Western Wind: A Clean Energy Rodney Dangerfield?

Renewable energy power producer Western

Wind Energy Corp (WNDEF.PK, WND.V) feels it gets no

respect. In particular, they have long felt that the investing

public does not recognize the value of the company's existing and

nearly completed wind farms.

Western Wind's Kingman I Wind and Solar park. Photo courtesy of the company.

Independent Valuation

Almost every company will tell you that their shares are

undervalued, but what's a bit more unusual in this case is that

their assets (Wind farms with a little solar thrown in) are fairly

easy to value with a rigorous discounted cash flow (DCF)

model. While wind and solar resources vary from hour to hour

and even year to year, the expected energy production from wind and

solar farms is fairly predictable over time, and all Western Wind's

projects except for Mesa have Power Purchase Agreements (PPAs) with

electric utilities that specify the prices those utilities will pay

for as long as 20 years, leading to fairly predictable revenue

streams over time, and fairly low uncertainty in asset

valuation. The company is currently selling electricity from

Mesa at the spot price, but they are in the process of negotiating a

longer term PPA.

Last year, company management decided to back up their words by hiring

the independent DAI Management Consultants, Inc to value the

company's equity stake in their renewable energy projects.

Western Wind has a 30MW operating wind farm (Mesa), an operating

combined wind (10MW) and solar (500kW) farm (Kingman I), a 120 MW

wind a farm and that is nearing completion and expected to be fully

operational by the December 2011, and a 30 MW solar farm in Puerto

Rico (Yabucoa) that is expected to be completed by the end of

2012. Windstar and Kingman have signed PPAs and debt financing

in in place, and Mesa is fully financed and operating under a spot

price sale agreement. Yabucoa has a signed PPA and the company expects

to close financing for it by the end of 2011.

Assumptions

Western Wind has released the results of DAI's valuation in a series

of press releases as the valuation of each project was

completed. The complete valuation is not public because it

depends on the terms of the PPAs, which are confidential.

(Confidential PPAs are a practice which I believe is

counterproductive as well as counter to free market

principles. Nevertheless, keeping PPAs confidential is

standard utility industry practice, and could only be banned by

utility regulators; it's not something I or Western Wind have the

power to change.) They did, however, release the assumptions

on which DAI's valuation was based. These assumptions are

included in the table below.

Assumptions used by DAI in valuation model.
	Windstar	Kingman I	Mesa	Yabucoa
Project type and size	120MW wind	10MW wind, 0.5MW Solar	30 MW Wind	30MW Solar
Commercial operation date in valuation model	Dec 31, 2011	Dec 31, 2011	Existing operations	Dec 1, 2012
Remaining asset life	30 years	30 years	20 years (older assets)	30 years
Power Purchase Agreement (PPA)	fixed price for years 1 to 20 via signed PPA and merchant prices thereafter	fixed price for years 1 to 20 via signed PPA and merchant prices thereafter	fixed price per CPUC MPR for years 1-20	fixed price for years 1 to 20 via signed PPA and merchant prices thereafter
Land	Owned	Owned	27 year right of way	40 year lease
Tax incentives	30% cash grant and 100% bonus depreciation	30% cash grant and 100% bonus depreciation	None	30% cash grant, 50% bonus depreciation and 50% Puerto Rico investment tax credit
Source of key assumptions	Independent engineer	Independent engineer	Management	Management
Debt --to-capital ratio	54%	54%	35%	43%
Term of debt	20 years	20 years	15 years	20 years
Cost of debt	6.0%	6.0%	5.1%	6.0%
Discount rate on equity returns	Under PPA: 11.48% Merchant generator:15.75%	Under PPA: 11.51% Merchant generator:15.85%	Under PPA: 10.52% Merchant generator:NA	Under PPA: 10.96% Merchant generator:14.74%
Weighting of income approach vs cost approach	75%	75%	100%	75%
Construction cost contingencies	5%	5%	NA	5%

One assumption that I would have liked to see is the expected

capacity factors for each of the wind farms, since that is key to

knowing how much energy each project is likely to produce, but

otherwise the disclosure seems comprehensive.

Assuming the capacity factor estimates are accurate, an assumption

which shows the fairly conservative nature of the valuation is the

second-to-last row "Weighting of income approach vs cost

approach." This row indicates that for each of the incomplete

wind farms, only 75% percent of the valuation given is based on a

DCF model; the other 25% of the valuation is a replacement cost

approach using comparable market transactions. This is

conservative because the DCF model should give a considerably higher

value than cost when valuing a wind project because unfinished

projects trade at a discount: Why invest money if the expected

returns (DCF valuation) are below what you could get by selling the

project?

