Active Energy Group - A Canadian Twist

http://www.active-energy.com/


Of all the companies in the site portfolio, Active Energy Group is the one that has been most interesting over the past six months and that is shown through the necessity to write three articles prior to this, within a 6 month period. Admittedly, that is partly down to the unstable situation in Eastern Ukraine, but it is primarily because the company has made such rapid progress in expanding its operations. Taking a contrarian approach and fully understanding what the company offers has been central to recognising an opportunity to invest in a company that has undergone a full transformation. Investors have been rewarded with the share price is up nearly 90% from the lows made earlier this year. Over the past couple of months, Active Energy has revealed a very interesting Canadian twist to investors and I continue to see fair value being near substantially higher than the present price.


Technicals


The share price performance over the past few months is proof of the scale of Active Energy's transformation, because the very impressive rise is despite conflict in Eastern Ukraine between Ukrainian troops and Pro-Russian rebels, along with incursions made by Russian troops that has seen the downing of a commercial jet amongst other high-profile events. Considering that the company's primary revenue generating operations are located in Southern Ukraine, the price strength is down to investors recognising that there is significant potential above and beyond the Ukrainian operations. However, I have also been keen to point out reasons why having very serious concerns about the Ukrainian operations would be wide of the mark at the current point in time.

The fact that the share price is breaking to new medium-term highs is extremely positive against this backdrop, which will inevitably have deterred some investors, regardless. Indeed, the technical outlook is bullish following the break of 3p although the spread can be deterring at points - it is currently between 3p - 3.15p dependent upon volume. Once again, given the scale of the undervaluation, the spread can be disregarded to a certain extent, although be aware that liquidity can be poor periodically and prone to share price swings.

There has been one notable technical pointer since the last updated - CEO Richard Spinks purchased a further £10,500 shares at 3p. That is obviously a positive indicator for investors and the share price is currently in line with the purchase price.

Operations

Although the Canadian development will be at the core of this review given the extensive coverage of the other operations in past reviews, it is worth very briefly outlining the other two operations.

As investors familiar with Active Energy will know, the core operations are currently dockside in Odessa, Ukraine. I describe them as core since they are revenue generating and they are forecast to be strongly and increasingly profitable in 2014 and 2015. The Ukrainian operations primarily revolve around sourcing waste wood and associated discarded wood from the Northern and Western parts of Ukraine through working with forestries, bringing them to Yuzhny port in the South of Ukraine by rail, chipping the wood, and shipping it across the Black Sea to MDF manufacturers in Turkey where the company has several large contracts. There are geographical advantages to this as the product is fresher than wood chip from the Americas plus there is a lower logistics and transport cost.

Many investors have been taking a very cautious approach to Active Energy as a result of the conflict in Ukraine, although to date the volumes have been unaffected and have actually been rapidly increasing. Furthermore, I have commented that investors have a degree of safety given the sheer distance between where Active Energy's operations are (Odessa), and where the conflict is taking place (Luhansk and Donetsk regions). To re-iterate, the distance is roughly equivalent to the distance between Liverpool and Calais (in France). That means that, if you keep a watch on events in Ukraine, you should be able to adjust positions in decent time if you become uncomfortable - there has been talk of an unwinding of the situation in Ukraine today, which will only alleviate the risks further.

There are recent start-up operations in Spain and Montenegro, which involve sourcing and supplying wood chip to biomass power plants, predominantly in Italy. This provides intra-Europe diversification to the core business at the moment. Together with the Ukrainian business, we can refer to this collectively as the main 'European' business.

The second side of the business is more speculative, but also very interesting, and is based on an invention for a pelleting technology. This is outlined in depth in the last review, "Operations Stacking Up", but essentially, this is a technology that is touted to produce pellets (for biomass) at a far lower cost than existing technologies. It also has several other desirable characteristics such as burning more cleanly than current pellets. The technology does still need to have certain parts of the intellectual property protected, and it is early stage, but given the likelihood of boasting a high internal rate of return for purchasers, it presents a compelling technology play against the more pedestrian main European business.

