Innergex: The Path Is Right, Yet Still Some Shadows (INGXF)

Innergex (TSX:INE:CA) (OTCPK:INGXF) is a Canadian-based Independent Power Producer active in power generation from wind, hydro, and solar sources. Increasing competitiveness and incentives offered by some major governments globally, such as the Inflation Reduction Act in the United States, are two key factors supporting the company’s long-term growth. However, the increase in interest rates over the FY21-23 period harmed the company and the entire sector in which it operates, being the latter capital-intensive and requiring a significant amount of financing. The increase in interest expense incurred by INGXF contributed to the decision to halve the dividend to $CAD 0.36 for FY24, to have more cash to self-finance pipeline projects, a factor that could lead to value creation in the long run. My Discounted Cash Flow analysis highlighted that the current share price is c.a. 18% above its fundamental value. I overall assign a Hold rating to INGXF, because although growth in recent years has been good and projects nearing completion will further increase it, the current level of rates still raises concerns for me, and at the valuation level my DCF resulted in an overvalued stock. In the following sections, I will look at Innergex’s business, pipeline projects, and financial performance, to provide an insightful justification for my outlook on the stock.

Business Overview

Innergex has a net installed capacity of 3600MW (4234 MW gross installed capacity) of renewable energy as of Dec 23, including 1987MW of wind power, 923MW of hydropower, and 690MW of solar power. From FY16 onward, INGXF has more than doubled its wind power capacity, making it the main source of revenue, and has substantially increased its installed capacity of photovoltaic plants, practically non-existent in 2016.

Innergex acts as a developer and builder (not in every project) of renewable facilities. Then, through PPA contracts, it sells the electricity produced to utility companies and state bodies. In FY23, 90% of revenues come from PPA contracts (12-year average remaining life) indexed to inflation, and the remainder from the sale of electricity directly at market price. In FY23, 51.5% of revenues generated came from Wind, 34.4% from Hydro, and 14.1% from Solar. The highest marginality segment turns out to be Hydro, with an EBITDA margin of 77.1%, up from 74.4% in FY22. Wind, on the other hand, experienced a downward trend, going from 78.8% in FY22 to 75.5% in FY23. Solar, although characterized by an outstanding improving trend, currently has a lower marginality, 64.6% in FY23. I believe Solar will reach the other two segments’ marginality in the coming years, both because of a steadily evolving technology and because INGXF is increasing its photovoltaic installations.

Geographically, Innergex obtains 42.4% of its FY23 revenues in Canada (the main market for hydropower generation) and 31.0% in the United States, mainly through wind and solar. The US is also the largest market for geographic expansion, due to the latest and upcoming installations. The remaining 26.6% of revenues are obtained in Chile (14.5%) and France (12.1%).

Pipeline Projects And Opportunities

The dividend cut-off by Innergex came because of the need for a significant amount of capital to finalize numerous projects, expected to be completed between FY24 and FY25. Before going into detail about such projects, it is good practice to look at how INGXF has financed itself in recent years. As deepened in the FY23 Annual Report, 75-80% of each project has been financed through debt, whereas the remaining 20-25% has been raised through equity tax financing. The latter is a hybrid form of debt, allowing a project to be financed both through the repayment of future cash flows obtained from the project and through the absorption of the tax credit resulting from the investment.

Following the introduction of the Inflation Reduction Act, photovoltaics system builders can obtain up to a 30% tax credit value on total construction costs and a federal income tax credit of $0.026 per kilowatt-hour produced. This rationale has prompted Innergex to focus heavily on the U.S. market in the coming years, although similar initiatives are in the pipeline from Canada and France as well to support the growth of new installations. Between FY24 and FY25, the two largest projects the company will complete are indeed in the US.

In particular, Boswell Spring is a wind project with an installed capacity of 329MW at a total cost of $534m, $203m of which is financed through debt and the remainder through equity financing. Based on the average revenues of the INGXF wind segment per single MW of installed capacity, I forecast a contribution of about $60m to revenues from the start of plant operations, estimated for Q4 FY24. Boswell Springs is expected to benefit about $65m in property tax, $34m in wind generation tax, and $20m in sales and use tax over the 30-year life of the project.