Another row worth noting is the third to last, "Discount rate on

equity returns." This is extremely important because DCF

valuations are highly sensitive to the discount rate assumption: a

slightly lower discount rate can lead to a much higher project

valuation. Discount rates vary with the riskiness of the

project, and with interest rates in the economy in general. (Risky

projects should have higher discount rates, and we see this

reflected in the fact that when power is to be sold on the spot

market rather than under a PPA, DAI used a significantly higher

discount rate.)

As an investor, the simplest way to judge if an equity discount rate

is appropriate is to ask yourself if you would be willing to earn

that discount rate as an annual return for owning a slice of the

project. For myself, I would be happy to own a slice of a

operating or nearly-completed wind farm for 10.5-11.5% per

year. I'm not quite sure why the Yabucoa solar farm is given a

lower discount rate than the others even though it is over a year

from completion, but I still consider the return to be sufficient.

Given these assumptions, DAI came up with the following project

valuations:

Project Valuations from DAI
	Windstar	Kingman I	Mesa	Yabucoa
Project Valuation	$358 million	$32 million	$25 million	$206 million
Project Liabilities	$275 million	$24 million	nil	$152 million
Value of Western Wind's Equity stake	$203 million	$16 million	$24 million	$110 million
Value Per diluted share (70m shares)	$2.90	$0.23	$0.34	$1.57

I then calculated the implicit value per share of Western Wind and

adding in the value of the company's tax loss carry-forward, and

assuming that all unexercised share options and warrants with

exercise prices below the current stock price would be

exercised. This has the effect of increasing the number of

shares outstanding from 60 million to 70 million, and adding $12

million dollars of cash to the company's balance sheet to reflect

the cost of exercising the options and warrants. Note that the

fully diluted shares given on Western Wind's website are 71.8

million, but this included the exercise of options and warrants with

exercise prices above the current share price: the exercise of those

options would result in a net gain to investors who buy at the

current price.

Share Valuation	Value (millions $)	Value per diluted share (70 million shares)
Total DAI Company Valuation (including above projects plus project pipeline)	$383	$5.47
Tax Asset (loss carry forward)	$9	$0.13
Value of Cash Paid for Exercise of Warrants & Options	$12	$0.18
Total	$404	$5.78
Share price (10/31/11)		$1.60
Appreciation needed to reach fair value		3.6x

As you can see, I arrived at a per-share valuation of $5.78, three

and a half times the current share price. I think it is

unlikely that the company's share price will go quickly to this fair

value given the current climate of uncertainty, but even if the

company were to remain at this current 3.6x discount, we could still

expect the stock to rise over time, for a couple of reasons.

First, if the Windstar is completed on schedule by the end of the

year, it should no longer be valued partially based on cost, and

should be valued solely based on DCF. This should lead to an

immediate value boost, as discussed earlier. Kingman is

already

fully operational, and so should also be valued solely with a

DCF model. Second, as time passes, cash flow will be

produced from the operating farms (and Yabucoa will come closer to

completion), and this should lead to a gain in value approximately

equal to the discount rate on equity returns used in the project

valuations.

Hence, even if a company trading at a 3.6x discount to fair value

does not attract takeover offers or the share price does not quickly

adjust upwards for other reasons, we can expect at least a 10%

annual return just from accrued income and impending project

completion. In fact, since the valuations above were completed

in February (Windstar) and May (the other three), the current

valuation of the company should be at least $18 million or $0.26 per

share higher today than shown in my table above. But who's

counting?

I personally found the calculations above convincing, and began

buying the stock in September.

Possible Takeovers

If the relatively slow 10-12% annual growth in the project values is

not enough to excite investors, the possibility of a buyout offer

seldom fails to do so.

The first hint we got about takeover offers was on October 1st, when

Western Wind asked

the Investment Industry Regulatory Organization of Canada

(IIROC) to review the large numbers of matched trades which had been

occurring over the previous six months. In the complaint to

IIROC, Western Wind stated "it has been made aware in the past few

days, that a certain party would like to make a take-over bid of

certain or all of the assets of the Company," with the implication

that the company's share price had been manipulated down to make a

low takeover offer look attractive to investors.

