What good is a stock rec if you never check in on it? In this week's episode of Industry Focus: Energy, host Sarah Priestley and Motley Fool contributor Jason Hall look back over two Industry Focus stock picks from last year and see how they've been doing since then.
NV5's (NVEE 0.14%) stock has been up and down and all around since being recommended, but the company still looks to be in a fantastic long-term position. Pattern Energy's (PEGI) stock has been a bit worse for wear, as the tax code has presented some new and significant challenges. But Pattern's story doesn't end there, and there's plenty of bright spots for the business. Tune in to find out how rec-worthy these companies are today and what investors need to know about them before buying.
A full transcript follows the video.
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This video was recorded on April 12, 2018.
Sarah Priestley: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. Today, we're talking Energy and Industrials. It's Thursday, the 12th of April. We're going to be checking on a couple of former recs. I'm your host, Sarah Priestley, and joining me on Skype from the West Coast -- is it sunny on the West Coast?
Jason Hall: It actually is today. It's not going to be that warm, it's just going to be in the 60s, but yeah, it's really sunny today.
Priestley: [laughs] Well, it's Jason Hall, as you all may recognize, who is an all-around nice guy and Motley Fool contributor. Jason, thank you very much for making time for me today!
Hall: I love coming on any time, you know that. I'm happy to come on!
Priestley: One thing I wanted to tell the listeners about before we start is, The Motley Fool has a competition for college students, and it's open to anybody 18 years or older in the U.S. who's attending college. The first prize is $10,000, and there are 20 runners-up prizes of $1,000. It closes very soon at the end of April, so if you want to apply or know one who should, definitely get to it soon. Terms and conditions apply. Please visit www.fool.com/competition for more details. Jason, do you know a college kid who could use $10,000? Or, an adult.
Hall: I actually know several college kids who could use that. I'm going to tweet out about this as soon as we get off. I always forget about this, every year. I need to tweet about it.
Priestley: I appreciate it, thank you very much. People always think these things get inundated, but I can tell you with the insider knowledge that there's plenty of opportunity, if people are reading between the lines there.
We'll get right to it. The first company we wanted to talk about is NV5, ticker NVEE. Jason, you pitched this stock on our show on the 19th of October, and it was part of our Pitch A Stock week, where we got some Motley Fool contributors to tell us about stocks that they're watching. NV5 is a small, founder-led engineering infrastructure company. They provide consulting services to public and private sector in the U.S. and abroad. They're kind of small compared to a lot of the megacaps that we tend to talk about on this show. Their market cap is $634 million. Last year, they generated $333 million in total revenue. So, here's an excerpt from your comments, I'm definitely paraphrasing you, from the show in October. You said the U.S. needs to spend about $800 billion a year on infrastructure modernization and competitive investment. Globally, it's a $3 trillion industry, and it needs a company that designs projects and manages projects.
Very compelling pitch when you did it. The stock was expensive, but a lot of growth potential. So, what's happened in the in-between time?
Hall: Let's be honest, I looked like a complete buffoon --
Priestley: [laughs] No, not at all.
Hall: -- for the two and a half months following the recommendation. And it's interesting, because it's a reminder of some of the things we talked about. This is a very small company, it's actually a micro-cap. It's a $600 million company. At one point, by mid to late February, I think the market capitalization had dropped like $430 million, and the stock just plummeted. Small-cap and micro-cap stocks can do that very, very quickly, and often on no news.
And that was the really interesting thing that was compelling for me in the months that followed. You fast forward to today, and the stock is $62, it's at an all-time high based on price. But we talked about valuation back in October, and it was 35X earnings, somewhere around there, I think, is what we said it was. Actually, the stock price is higher today, but on an earnings valuation basis, it's actually cheaper today than it was when we talked about it before.
We talked about the thesis for the business a little bit. There are two prongs of what make this an exciting opportunity. No. 1 is all of the investments that need to be made in modernization in the United States, and on a global basis, the trillions of dollars that need to be spent, especially as the urban middle class grows. Over the next couple of decades, the urban middle class around the world is going to grow by a billion people. Think about all the water infrastructure and the highways and the ports and the bridges and the telecom infrastructure, all of these things that have to be built just to support a billion more people living in cities. It's a huge opportunity for a lot of companies.
Where NV5 fits into that is, No. 1, the dollars that are spent, it should be able to capture a significant amount over time in organic growth. But the key thing that's going to be driving that over time is acquisitions, which is a really hard way to grow. The CEO and founder of the company has a really long track record, over 25 years in the engineering industry, of acquiring other engineering and consulting companies in this business and building a bigger business. So, if you think about, in the U.S. alone, there's 130,000-140,000 engineering firms. There are lots and lots of these small companies, and a lot of them are specialized. So, by bringing them into a single company, NV5 is able to add geographical scale, it's able to add additional scope, since a lot of these companies are specialized, and it's able to drive a lot of the costs out through the back end through having a single back-end system. It's able to cross-sell, since the company will offer more than just that one specialized engineering service. So, there's a lot of really compelling things about it.