The background markets for these two divisions are strong, and biomass in particular is still a growing market. In the UK, there area a number of wood chip/pellet feedstock plants being planned/seeking finance with opening dates over the coming years. To name three are plants in Tilbury, Immingham and Hull, although that is just a small representation of a biomass push that continues across the rest of mainland Europe as well.

In my last review, I noted "With a highly experienced management team who have already transformed AEG into a soon-to-be profitable business notwithstanding disruptive domestic conditions and the collapse of AEG's shipping partner is nothing short of phenomenal. Continuing to back the management is likely to pay off especially given the current undervaluation versus Rentech and other comparators - I foresee AEG growing into a significantly larger company in the years ahead. I retain my Buy tag on Active Energy Group." That was without the recently announced Canadian venture, which means there is now the opportunity for Active Energy to become a much larger company than even envisaged at that point in time. Of course, that prediction is not without notable risks so it is important to be very flexible on any targets, but the Canadian development adds major diversification given that Canada is universally regarded as an incredibly safe country to work in.

The Canadian twist was announced to the market in July and the scale of the move was particularly surprising. Active Energy entered into a joint venture (JV) to "exclusively commercialise" 100,000 hectares of mature forestry assets in Alberta, West Canada - that land package was expected to yield 20 million cubic metres of commercially standing timber. That development was made at little immediate purchase cost to the company.

How was that managed? It is actually a very unique deal that sees Active Energy partner the local First Nations Metis people of Alberta, in particular in three settlements - Peavine, Paddle Prarie and East Prairie. As part of the deal, the Metis settlements transfer their land rights over to a newly formed JV vehicle and take a 45% stake. Active Energy also take a 45% stake, and the broker of the deal, Grand Chief Derrickson, takes the remaining 10%. This means that the company is in an equitable partnership with the Metis to develop a very substantial land package that was previously undeveloped and which the Metis settlements did not have the means to develop in an attractive way.

The scale and cultural significance of the deal is underscored by the circa 6 years over which it was negotiated and it is unique as it sees the Metis settlements take an equitable stake in the development of the land, rather than royalty schemes in which the economic return is far lower. A royalty scheme would almost certainly see the First Nations people exploited by 'big business' and so there has been little incentive in the past to develop the forestry assets. Indeed, such exploitation of indigenous groups regularly takes place in many other countries around the world, such as Indonesia, so the fact that the JV is equitable is highly important - it aligns Active Energy with the Metis settlements, and if there is success, it is shared. The population of these settlements is only a few thousand, but the assets they have own are very large. The hope is that this deal will act as an example for other companies wishing to work with indigenous populations and there are certain safeguards - for example, all commercial transactions will include an obligation to provide local employment for Metis citizens. Of course, working with the environment is a sensitive topic, so it is essential that the JV partners collaborate very closely together, and that has been signalled through having a board with equal backing - 3 members from Active Energy, the three Metis Chairman for the three settlements, and Grand Chief Derrickson. Back to an investor's point of view, this is a further example of CEO Richard Spinks' high level of credibility and excellent operational skills.

Active Energy is in charge of commercialising the asset on behalf of the JV, known as KAQUO (meaning "All together"), and the deal sees the company working back with the resource, at the start of the supply chain. I did say 100,000 hectares, but it was recently announced that there is a "significantly large hectarage than first envisaged" and that "in any case" it would not be less than 200,000 hectares. In other words, 200,000 hectares is a base case number we can use when performing calculations. Just to put that into perspective, Greater London covers an area of 157,000 hectares, so the new land package is at least 25% larger than Greater London. The size of the resource is massive, especially for a company with a market capitalisation of less than £20m. The forests are a mixture of prime mature standing hardwood and softwood, with the timber considered 'A' grade plus the terrain is favourable since it is flat, and the level of insect/disease problems are relatively low. Transportation infrastructure and links are already largely in place.

The method of commercialisation would seem to be most interesting although it requires some clarification beyond what was released in the RNS'. 

What we know is that KAQUO will be allowed to enter into sub-leases with third-parties for periods of around 200 years to facilitate the long-run development of the Metis population. The development is expected to be in collaboration with international investors and commercial partners. The first step, which is being conducted currently, is to undertake an extensive sampling programme - 2% of the total forestry. This will allow the JV to understand what they have, in detail and will allow for an updated volumetric estimate of standing timber to be released within two months. 