On October 11, the Company revealed that Algonquin

Power and Utilities (AQN.TO/AQUNF.PK), a company I also own,

had expressed interest in buying the company at $2.50 a share.

I most recently wrote about Algonquin in a review

of the larger alternative energy power producers. I

chose not to discuss Western Wind and another Renewable Energy

project developer, Finavera

Wind Energy (FNV.V/FNVRF.PK) in that article because they are

earlier stage companies, because I was in the process of buying

shares of both at the time, and I did not want to raise the price

for my own purchases in these relatively thinly traded stocks.

After the Algonquin offer became public, there followed a series of

press releases from Western Wind and Algonquin, with Western Wind

basically saying that the price was way too low, and that they were

looking around for other offers, and Algonquin making it clear that

they weren't ready to raise their price significantly. Western

Wind made the point that Algonquin was not the ideal acquirer

because, as a Canadian company, they would not be able to realize

approximately $1 per share worth of tax deductions in the form of

accelerated depreciation on the company's wind farms. Before

making the bid public, Algonquin had entered into a

"lock-up agreement" with a large Western Wind shareholder

owning 18.6% of the company. The shareholder had agreed

to support Algonquin's bid, giving the company the confidence they

needed to make the bid public.

At Algonquin's request, Western Wind

formed a special committee to consider any formal offer for

the company, including Algonquin's. Nevertheless, on October

26th, Algonquin

terminated the lock-up agreement and indicated they were no longer

interested in pursuing the deal. I can only speculate as

to Algonquin's reasoning, but my feeling is that they were not

interested in a prolonged takeover battle which would probably

require them to raise their $2.50 initial offer.

About the same time, Western Wind announced

that it was discussing a buyout of a 100 MW wind project, in order

to remind investors that there was a lot more to the company than

the possibility of a takeover from Algonquin.

It concerned me that Western Wind was considering the acquisition of

a wind project if they thought their own shares were so far

undervalued. Why not just buy up the company's own undervalued

shares instead?

I tried to get some details from Western Wind's investor relations

contact, but he could not reveal any details of the negotiations,

which are at a very early stage. He did say that the reason

the project's owners are willing to sell is because they cannot get

the capital to develop it. Western Wind expects that, if the

company proceeds with the deal, it could find a way to develop the

property with minimal or no share dilution. Lack of dilution

is no guarantee that such an acquisition would create more value

than a share buyback, but it is comforting that they are paying

attention to shareholder value.

What it Means

As a long-time Algonquin shareholder, I'm pleased to see that the

company was only interested in buying Western Wind at a knock-down

bargain price, and hope that they continue to take that approach to

all future acquisitions.

As a Western Wind shareholder,

I was a bit disappointed that the deal did not go through. I'm

not immune to the lure of a considerable and very quick profit on my

WNDEF shares. On the other hand, I did not buy those shares

because I was expecting a near-term takeover. Instead, I

bought them because I expected (and still expect) long term

appreciation based on the fundamental value and earning power of a

company with large wind projects just now coming online.

The IR spokesman also pointed out that the company is considering a

share buyback in 2012 using some of the proceeds of the Windstar and

Kingman federal cash grants, as announced

last December.

Give Western Wind Some Respect

Western Wind became profitable only in 2010, and is right in the

middle of the transition from being primarily a renewable energy

developer to a renewable energy power producer with strong cash

flow. This change means this Rodney Dangerfield of a company

will begin to get some respect from a new class of investors, and

the attention brought by the takeover offer seems to have attracted

the attention of a few such.

Although Western Wind's shares fell when Algonquin decided not to

pursue its offer, the shares are still trading higher than they were

in September. But at $1.50-$1.60 per share, there is still

considerable room for appreciation to fundamental value.

In the near term, the free cash flow after operational expenses from

Windstar and Kingman alone should be $14 million annually, with the

potential for another $4-5 million from Mesa and Yabucoa, or 26

cents a share before company level expenses and the benefits of

accelerated depreciation and cash grants.

For that alone, Western Wind deserves a lot more respect from

investors.

DISCLOSURE: Long AQUNF, WNDEF,

FNVRF.

DISCLAIMER: Past performance is

not a guarantee or a reliable indicator of future results.

This article contains the current opinions of the author and such

opinions are subject to change without notice. This article

has been distributed for informational purposes only. Forecasts,

estimates, and certain information contained herein should not be

considered as investment advice or a recommendation of any

particular security, strategy or investment product.

Information contained herein has been obtained from sources

believed to be reliable, but not guaranteed.