they really need one. 

Without this, I can almost guarantee the DOW/S&P charts would look a lot more like KRE than they do now.  Investors are completely reliant on The Fed right now for this.

One could argue that these big board index charts are pricing in almost NO systemic risk.  And to be fair, big banks are not in (near as much) trouble.
 
 

THE SCHWAB SCENARIO…

 

There are plenty of banks that are at the center of this storm but the stock that has held my curiosity the most has been Charles Schwab (SCHW – NASDAQ).

Schwab just seems like such a stalwart.  You’d expect Schwab to run into trouble about as much as you’d expect JP Morgan (JPM – NYSE) to run into trouble. 
Yet trouble it found.

Everybody says Schwab is unfairly sold down because they’re enjoying great account growth, they’re taking share, their earnings are up.

Yet the stock price keeps going down!

3

Source: Stockcharts.com

Schwab may not be as safe as everyone says.

If you tweak your numbers enough, make some assumptions about the haircut they would have to take on their assets if they absolutely had to sell them TOMORROW, you can imagine a distressed scenario where the company’s earnings would be..A LOT less.

We think of Schwab as a broker but Schwab is also a bank.  And banks need to maintain capital.  Schwab, like all banks has capital but some of that capital is underwater if it is marked-to-market.

Now if something went south and Schwab was in the place of having to sell assets they probably wouldn’t be able to – at least without raising more capital to offset the loss – by selling shares.

If Schwab did that, the dilution would lower EPS. 

Schwab is really the poster-boy for the entire banking system right now.  It is not about whether they are going to make it – Schwab is going to make it – it is more about what the earnings look like on the other side. 

Schwab made $6.6 billion last year, or $3.52 EPS.  With some not-so-heroic assumptions you could spitball $5 billion of forward earnings on a higher share count to get <$2.50 EPS.   Suddenly that $50 share price is 20x earnings and the stock isn’t looking “cheap” anymore.

What can be said for Schwab can be said for much of the system.

 

Two Possible Outcomes

 
In the first, we scoot on through with a version of Extend-and-Ignore.  Eventually the mark-to-market losses get amortized and marked toward maturity.

In the second, events happen that cause “a deleveraging event”. That means banks become forced sellers of assets.  If this happened and the Fed didn’t step in (I think they would), they would all be taking massive losses.

That’s why investors are now SO DEPENDENT ON THE FED.

This whole thing is like watching a kid chase a ball into the street as a car barrels ahead further down the block.  You don’t know how it ends.  

You think the driver of the car is probably going to see the kid, it is probably going to stop in time, or someone else could even jump out in the street and save the day.  In other words, there are a lot of things that could go right.

But there is one outlier scenario where things could go very, very wrong. 

The thing about banks is that the whole system can quickly become reflexive, self-reinforcing.   That can create a downward spiral. And that is the big risk.

There has been a big spike in downside volatility in the last few days. You know, something that anticipates the possibility of big down days.

A lot of this is going to depend on the Fed.  Not to overdo it.  More importantly – to take their foot off if it begins to look like that spiral is about to start.

I REALLY hope that they manage us through this.   If they do, this could be the start of the next bull market


Keith Schaefer

WHO WILL WIN? SENTIMENT (BAD) VS. TECHNICALS (GOOD)

0

The Problem Is – Markets Don’t Always
Anticipate The Downside
 

LB


Right now the Dow Jones Index doesn’t look that bad–in the last few few months there have been higher lows, and an investor could reasonably think the market could break out, not break down.
 
But sentiment–and a lot of economic data–is quite negative right now.
 
How do we reconcile this?
 
Dow 2 yr chart Apr 21 23
We’re always being told that stocks move ahead of the economy.   It is one of the most common tidbits of market wisdom.  Stocks move before the news.

Unfortunately, it is not true.  At least, not always.

Yes, stocks usually anticipate the news.   But the caveat is this:  they do so when that news is to the upside.

To the downside?  That one is a bit trickier.

Here is a much lessor known market truism: stocks do not go down until they have to.

Implicitly we know this.  When we talk about volatility rising, we almost always mean because the market is going down.   Volatility, a measure of the sudden movement of stock prices, is subdued in a bull market.

That is because stocks methodically price in the potential that good news is coming.

But bad news?   That is a completely different beast.  Bad news does not get priced in until it has gotten so bad that it can’t be ignored.