Following this, there is a relatively common process employed in many similar situations. There is likely to be a process of cleaning the forest of 'competition' - these are the less desirable trees that compete with the more valuable trees for light, water and nutrients. Removing these will enable quicker growth of the highest quality trees, enhancing the value for any partner. Alongside this and potentially beforehand, discussions will be entered with logging companies, financiers and TIMOs to observe what direction of development is most attractive. 

Active Energy has also commented that there is the potential to develop power plants at or near the forestry locations. The volumes are likely to be large enough to entirely sustain two small/medium-sized power plants either alone or in partnership with third parties - the three settlements can be broadly separated into North and South. To the North is Paddle Prairie and to the South are Peavine and East Prairie - these two settlements could share a power plant. The rationale behind the power plants is that there is touted to be regional electricity strains, partly down to Alberta's large-scale oil and gas developments of their oil sands. It's therefore potentially very lucrative to pursue this strategy.

KAQUO may then choose to sell the forestry rights (not land rights) to certain areas of land to third parties, for a number of rotations or for the circa 200 years noted earlier. The length of a potential deal would likely be particularly attractive to certain large-scale TIMOs as it gives a degree of security. The third party would be able to develop the land as they see fit whilst any waste wood and unsuitable logs are used to power the newly-built power plants. Since most of the costs associated with the general process are related to logistics, it would be a very cheap source of feedstock, especially since waste and unsuitable logs are typically burnt on site if they cannot be used. That would make KAQUO a low-cost power generator to the region, giving the Metis people a louder voice in regional politics and turning them into a 'net contributor'. Moreover, the low-cost power generation makes compelling electronic sense, especially since it would be entirely reliant on chipped waste wood or associated products meaning that margins are very attractive.

Interest in the forestry rights is likely to be high given the political and geographical setting alongside the excellent quality, high age class and high density forestry assets. In addition, there are a number of lumber demand drivers that keep parties on the lookout for opportunities such as KAQUO's, which are increasingly hard to come by. A few of those drivers are increased shipments to China, supply-side pressures and US demand from housing construction.

We can actually start to derive a valuation for the hectarage that has been confirmed using sales/purchase prices achieved in other corporate transactions including Hancock Timber Resource Group and The Forestland Group. Transferable valuation suggests span $2,000/hectare to $7,000/hectare dependent upon a variety of factors including infrastructure and various forestry characteristics. In KAQUO's case, the eventual number will probably be somewhere within those two implied boundaries - perhaps between $2,000/ha and $5,000/ha as a sensible range before further details are released. Recall that the lower limit for hectarage is now 200,000.
    - At $2,000/ha, $400,000,000 total asset value = £109,000,000 net to Active Energy
    - At $5,000/ha, $1,000,000,000 total asset value = £273,000,000 net to Active Energy
 
What is abundantly clear is that it's a potentially huge asset relative to the current market capitalisation. £109m is effectively the base case and is well over 6 times the current company valuation. Importantly, if forestry rights are sold, then it tends to take the form of an up-front non-refundable payment of $X for Y hectares (or acres). If forestry rights for 30,000 hectares were sold off at $2,000/ha, then KAQUO would receive $60 million in cash that would be distributed according to percentage ownership. That would effectively see Active Energy Group receive $27m or £16.4m, and that is based on only a fraction of the total asset and assumes the base case $/ha. Of course, that would leave the market capitalisation at present looking extremely low and by a large margin - larger hectarage sales would exaggerate that point.
 
Under IFRS and IAS 41, Active Energy's share of the forestry rights that are not sold can be shown under Active Energy's balance sheet as the land is freehold. It can be stated at fair value less the estimated point-of-sale costs or, if there is no reliable measurement of fair value, stated at cost. It is key to not lose sight of the Metis settlements' involvement in the whole joint venture - after all, they have entrusted Active Energy with a substantial asset and are reliant on them acting equitably and in the best interests of both parties. With the management team in place, it is understandable why they would be willing to partner with Active Energy.