But, really, what it gets back to for me is the management. The executives own close to 30% of the company, so there's a lot of alignment with shareholders. The thesis hasn't changed. The company has continued to perform well. Earnings have grown significantly, as you can see by how much the valuation has improved. So, yeah, a great time to buy.
Priestley: Exactly. It's not all bad news. Something we're very keen on here is being transparent about picks that we've made and how they've performed, so to recap this stock, I think, is an excellent practice. But if anything, it's good news, because like you said, the valuation has improved, the thesis hasn't really changed.
You mentioned these acquisitions that the company has made. They bought Marron and Associates, which is an environmental services firm in Albuquerque, New Mexico about September of last year. They're already seeing the benefit of that acquisition. Butsko Utility Design is another purchase that they made for technical resources in utility and energy projects. So, all of these incremental additions are really helping to expand their repertoire, and you can see that. They've had some wins with the TransCanada Pipeline, which, if people listen to this regularly, they'll know we're pretty bullish here on pipelines generally, and energy infrastructure is a growing subsector of the market. So, really, it's really paying off for them. I was reading the earnings transcript before the show, and the CEO -- I'm sorry, I can't remember his name.
Hall: It's a mouthful.
Priestley: Dickerson Wright.
Hall: Dickerson Wright.
Priestley: Dickerson Wright, excellent. He said, "Our M&A pipeline remains solid. We continue to be active but selective with targets that will add growth to all of our service verticals." He says, "I feel confident that our organic growth and growth through acquisitions have us on schedule to achieve our goal of $600 million in the run rate revenues by the end of 2020." So, he's really expecting this phenomenal growth to be powered both organically and through acquisition. And I think like you said, there's just such a big opportunity for consolidation and the benefits that can bring in the industry, that this seems like quite a smart move.
Hall: Yeah, I like it. I think it's worth mentioning, again, that anyone who invests in a company like this, especially because of its small size, has to be prepared to invest for the long run, because there can be extreme unpredictability in the stock price volatility within a few months, as we've seen. But, as long as the business continues to perform well, and the thesis remains sound, these are exactly the kind of stocks that can absolutely crush the market in terms of long-term performance.
Priestley: There is, obviously, some negativity around infrastructure spending. President Trump announced the $1.2 trillion that he hopes to generate through both a mix of government spending and private-sector spending. People are hesitant, nervous, have their own opinions about that. But what remains is, infrastructure spending is inevitable in the U.S. and abroad, both in terms of new projects and, eventually, we will be forced to actually pay some attention to existing roads and bridges and water infrastructure and all those wonderful things.
Hall: Right. Circling back to management, because we've been hearing about the need for infrastructure spending in the U.S. and modernization for decades at this point. This isn't something that just popped up this election cycle, this has been talked about for years and years. So, having a management team in place -- a lot of the executives that work with Wright have worked with him at the company prior that he founded, and the company before that that he worked at. So, there's that vast experience in working through the cycles, because there are ups and downs of the spinning cycle of any major industry, but having a team that knows how to navigate those different cycles can be invaluable. So, there's even more to it than just they own a lot of the company and they have this great growth thesis and a strategy. There's also this benefit of, they know how to navigate through the industry, and that's really, really important.
Priestley: I would say, if you like the industry, if you like the company, now is a great time to buy. The trailing 12-month P/E is 26X. Forward P/E is 19X. Incredibly competitive compared to average P/Es we're seeing in the market right now.
Hall: Yeah, especially for a hyper growth stock.
Priestley: Mhm. So, I wouldn't beat yourself up too much about that one, [laughs] actually. I'm pretty bullish, I like the recommendation a lot.
We're going be talking about Pattern Energy Group. We discussed Pattern in a show on utilities on the 9th of November last year. It was part of a broader discussion we were having on utility companies generally. Our premise was, this is seen as a really boring market, so we discussed the nuances of the utilities market. Most of these are stable, dividend-paying government-sanctioned monopolies, and it's a defensive industry that's heavily regulated, so it attracts a lot of income investors and a lot of people placing pensions and retirement allocations, too. The other thing we touched on was a rise of independent power providers, and lots of other good stuff around that.
Today, I just want to recap on one of those. You pitched Pattern for the future of utilities. For anyone who's listening or new to the show that didn't catch the previous episode, can you just recap for us a little bit on what Pattern does?