The other major investment involves the construction of a photovoltaic plant in Palomino, with an installed capacity of 200MW, which is scheduled to become operational during FY25. Four additional projects, with a total installed capacity of 98.4MW, are expected to be finalized in FY24 and FY25 (please refer to the below table for further details).

I estimate, looking at average revenues per single MW installed for each segment, that these 6 projects’ total new installed capacity of more than 600MW, will lead to revenue growth of $110-120m.

Commentary On Financial And Economic Results

In FY23, INGXF reported a 7.4% revenue growth, a result partly affected by the acquisitions of the Sault Ste. Marie facilities, with a 60MW of installed capacity, and the 34-MW solar thermal plant in Chile. The projects discussed in the previous paragraph are expected to bring in another $110-$120m in revenues between FY24 and FY25, not considering possible changes in electricity prices.

In FY23, INGXF recorded an EBIT margin equal to 33.7%, -8% compared with FY18 results. Despite this deterioration, its EBIT margin was above both the average and the median of the industry peers considered in FY23. The Net Income was equal to -$77m but affected by an impairment loss of -$88m, without which Innergex would have essentially reached parity. During FY24 I expect a further reduction in the loss that should turn into profit from FY25, especially in the case of a reduction in the overall interest rates. The company is indeed capital-intensive; hence interest expenses are a major item of expenditure for it.

Over the past 3 years, the combo of both higher amount and cost of debt has led to a very large increase in interest expenses, negatively affecting profitability. However, the debt incurred by the INGXF has overall a shorter remaining life compared with financed assets, meaning they can be amortized over time using the asset itself as collateral. Between FY17 and FY23, the cost of debt increased from 4.27% to 5.26%, while net debt reached $4.8B, up from $3.5B in FY17. This increased interest expenses by about $100m, heavily affecting profitability. I believe that between FY24 and FY25 INGXF will return to profitability, thanks to a possible lowering of rates, coupled with increased use of internal cash flow, resulting from the dividend cut-off.

In my opinion, the dividend cut-off was also necessitated by the high indebtedness of INGXF, which could reduce its funding sources and make it riskier in the eyes of the market. A comparison of its debt/equity ratio with other companies in the sample shows it to be the most leveraged with a D/E ratio of 5.3x as of Dec 23, significantly higher than the average of 3.1x. I believe therefore that such a decision was mainly due to a debt control strategy rather than a factor to further fuel growth.

Discounted Cash Flow Analysis

I conducted a DCF analysis, resulting in an equity valuation of $0.97B for a price of $4.76 a share, -18% compared with the current market price. The analysis was carried out based on the following inputs:

Beta = 0.375, obtained from Investing.com

MRP = 6.04%, obtained using Pablo Fernandez’s data weighted by INGXF geographic revenue exposure.

Risk-free rate = 3.74% obtained in the same way as MRP.

Cost of equity and WACC = 4.61% and 4.18% respectively.

A two-stage DCF was applied, with the first 5 years (FY24 to FY28) estimated based on the company’s historical growth data and my view, whereas g = 1% has been assumed from FY29 to FY53.

The Terminal Value has been obtained by discounting the FCFF of the 25 years going from FY29 to FY53.

Conclusion

Innergex is an interesting company, with well-thought-out management and operating in an industry about which I am extraordinarily optimistic in the long run. Over the past 6 years, revenues have more than doubled, and expectations are also positive for the years to come. That said, however, we cannot ignore the fact that the current interest rate environment is not optimal, and an improvement in this is necessary for INGXF to achieve a positive and sustained net profit margin. Furthermore, my DCF analysis highlighted that the stock is currently overpriced. Overall, I rated Innergex stock as a Hold, waiting for economic figures that may lead to an upgrade rating.

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