A great example of this occurred during the bear market of 2007 and 2008.

Below is the performance of the S&P 500 from July 2007 until October 2008.  July 2007 is, by most accounts, when the subprime crisis took center stage.  House prices began to fall, lenders began to wobble, and the first dominos in the hedge fund business closed shop.

Yet it wasn’t until late September 2008, when Lehman Brothers failed, that the stock market finally fell out of bed.
 
Downside 1
Source: Stockcharts.com

Zoom in to this chart to the period ending mid-May 2008.   At that time the market was only down about 7% from the peak.
 
Downside 2
Source: Stockcharts.com

Taking the chart on its own, you would be forgiven for thinking that the market had double bottomed and was on its way back to the highs.

Yet by mid-May the burgeoning crisis was well known.   It had been over 6 months since the WSJ had published its piece on the United States of Subprime way back in October 2007.
 
Downside 3

Source: WSJ.com

Bear Stearns had already failed a few months before.  The stocks of money-center banks like Citigroup (C – NYSE) and Bank of America (BAC – NYSE) were looking precarious.  There was PLENTY of reason to be afraid!
 
Downside 4
Source: Stockcharts.com

Yet the market as a whole was holding up well.  Pockets of the market, commodities for example, were rushing off to new all-time highs.
 
Downside 5
Source: Stockcharts.com

DON’T RELY ON PRICE ALONE

Of course, what we are experiencing today is not 2008.  In fact, I am always reluctant to use 2008 as a comparison to anything.   The Great Financial Crisis is wheeled out every time a fear-mongering doomer wants to make a point.

But the point I am making is not to compare now to then.   I don’t know what is going to happen.  We may be in the very early stages of the next bull market.  We may not.

It is to point to market behavior.   Particularly, the way the market behaves when it is in a bear market.   While investors expect markets prices will always look ahead, that is not the case when the future is to the downside.

To give another very recent example, consider the banks.

The banks have had an awful month.   The collapse of Silicon Valley Bank (SIVB-NASD), the deposit runs at First Republic (FRC – NYSE) and others, and now the worries about commercial real estate loans.

You know what?  None of this is new.  All this stuff was plain to see even 6 months ago.

The market?  It didn’t care.  The bank index chugged along happily.  And then the bottom fell out in mid-March.
 
Downside 6
Source: Stockcharts.com

If you look at the chart of the SDPR S&P Regional Bank ETF (KRE – NYSE) from May 2022 to March 2023 you would have been hard pressed to see what was about to happen–even though all of those factors I mentioned above were already in play.

Again: the market does not care about the downside until it has to care – which in this case meant: when depositors start pulling their cash out.  
 

PRICE DOESN’T ALWAYS TELL THE STORY


I am always wary of simply following the trend.   In a bull market, it is a good strategy.  Markets are pricing in the probability of future success ahead of time and so you are just riding the wave.

But in a bear market?  That is a bit dicey.

When I look across sectors today, one that seems to be finally getting a little bit of love is biotech.   It has been a rough couple years for the biotech stocks.  They started going down before everything else and since bottoming last May every rally has been sold.

What do I make of this last bit of strength?   Is this finally the move up we’ve been waiting for?
 
Downside 7
Source: Stockcharts.com

Well… biotechs are starting to get some love but this remains a blah market.   And potentially still a bear market.  I’m not yet ready to call it a bull market.

Until I am, I remain wary of pronouncing any sector as “off to the races” just yet.

You have to remember just how bad 2022 was for most stocks.  The averages don’t truly reflect the carnage that took place.

Just like how the May 2008 rally came off of the depressed “Bear Stearns” lows of February 2008—the rally we are getting now is coming off of a period of real weakness in 2022.

Is this just a dead-cat bounce off of very depressed conditions?   Are we just so happy that the bottom didn’t fall out this year that we are running back to the table without realizing it still could?

In my portfolios I am sitting on small positions.  I am not out of stocks. I don’t want to ever be out because when the turn comes, I probably won’t catch it.  But keeping my position size small lets me have skin in the game while managing my concern.

I am sitting on a large cash position right now.  Larger than I’d like.

I don’t want to be so cautious.  A lot of stocks look cheap.  This is especially the case for the micro-cap names where I play.

But until I get more of an all clear signal from the market I’m just not willing to guess the trend.