Hall: There's actually some similarities with NV5, some things that I like. It's a pretty decent amount of founder-led ownership with the CEO of the company. The short version is that Pattern has focus on wind energy, wind projects. Their name, Pattern, actually comes from years of scientific research looking at wind patterns and that sort of thing to really leverage that wind resource to generate the best return based on where they build the farms and that sort of thing. The short version is, the things that drew me to Pattern is, it's really, as the name of the episode we did was, the future of utilities.
It's an independent energy producer. Basically, what they do is build and invest in these wind farms and sell the power to utilities. Over time, I think we're going to see more of that, where there are more companies like Pattern that are actually generating electricity and then selling it to either a utility user, and the utilities just become the lines that connect everybody from the producer to the user.
The thing that's driving so much for Pattern is, the costs of production are falling for wind. The turbines are getting cheaper, they're getting more efficient, so their costs of producing wind power are coming down. That's even as the production credits are gradually reducing, in coming years, the federal tax credits they get for power production. The other part of it that I like about Pattern is, they started talking almost a year ago about spreading beyond just wind and looking at some solar projects, and also looking at battery storage, which, just like solar and wind, technology is getting far, far cheaper. Storage has the ability to unlock the true potential of wind and solar. When the wind isn't blowing and the sun isn't shining, to still be able to have captured that really cheap electricity and still be able to utilize it to further out-compete more expensive nuclear and natural gas in those sorts of things.
Priestley: Absolutely. I'm a bit of a broken record, I've talked about this before, but batteries, harnessing that renewable energy, is really going to be what unlocks the potential around a lot of the solar and wind technology. Taylor and I last week mentioned that last year, in 2017, I think in March, California paid Arizona to take electricity from their solar farms for about 14 days. And really, it raises two questions around this model, where the renewable energy creators are selling their power onto the grid. It's that kind of exchange or that negotiation that's going to happen with traditional utilities. And then, storage, if they could have saved those 14 days for less sunny days in winter, perhaps, that would have been a more effective use of that power. Just kind of a fascinating, on-the-side question. But, it's definitely great to see Pattern diversifying into these regions.
Hall: Absolutely. And the other thing, too, talking about the diversification, Pattern is not just looking at doing different kinds of technologies and renewables, but geographically, they're also very diverse. They operate in the U.S. They also have significant operations in Canada. One of their largest financial partners is a Canadian government retirement system, which is a major investor in renewable projects.
One of the concerns since the end of the year is -- before I say that, let me say this. One of the major funding mechanisms for wind projects is tax equity investing. If you think about a large company, they may have a really large tax exposure because they're highly profitable in whatever they happen to do. You look at wind, especially, wind has access to two different kinds of taxes. It has production tax credits and also, there's tax credit for the actual equipment, investing in the equipment itself. As part of the lower corporate tax rate that was passed by the federal government at the end of the year, there's a new rule called the base erosion anti-abuse tax, so, the acronym is BEAT, which is horrible but typical. The provision in the bill, and this is from Pattern's CEO in a letter in December, he said they expect this bill will narrow the pool of potential tax equity investors. And that would likely delay some projects to start the year while these different organizations analyze the provision and determine if it would prevent them from being able to take advantage of the tax equity investing.
I think that's scared a lot of investors away from a lot of these independent energy companies and yieldcos that use tax equity investing to raise a lot of capital. It's corresponded with interest rates rising at the same time. So, issuing notes and other types of debt has also become a little more expensive, because interest rates have gone up. The stock price has fallen. The yield has shot up. It's over 9% now, which is incredibly high. And it's within the range of what the company can afford to pay, but the issue is, the company can't just issue a ton of stock to raise capital paying a 9% yield and get any kind of rate of return on that. So, the risk is the company being trapped in a situation where it can't access capital through debt and it has to cut the dividend to issue stock to use that capital at an effective rate of return. That's kind of where things are with Pattern right now, and why I think investors should be a little bit cautious. But I still think, in terms of the long-term opportunity, it remains incredibly strong.
With that said, Pattern has a lot geographic exposure outside the U.S., like we talked about with Canada. One of its major investing partners is a Canadian retirement fund, and those are Canadian assets that are generally getting used to fund that money with. It has large assets in Puerto Rico. It just put its first Japanese wind farm into service. So, there's a lot of geographic exposure to other markets that have completely different incentives than what's happening in the U.S. I think that gives it a lot of optionality and makes it a lot stronger than it may feel based on how much the stock price has fallen based on these concerns.
Priestley: There's a lot of U.S.-centric activity and a lot of U.S.-based stockholders, I'm sure. But, as you said, they didn't up their dividend, and that's the first time they haven't done that for 16 quarters. Management was discussing that this was a very difficult decision for them, which, like you said, for any of these yieldcos, it is, because it's such an intrinsic part of people's thesis. This is kind of a golden goose, where you get, potentially, a lot of growth and consistent income, and you can't expect to have that without some hiccups along the way.
