11/16/11: All In: Capstone Reports

By Roger Conrad • November 16, 2011

Third-quarter results are all in for Canadian Edge Portfolio holdings. Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF) released its numbers after the market closed Monday afternoon, followed up by a conference call Tuesday morning.

Highlights include a 16.7 percent jump in revenue over year-earlier levels, thanks mostly to the startup of the Amherstburg Solar Park. This facility sells all of its output at premium prices to the Ontario Power Authority under a 20-year contract. The company also enjoyed a quarter of cash flow from the 33.3 percent-owned Varmevarden district heating facility in Sweden and higher electricity rates at its Cardinal power plant.

Cash flow excluding the cost of internalizing management and other functions rose 28.4 percent. Meanwhile, funds from operations (FFO)–the account from which dividends are paid–surged 21.4 percent excluding internalization costs.

The biggest negative was a jump in FFO payout ratio (also excluding internalization costs) to 171.4 percent for the quarter, up from 128 percent a year ago. There were four basic reasons for the higher ratio.

First, the company issued stock to finance its business growth. Asset-focused businesses that aren’t regulated–like Capstone’s–must spend money to buy or build before they start earning cash flow. As a result, new issues of stock always dilute results initially, although they pay off richly down the road.

Second, the company experienced a steep rise in business development costs, which were up 482 percent including the internalization process and 45.6 percent higher excluding them. Business development costs basically include the cost of making acquisitions and other expansion. As Capstone had a very active quarter, it’s not surprising these are temporarily higher as well.

Third, the company repaid CAD2.3 million in debt principal during the quarter, partly to pay back a loan made by a unit of parent Macquarie Bank. Excluding that payment, FFO less maintenance capital spending produced a payout ratio of 124 percent, basically in line with last year’s tally.

Last but not least, operating expenses were 9.2 percent higher. That was entirely due to a 36.6 percent jump in gas transportation rates charged by TransCanada Corp (TSX: TRP, NYSE: TRP), mainly to fuel the Cardinal plant. The company and other pipeline users have since reached an agreement with TransCanada to basically take transport rates back to 2010 levels. The deal must be approved by regulators, so the timing is uncertain. In the meantime, however, rates have been rolled back to an “interim” level, which will reduce the impact on the bottom line considerably.

Capstone’s most important development during the quarter was the announcement of the CAD215 million (including assumed debt) purchase of a 70 percent interest in Bristol Water of the UK from Suez Environnement (France: SEV, OTC: SZEVF). The deal was completed after the end of the third quarter, and the company subsequently issued 12 million shares of stock to fund the deal, with the balance of the purchase covered by cash.

The assumed debt pushed the company’s debt-to-capitalization ratio from 44.1 percent to 59 percent. It also makes Capstone’s revenue more reliable overall, as Bristol cash flows are both regulated and steady, making the higher debt level arguably more manageable post-deal than the lower level was pre-deal.

Despite the shortfall in third-quarter results, Capstone’s outlook for its payout ratio in 2011 and 2012 remains basically the same as it was at the beginning of the year. The 2011 payout ratio as a percentage of adjusted funds from operations (AFFO) is expected to be between 120 and 125 percent. The 2012 payout ratio, meanwhile, is anticipated between 85 and 90 percent. Meanwhile, management has reaffirmed its ability to maintain its current distribution rate through 2014, even if it fails to expand its asset base.

Beyond that, the greatest uncertainty for Capstone remains negotiations with the Ontario Power Authority to renew the power sale contract for the Cardinal plant. Cardinal was a cornerstone asset when Capstone was founded as the former Macquarie Power & Infrastructure Income Fund. Buying Bristol and starting Amherstburg has reduced dependence on Cardinal, but the plant still accounts for upwards of 40 percent of Capstone’s overall profits.

Management remains close-mouthed about the negotiations, other than the statement in the MD&A documents that negotiations began in the third quarter of 2011 and continue. In addition, CEO Michael Bernstein maintained once again in the third-quarter conference call that he believes “Cardinal is well positioned for these discussions,” citing its flexibility as a power source and solid operating record.

The bottom line, however, is fairly stark. A favorable outcome to the negotiations could trigger a dividend boost. A middling decision would likely mean no increase, though the dividend will likely be raised as the company fulfills its strategy to become “Canada’s leading diversified infrastructure company.”

Finally, a purely negative outcome on Cardinal won’t bankrupt the company. For one thing, at least some of the power will be purchased by Casco, the plant’s industrial host. And the rest of the output will almost certainly be used. But it would make it a lot harder to maintain the current dividend rate, particularly as Capstone passes through a period of high growth and high payout ratios.

Fortunately, trading at a current yield of nearly 11 percent and barely book value, Capstone is pricing in a great deal of risk now. That leaves little downside risk, even in a worst-case for Cardinal and a lot of upside if negotiations wind up with an amicable solution.

The uncertainty about Cardinal does make Capstone a bit riskier than my other Conservative Holdings. But in any case management will still be able to execute what is in effect a very low-risk growth strategy.

The company’s debt structure is transparent and mostly tied to specific assets. Of the CAD350 million in long-term debt before the Bristol deal, for example, CAD104 million is fixed-rate project debt at the Erie Shores wind plant. Roughly CAD94 million is tied to the Amherstburg Solar Park, CAD25 million is linked to the Wawatay hydro plant and CAD43 million is in convertible shares with a maturity in 2016. And the rest is a credit facility maturing Jun. 29, 2012, for which the company has numerous options to roll over or pay off.

Adding Bristol will bring CAD406 million more in debt. None of it, however, is recourse to Capstone. That means even if Bristol went bankrupt, Capstone wouldn’t be liable for this debt. The company also still has CAD30 million in cash with which to execute more acquisitions.

The bottom line is I’m still rating Capstone Infrastructure a buy up to USD9 for those who don’t already own it. We may have some ups and downs along the way. But given strength of the existing portfolio, balance sheet and management, a return visit to double-digits is a lot more likely than a return to the late 2008 lows. Note this is not a recommendation for anyone who already owns the stock to double up.

Where the Numbers Are

Here’s where to find my analysis and the numbers for Canadian Edge companies, all of which have now reported third-quarter results. The December issue–e-mailed and published at www.CanadianEdge.com Dec. 9–will have further analysis on these companies as well as a recap of earnings of the rest of the CE How They Rate universe.

Conservative Holdings

Aggressive Holdings

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