Keith Schaefer

HOW GFL ENVIRONMENTAL BECAME A (RENEWABLE) NATURAL GAS PLAY

0

 

 

Talk about poor timing!

GFL Environmental (GFL – TSX/GFL-NYSE) saw its IPO debut on March 3rd, 2020.   Smack dab in the middle of COVID and a big plunge in the stock market.

It made for a rough start for the stock.  But after falling from an IPO price of C$25 to a low of $16.77 at the peak of the pandemic, it has been nothing but roses for GFL.   Even as the market swooned into year-end last year, GFL bucked the trend and has since taken off toward new highs.
 

1

Source: Stockcharts.com

How has GFL avoided the ups and downs of the rest of the market?

Some of it can be explained by a flight to safety (GFL is in the waste management business, which you would expect to be reasonably recession resistant).

Some of it can be explained by their successful roll-up strategy.  Since going public in 2020 they have acquired over $7 billion of new businesses.  In 2022 GFL acquired 40 new business for just under $1.3 billion.  The result was 32% revenue growth in 2021 and 22% in 2022
But another factor has passed under the radar of most investors. 

By 2025 GFL will be deriving meaningful revenue and EBITDA from natural gas production.

That’s right – natural gas.

In fact, using their own expected pricing, GFL natural gas revenue will be in the same ballpark as some of the biggest gas names in Canada.

2

Source: Company Filings, GFL Management Estimates

Wait, what?

I kid you not.

To be sure, GFL is not turning itself into a natural gas producer.  Natural gas will account for ~5% of revenue and a little less than 10% of EBITDA if all goes well.   Yet it is certainly becoming a piece of the pie. 

The real story here is in the “how?”

How does a waste management company generate this much incremental EBITDA from natural gas?

The answer lies in the type of gas they produce.  GFL produces a special kind of gas, one they get a lot more money for it.
 

LANDFILLS ARE A GOLD MINE (OR AT LEAST A GAS FIELD)

 
GFL is waste management company.  They operate landfill, recycling and organics facilities across 26 states and 9 provinces.
 

3

Source: GFL 2022 Investor Day

Most of what GFL does is contractual waste management with municipalities.  While not entirely recession proof, it is about as close as you can get.

The vast majority of the business is boring and dirty.  Collecting waste, collecting recycling, managing industrial scale composts.  They collect fees from municipalities for contracted waste and recycling disposal.

But those landfills contain a hidden resource.

Deep in the landfills organics are decomposing.  That slow decomposition releases methane, which becomes trapped below the waste.

It is that methane that GFL is able to make money on.  When extracted, it is considered renewable natural gas (RNG).
 

WHAT IS RNG?

 
RNG comes from the decomposition of organic material in landfills.  Solids, yard scraps, food.
 

4

Source: EPA Landfill Methane Outreach Program

The gas is extracted with wells drilled into the waste.  These wells are not that different than the conventional natural gas wells drilled into the ground.
 

5

Source: EPA Landfill Methane Outreach Program

The biogas that comes out is not pure natural gas.  It is a roughly 50/50 mix of methane and CO2, along with a small amount of other organic compounds.

To be useful, the biogas must be processed.  Just how processed depends on the end use.  For electricity production a relatively “dirty” mix of methane and Co2 is used.  If it is going to be pipeline quality, much more upgrading to pure methane is required.
 

6

Source: EPA

At its most pure form, what you are left with is methane – ie. natural gas.  The same stuff that comes out of the ground.
 

IT LOOKS LIKE NATURAL GAS,
TASTES LIKE NATURAL GAS…
BUT IT ISN’T PRICED LIKE NATURAL GAS

 
While the chemical composition of RNG is no different than the stuff coming out of the ground, the price is a whole new ballgame.

RNG prices can be as high as $75/MMBTU.   Even with conservative assumptions you are usually looking at $20/MMBTU+.

Consider GFL’s own pricing assumption on their RNG projects:

US$26/MMBtu over the periods reflected and is equivalent to underlying price assumptions of US$2.00 RINs and US$2.50 natural gas

Clearly the current going rate – $2.50 natural gas – isn’t driving the price of RNG.  The vast majority comes from the “renewable” component.  In the United States (where most their projects are), that comes from renewable identification numbers (RINs).
 

ABCs OF RINS

 
I’ll be honest with you.  I hate RINs.  Not because there is anything wrong with them.  But because every time they come up (and they come up a lot in the refining world), I have to figure out how they work all over again.