But, interesting to see them getting squeezed on both sides with the interest rates going up and then the tax reform. Obviously, such a capital-intensive industry for implementing wind farms and any kind of renewable and conventional utility is so heavily reliant on debt. But, you also really like the leadership, similarly to NV5 here. Michael Garland has 20 years' experience in the business?
Hall: Yeah. And actually, before he came to the private sector and started building and working on the development side of these projects, he worked for the government on the regulatory side. Those are invaluable experiences, in terms of knowing how to navigate the market, navigate the debt cycles, navigate changes in regulation. It's incredibly valuable.
The other part of it, too, is Pattern's ... it's really more of a sister company than a parent company, Pattern Energy LLC, which is a project developer. It's privately held. It owns a small stake in Pattern Energy, the publicly traded company, but their main business is developing and financing and selling off these large renewable projects, and not actually running them. Pattern Energy, the company we're talking about, is actually involved in running and operating these projects and collecting the cash flows, like the utilities.
But, the point is, Pattern Energy, the development company, has this massive pipeline of projects. And Pattern Energy, the company we invest in, has the ability to work directly with its sister company to pick and choose which projects it wants to invest in. So, that pipeline is incredibly valuable, with the caveat that in the short-term, there are some questions about access to financing and how that's going to play out. But, having an experienced CEO with a lot of history and expertise in navigating this industry should prove to be really invaluable.
Priestley: Yeah, absolutely. Just to recap, when we first spoke about this stock, it was up 18% at that point in 2017, and the company had a price-to-earnings ratio of 61X. The stock is now down 17% year to date. But its EBIT during 2017 was up 13%. Its production was up 14%. The majority of their electricity is sold under these power sale agreements with long contract lives.
Hall: Yeah, 20-plus years long. These are long-term.
Priestley: Yes. So, I absolutely agree with you that it definitely seems like there's still potential here, given the diversification of both their activities and the regions they're operating in. People, you described it as getting spooked, and I would agree with you, it's a slight overreaction to some of the recent news.
Hall: Right, absolutely. To add onto that, it's not for no reason. I think it's definitely an over-reaction, but there is some risk. Again, the worst-case scenario is the company has to put a freeze on nearly all of its expansion because it has trouble accessing capital, and it would be forced to cut the dividend to raise capital by issuing stock. It wouldn't be cutting the dividend because it couldn't afford the dividend, but literally, it had no other way to generate the capital that it needed to invest in projects.
So, I think anyone that invests in the company should go into it with understanding that, from a cash flow perspective, I think the dividend is relatively secure, but it's more of a financial mechanism perspective that, in the worst-case scenario, the dividend could be cut, because of the need to use stock to raise capital, if that makes sense. So, it doesn't change my personal thesis, in terms of the long-term prospects. But, for anyone who's looking at this as, "Hey, it's a 9% yield, I'll get paid, I'm just going to buy this stock," just be careful, and be conscious of the dividend as being a little bit in play based on that over the next year or so.
Priestley: Yes, absolutely. I think that's it from us today. Is there anything you wanted to add, Jason?
Hall: On Pattern Energy, one other thing I would want to add is, because it's investing so much in really expensive stuff in its capital investments, GAAP earnings aren't necessarily the best way to value the company, because its depreciation and amortization numbers are going to continue to grow. From a quarter to quarter basis, those are non-cash. Obviously, they're based on massive amounts of debt that it's issuing to buy all of these wind farms and build the infrastructure to support them. But, it's a really good idea to also look at cash flows.
A couple of numbers that management will talk about and that you can read in the earnings releases are FFO, funds from operations, which is a cash flow metric that removes depreciation and amortization. So, it's more of, here's how much cash flow is actually being generated by the business. Because, those wind farms are going to be good for 30 years, and the lines and the infrastructure that they build to connect them to the grid are going to be valuable for 50 years, the depreciation and amortization -- eventually, they have to be replaced, but not in five or seven years. FFO is a good number to use as a metric for valuation. Also, cash available for distribution, which is a metric that talks about the dividend, and cash that's generated to be able to support the dividend payments.
So, those are two metrics that you should always look at when valuing the company, and also understanding its cash flows from, how secure is the dividend and how safe is the company's cash flows. I think that's really about it for Pattern, that I would add.
Priestley: Perfect. Jason, thank you so much for being on the show! Always a pleasure.
That's it from us today. If you would like to get in touch, please feel free to email us at [email protected], or tweet us on Twitter @MFIndustryFocus. As always, people on the program my own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thank you to Austin Morgan for producing the show today. For Jason, I'm Sarah Priestley. Thanks for listening and Fool on!