Description

AES [AES]

AES is one of the largest electricity generation and utility companies in the world and is transforming into a market leading renewable energy developer. With +6GW of renewable backlog, the company will grow earnings 7%-9% through 2022, well ahead of its peers in the utility indices. Despite this outsized growth, the company trades at only 12x next year’s consensus earnings vs. 19x for the index. Led by an outstanding CEO and aligned board, the company is moving away from coal and into solar/wind/storage at an aggressive pace. As a free call option, AES is a 50% owner of Fluence which is the largest battery storage provider in the world by GW deployed and awarded. A private mark this year and an IPO in 2022 should add $5 of value to the share price. A series of short term catalysts detailed below will begin the rerating of AES stock and the buildout of the green backlog will close the valuation gap between peers by 2022. We see a $32 (+65% upside) stock price for AES in 2022 based on current multiples and a conservative valuation for Fluence. Growth beyond the current backlog and modest multiple expansion implies a stock price more than double today.

Catalysts:

In the next six months AES will become dramatically more investable for generalist and ESG investors:

1. AES parent debt will be investment grade by yearend. Fitch upgraded the debt to IG before the pandemic and S&P/Moody’s are expected to reach the same decision very soon. I’ve pitched this idea to multiple funds who put their pencils down as soon as they saw the non-IG rating.

2. Coal exposure will be below 30% at the end of the year and AES will be within Norges bank ESG criteria. AES has been on the exclusion list from the Norges Bank, which is the largest sovereign wealth fund in the world. Norges is a leader for European ESG investors and alone has $23B investments in green utility stocks. This will unlock considerable ESG AUM flows to AES equity. 

3. Fluence is targeting a private mark by yearend with IPO planned in the next 15-24 months. Most sell-side analysts value this stake at $0-$1/share. My discussions with clean tech analysts peg Fluence’s value in the public market as substantially higher. It should equate to $5/share when it goes public.

LT catalysts include the development agreement with Google, reducing coal exposure to 10% by 2030, return to growth at Gener post 2022 and the proliferation of energy storage.

Brief Company History: Under CEO Andres Gluski, AES has embarked on a dramatic transformation since 2012. The company has exited 18 countries, paid down +$3B of parent debt (50% reduction), and refocused on renewable energy development in the Americas with one of the largest green backlogs in the world. Revenues have been substantially de-risked with 85% dollar denominated contracts under long term +14-year agreements. Before the simplification, the company consistently missed earnings guidance. Currency and fuel price fluctuations, rainfall, project delays and geopolitical issues were a nonstop headwind. Now after eight years of restructuring contracts, selling assets and signing new PPA’s, the company is set up for a highly de-risked 7%-9% earnings growth through 2022. Even Covid-19, which has been a disaster in South America, only resulted in a 5% reduction to 2020 earnings guidance. The CEO deserves much of the credit for this turnaround, but the transformation accelerated in 2018 when Jeff Ubben joined the board. AES has been the cornerstone position for his Spring Fund since its founding (now Inclusive Capital) and he has added to their position multiple times this year.

Business Units:

A detailed description of the business units follows below. AES has a number of fully and partially owned subsidiaries which can make modeling a complex task. These models are purely meant to illustrate the backlog growth overtime using high level industry assumptions and company disclosures. I also included BofA’s PTC estimates per segment for reference. PTC = Net Pre-tax Contribution

US & Utilities (40% of revenue, 40% of EBITDA, and 36% of PTC): 

This is AES’s highest growing and most valuable segment. The company owns a majority stake in Indianapolis Power & Light (IPAL) and 100% of Dayton Power & Light (DPL). Both utilities should grow earnings between 5%-10% going forward and service a combined 2.2mm customers. They should be valued at standard utility multiples. More interesting is the renewable energy development arm within this segment. This includes: (1) 50% ownership in sPower, one of the largest solar developers in the US with a pipeline of 15 GW (2) AES Distributed Energy which pioneered large scale paring of solar+battery deployment (3) Southland, a state-of-the-art 1.3GW CCGT complex in southern California offering much needed baseload power and energy storage to the CA market (4) Puerto Rico subsidiary which provides 8% of the generation capacity on the island.