RINs are ubiquitous in the (US) refining world.  US Refiners are required to attach RINs to gasoline and diesel they sell to verify that they meet renewable fuel content requirements.

If a refiner has not produced enough renewable fuel per gallon of gasoline and diesel, they have to go out and buy RINs from another refiner who has produced enough renewable fuel to have an excess.
Thus, the RIN price is determined by supply and demand.

RNG counts as a renewable fuel.  The EPA has determined that RNG producers get 11.7 RINs for each MMBtu of RNG that they produce.

Depending on the RIN price, this can be a windfall.  RINs have been as high as $3 at times!
 

7

Source: https://www.epa.gov/fuels-registration-reporting-and-compliance-help/rin-trades-and-price-information

At $2 RIN, which is roughly the average over the last 3 years, and RNG producer is getting over $23/MMBtu!
With the going rate for natural gas being under $2/MMBtu, this is obviously a windfall.
 

GFL – A BURGEONING NATURAL GAS PRODUCER

 
GFL announced their RNG strategy in 2021 at their Environmental Investor Day.

At that time, they outlined 4 signed projects, 5 more under negotiation and 9 being evaluated.

They estimated $65-$75 million of additional FCF from the 4 signed projects, and $105-$125 million from the first 9.
 

8

Source: GFL 2021 RNG Projects from Investor Day

Flash forward to today and we are up to 21 projects, all of which should be producing RNG by 2025.

Together these projects will produce 14.5 million MMBtu of RNG per year.

Now let’s be clear: this is not a massive amount of natural gas.  Going back to my earlier comparison, Birchliff (BIR – TSX) produced 10x that amount last year.  Peyto (PEY – TSX) produced 20x more.

But on a revenue comparison, GFL stacks up much closer because their RNG gets such a high price.

RNG revenue is expected to make a sizable contribution to corporate EBITDA.  GFL is estimating the cumulative run rate to be $175 million of additional annual EBITDA from their RNG.
 

9

Source: GFL Q4 2022 Investor Presentation

All the projects are MSW land fills.  While the company has not disclosed locations, it appears that most or all are in the United States.  They appear to be making headway on at least one project in Canada.
 

ONE TIME GROWTH

 
GFL is a very large waste management company.  They have a market cap of C$16 billion and an enterprise value of over C$25 billion.

To give some better perspective on the impact of RNG, GFL did $1.7 billion of adjusted EBITDA in 2022. 

They guided to US$2 billion to US$2.05 billion of EBITDA for 2023.

That means that the growth from RNG through 2025 is about a ~9% increase to this year’s EBITDA.  Not huge, but enough to move the needle.

Could there be more growth ahead?

Honestly, I am not sure.

GFL owns a lot of landfills.  Over 90 of them.  So far we are talking about RNG from about ¼ of them.

But not every landfill is well-suited for RNG.

While all landfills release methane, to make RNG processing worthwhile, the extracted gas must be tied into a pipeline.   That means pipeline proximity is key.   Then there is the approval side – both for the pipeline (which is never a slam dunk nowadays) and for a utility to offtake the gas.

GFL has been coy about just how many landfills it can retrofit.  When asked straight-up on the Q2 2022 conference call, they stuck to the script that they have 22 active projects.

That suggests to me that GFL is likely not going to become a renewable natural gas behemoth, building ever more production capacity each year.

I expect we will see more to come, but the easiest fruit has been picked.

Getting back to the stock – well, I have watched GFL for some time now and I always feel like I’m waiting for just a little more of a pull back.
 

Today the stock trades at 13x EV/EBITDA and, based on average estimates, a 5.7% free-cash-flow yield. That makes it neither cheap nor expensive. 

 

But what it does say–is that the Market is looking for every molecule of RNG it can produce.

 

EDITORS NOTE: I just updated my full report on my favourite RNG play. This stock is–by far–my largest position. And it is bumping up against 52 week highs. I think the catalysts here are near term, and huge for shareholders.

Get the name, symbol and report–RISK FREE–Click Here




Keith Schaefer

Not All Solar Stocks Have Sunny Charts

0

LB

 

 

My deep dive into solar has been a good news story.   I am finding companies growing revenue and generating cash.

Solar has tremendous growth ahead of it.  The Inflation Reduction Act (IRA) will great a boom for years to come.