Grand Chief Derrickson said, "In AEG, the Métis Settlements have finally found a partner with the experience, vision and international network to enable them to properly and fairly commercialise their assets for the long-term benefit of their communities.  I first became aware of Richard Spinks - Active Energy Group's CEO - through his ground-breaking work with Landkom International in Ukraine, where he successfully created a co-operative agricultural business that transformed the lives of many thousands of private land owners. Richard and I have been working together for the past five years to assemble a deal that finally gives the Métis an equitable share in the economic development of their forests, and I know that it will set the standards and terms for further agreements with other Métis, First Nations and aboriginal groups across Canada to enable them to develop and commercialise their assets in an equitable and sustainable manner to bring long-term economic growth, employment and stability to their communities and their peoples."

Financials

I commented in-depth of the financial projections for Active Energy in the last review, but with interim results due out in September, there are several points to draw attention to:

1.   Results this year will be second-half weighted as a result of expansion timings during the year. Only 101,000 of the 310,000 metric tonne full year forecast are expected to have been fulfilled during H1, but operational improvements such as the move to Yuzhny only materialised part way through the first half and did not ramp up fully
UAH:USD exchange rate
2.   The Ukranian Hryvnia weakened further during H1 and to date in H2, which will boost profitability given that the company buys raw materials in Hryvnia and sells in dollars.
3.   Nonetheless, H1 revenues and profits should show a marked improvement upon H2 2013 and an even more stark improvement compared to H1 2013 when the current business was not in operation
4.   Full-year adjusted EPS to ramp up in 2015

Looking past 2014, the company trades on even more attractive metrics, especially when understanding that they only relate to the Ukrainian business and exclude the pelleting technology, Spain/Montenegro and Canadian potential.
1.   Forecast 0.51p EPS in 2015 leaves Active Energy Group trading on a very low forward multiple of less than 6, given the rate of growth and low market capitalisation. This could yet prove conservative as it modelled a UAH 9:1 USD exchange rate whereas it is around UAH 12.5:1 USD at the moment. Each extra UAH per USD could translate into an extra £1.2m in EBITDA. It also excludes financials from Spain/Montenegro, Canada and the Pelleting technology. Earnings quality is relatively high although slightly dampened by the Ukrainian geopolitical factor
2.   Active Energy trades on an adjusted EV/EBITDA of less than half of that of my chosen comparator Rentech (at around 9.2). A multiple of 9.2 suggests a share price target of 5.43p
3.   WH Ireland retain a 6p price target implying near 100% upside and excludes Canada/Pelleting/Spain contributions

A Rapidly Growing Company with Excellent Management

The phenomenal progress made over the past six months alone continues to be testament to the capabilities of the management team and although there are unlikely to be any more new major operations unveiled for the foreseeable future, management is core to the investment profile. I noted in the last review that the pelleting technology and core wood chipping business alone were likely to demand a higher market capitalisation - the new Canadian twist only enhances that view, and there is now considerable potential to grow the business using the diverse asset base in place. Cash flows from Ukraine will assist in funding the new ventures, whilst alone supporting a share price considerably higher than circa 3 pence - the pelleting technology and the Canadian business are 'free' additions. At the same time, those deterred by the Ukrainian situation can now see that the current market capitalisation could easily be supported by Canada alone, and that the magnitude of the deal with the Metis settlements is likely to be highly rewarding for the Metis people and Active Energy over the short, medium and long-term. Of course, it's still worth keeping a close eye on events in Ukraine, but whilst activities continue to be unaffected, and growth continues apace, I foresee fair value at the moment to be at a market capitalisation comfortably north of ~ £30 million with room to grow as progress continues.

4 comments:

  1. Blinding call to stick with AEG even through the Ukraine crisis. Now its close to ending its catching me eye very nicely.

    John

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  2. You need that thumbs up feature like stockopedia :0)! Great writeup and piece on Active energy group. Canada is very interesting and if they get £109m by a chance ;0) wh Irelands 6p target is going to look cheeap as chips! Fabuloso :0)

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  3. Very bright future for anyone who invests under 5p IMHO

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  4. Briiliant write up. Thank you. Great investment too.

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