But not every stock has been a tempting buy.

If the story has an Achilles heel, I can tell you where: Financing.

Solar installations need credit.  Preferably cheap credit.

Today credit conditions are going in the wrong direction.  Liquidity has tightened a lot.  Rates are higher.  It is creating pockets of stress in solar financing.

There is no better example of this than the mess that Sunlight Financial (SUNL – NASDAQ) has found for itself.

 1 sunlight stock chart

THE BUSINESS OF SOLAR LENDING


Sunlight Financial came to the public market as a SPAC in January 2021.

Sunlight was born out of the Spartan Acquisition Corp II.  At the time of the business combination, they were valued at $1.3 billion.

Today Sunlight has a market capitalization of just under $100 million – or a 90%+ decline.

What happened?

Rates happened.  Sunlight got caught on the wrong side of the rise in interest rates.  Here’s how:

Sunlight is in the business of lending for residential solar installations and home improvement.

Most of Sunlight’s lending is on the solar side.  In Q3 22, 84% of their loans were solar installations.  These are loans to homeowners that let them put solar panels on their rooftops.

Sunlight is a big player in residential solar financing: it has an 8% market share in the US.

They get customers via a network of solar installers.  When a Sunlight approved installer sells a system to a homeowner, they offer a financing option to purchase the array with no money down, with the loan originated via Sunlight.

A loan gets made, the system installed, and some of the revenue from the electricity produced goes toward paying interest and principal on the loan.

These are decent sized loans, averaging just under $46k in Q3:

 2 average loan balances

Source: Sunlight Financial Q3 Results Presentation

While only 20% of residential solar system sales were financed with solar loans in 2015, by 2020 63% of residential solar loan sales were financed.  It is a large market and a growing one.

THE HOME IMPROVEMENT MARKET


In 2019 Sunlight added a new business when it began to originate home improvement loans.

Sunlight makes its home improvement loans in the same way as its solar loans.  A contractor agrees to a job with a homeowner, but in this case to pay for a new roof or new windows.  Sunlight has a network of ~1,000 contractors that act as their loan originators.

3 contractor growth

Source: Sunlight Financial Q3 Results Presentation

I’m not thrilled with this business.  Home improvement loans are a bit more dicey than solar.   They aren’t backed by a revenue stream.  These are loans that seem more likely to go south.

On the other hand, this is a small business compared to Sunlight’s solar lending (it is about 1/5th the size and was only 6% of revenue in 2021), the loans are a lot smaller ($17.8k average in Q3) and interest rates on the loans are far higher.  Sunlight also seems to be making loans to credit-worthy customers
 

4 customer interest rate

5 customer fico


Source: Sunlight Financial Q3 Results Presentation

At any rate, it isn’t the home improvement lending that causes Sunlight’s book to go south.

A 100 YEAR STORM


Solar lending should have a lot going for it.   There are subsidies, electricity rate advantages, and a relatively constant stream of cash.

Considering that ~85% of Sunlight’s loans are solar, you might think that this is a safe bet – cash flows that cover debt and happy lenders.

What could go wrong?

We always hear about 100-year storms.   We hear about them so often that it seems impossible that there could be one every 100-years.

The same goes for financial storms.  There is a 100-year financial storm about every 10-years.   Inevitably when one happens, boats get caught and capsize.

Sunlight found itself caught in the storm.  It remains to be seen if they capsize, but it’s going to be rough sailing.

THE LAG THAT CAN KILL


The storm that caught Sunlight was the speed of the rate hikes.

Throughout 2022 Sunlight made more loans than at any time in their history.

6 funded loans
Source: Sunlight Financial Q3 Results Presentation

But because rates rose so fast those loans quickly went underwater – before Sunlight could sell them to investors.

Sunlight is a point-of-sale lender.  Contractors and installers approach households with their solar product and offer Sunlight financing.  Sunlight approaches investors to funds loan.  Loans are matched up with lenders.

7 investor presentation
Source: Sunlight Financial 2021 Investor Presentation

There are two ways a loan can get funded.  Either before it is made or after it is made.

Sunlight’s preferred model is to pre-fund the loans.  Investors agree to a rate before the loan is even made.  This was the process described in Sunlight’s initial investor presentation:

8 spac
Source: Sunlight Financial SPAC Conversion 2021 Investor Presentation

The key in the above slide is the term “pre-agreed dollar price”.  Sunlight clarifies this in the footnote:

9 footnote

Source: Sunlight Financial 2021 Investor Presentation

For a pre-funded loan, there is no lag between originating the loan and funding it.  If rates rise sharply and suddenly, that is on the investor, not Sunlight.

But then how did Sunlight get in trouble? 

STRETCHING FOR GROWTH


Here’s how.

Historically, most of Sunlight’s loans are pre-funded (they called it direct lending).  At the time of the SPAC acquisition around 90% of lending was direct:

10 funded by channel
Source: Sunlight Financial 2021 Investor Presentation

Direct lending soared after the pandemic.  Money was cheap.  Banks were bursting with deposits.  Investors jumped at the chance to fund solar installs.

But in more normal times Sunlight has more loan volume than it can pre-fund.  In that case they take a different tact.

Sunlight uses an intermediary – a bank – to hold onto the loan while Sunlight looks for an end buyer.

They call these “indirect loans”.  They are basically loans that are warehoused with the bank until they can be sold to investors.

The process takes 3-4 months.

11 direct indirect
Source: Sunlight Financial 2021 Investor Presentation

This happens all the time with mortgage loans.   There is nothing wrong with the warehousing model. 

But for Sunlight, the model went south when rates went north.

The Fed hiked rates by over 4% in less than a year.  Last cycle it took 3 years for the Fed to raise rates 2.5%.

12 federal funds
Source: CNBC

This broke Sunlight’s funding model.  Sunlight was forced to move more loans to indirect funding.

In the first quarter of 2021 Sunlight funded $581 million of loans.  $84 million of that was from the indirect channel (15%).

In the first quarter of 2022 Sunlight funded $593 million of loans and $164 million were indirect (28%).

In the third quarter Sunlight funded $834 million of loans and $264 million was from indirect (34%).

At the same time, rising rates and widening spreads made loans only a month or two old underwater – with Sunlight holding the exposure.

On the Q3 call they said:

“we also continue to see interest rate increases of unprecedented speed and magnitude, which… will affect our ability to profitably monetize indirect channel loans originated earlier this year… loans in the indirect channel will be sold at a loss”
 

A BADLY TIMED BANKRUPTCY (NOT THEIR OWN)


Adding to their woes, in late September Sunlight announced an “installer liquidity event”.

That “event” was the bankruptcy of one of their largest solar installers, Pink Energy.

The bankruptcy hit Sunlight in a few ways.

First, Pink was a large partner and the loss of their business cut into new loan originations.

Second, Sunlight advanced money to Pink to build the customer projects.  Sunlight estimated they had about $32.4 million of advances that they would not recover.

Third (maybe most important), this was a hit to Sunlight’s credibility at exactly the wrong time

FIRE SALE


Sunlight is in a tough spot.  They are going to have to sell underwater loans and that means sell them at a loss.
They disclosed as much in a December 13th 8-K filing.

The filing announced several changes to the agreement with the bank partner.

The good news is that Sunlight’s bank partner increased their lending capacity.  More of Sunlight’s loans can be held on their balance sheet.

The bad news is that amendments changed the fee structure (likely not in Sunlight’s favor) and tightened Sunlight’s collateral requirements on non-current loans.

Sunlight also said in the filing that they will have to “sell a significant portion of their backbook loans in December”.

They will take a loss on these sales.  The impact is expected to reduce total platform fees in Q4 to only $0-$5 million – down from $31 million in Q3.

That still leaves $275-$300 million of backbook loans at the bank partner, which Sunlight plans to sell in the first half of 2023.

The long and short of it is that these sales will “significantly reduce the Company’s cash balance and may result in materially less available liquidity through the first half of 2023”.

Not surprisingly, Sunlight is looking at strategic alternatives: selling the company or raising capital.

They said they have “received interest from parties both in investing in the company and in acquiring the company”.   

GAME TIME


I have no idea how this plays out.  It will come down to whether Sunlight can find a partner with deep pockets, either to buy the company or provide capital to get them out of this jam.

That could happen.  Most of the loans are solar loans so these are long-term loans.   Long-term rates have come down a lot from the peak.

But Sunlight is distressed.  It is difficult to imagine them having much leverage in a negotiation with a potential partner.

That makes me want to sit this one out and just watch.

There may or may not be something worth owning once the dust settles.  If there is, subscribers will be the first to know.