In total the US segment has 10 GW’s of operating assets and a firm backlog of 3GW of renewable projects. This should propel the growth of PTC and EBITDA to 12%-15% for the next few years. The US contribution will approach 50% of EBITDA in 2022 and assuming continued non-core divestitures, should approach 50% of PTC as well. The XLU utility index has a weighted average 2020 P/E of 20x and EV/EBITDA of 13x. Large US peers focused on renewables growth like NEE, D, EXL trade closer to 24x and 14x, which is how the US segment should be valued in my opinion.

South America (31% of revenues, 35% of EBITDA, and 32% of PTC). 

AES South America has 13 GW of gross generation capacity which is evenly split between Chile, Brazil and Argentina. Renewables backlog is approaching 3 GW in this segment as well. The majority of this segment is comprised of AES’ holding in two publicly traded companies. AES owns 67% of AES Gener and 43% of AES Tiete. AES consolidates both companies in their financial statements and this has led to a complexity discount for the stock overtime. However, given the backlog strength, these firms will become some of the top renewable asset owners in South America. By the end of 2022, AES will be rewarded for these stakes instead of penalized.

AES Gener is predominantly in Chile, where they are the largest energy producer in the country. Chile is still considered the gold standard for foreign investment in the region. Gener shares have suffered in recent years due to hydro project delays and a pending PPA cliff in 2022. Gener will offset these PPA roll-offs overtime with their development pipeline and an innovative “green blend and extend” strategy which can replace a fossil fuel generation contract with a renewable source for similar or better economics. A large portion of contracts are with investment grade mining companies like Teck Resources and third party PPA owners like Google. Tiete is 100% renewable energy generator in Brazil and AES recently increased their ownership to 43%.

The majority of sell-side analysts simply value the Gener and Tiete stakes using their current stock prices. Given the growth at Gener post 2022 and the 100% renewable portfolio at Tiete, I think the market is currently undervaluing these companies. They should at least trade at South American peer multiples of 13x earnings and 8x EBITDA by 2022.

MCAC (19% of Revenue, 20% of EBITDA, and 23% of PTC)

The central America segment has 3.5 GW of gross generation which is evenly split between Mexico, Panama and the Dominican Republic. Backlog is only 600 MW’s in this segment so I will spend considerably less time on it. This region will benefit from AES strategy to provide LNG storage and infrastructure to the Caribbean and Central America. Remarkably similar to the New Fortress Energy strategy, there is a large arbitrage to be able to import very cheap LNG to displace bunker fuel generation which is dirtier and more expensive. Overtime this should trade at similar multiples to the South American peers.

Eurasia (10% of Revenue, 5% of EBITDA, and 9% of PTC)

This segment has been significantly paired down by divestitures over the years and I expect this to continue overtime. The only remaining assets are large coal plants in Bulgaria and Vietnam. I assume these plants will be sold in the next few years and hopefully by 2022. They should be able to fetch a decent multiple for the Vietnam plant with a contract out to 2040, but Bulgaria will be a wild card. AES has guided to at least $900mm of divestitures in the next two years and this segment has around $1.3B of non-recourse debt. I assume they can sell these assets for around 6x EBITDA which would essentially retire the non-recourse debt.

Total Company EBITDA and PTC

Combining the models above yields the following aggregate company EBITDA and PTC along with blended peer multiples for each. This is the basis for my base case which is detailed in the valuation section.

Fluence Energy Storage

Fluence is the real differentiator for AES and one of the main reasons we own the stock. Fluence is the world leader in utility scale energy storage with 2.1GW deployed or awarded. It already has more GW deployed than Tesla and will soon unseat it for largest storage project in the world. It currently generates $500mm of revenue, has a backlog of $1B and will grow revenue at the industry rate of 45% for the next 3-5 years. All current profitability is reinvested into the business, so it does not contribute to earnings currently, but should have a material effect on AES valuation.

Fluence is a 50/50 JV with Siemens to take advantage of the drastic need for energy storage in utility grids with high contributions from solar and wind power. Batteries can store energy during the day and discharge at times of peak demand to help mitigate the duck curve in place like California (and rolling blackouts for that matter). Fluence sells their own Li-Ion turnkey system to utilities and industrial customers and has patents surrounding the operating systems (OS). The 6th gen storage “cubes” are the most modular and “stackable” energy storage solution to date, which avoids expensive custom-built systems. The secret sauce and moat is around the OS built on 12 years of operating history and 240 terabytes of data. This powers the discharge algorithms and performance optimizations which outperform other storage solutions overtime and will keep Fluence in the market leading position.

Given the recent focus on wild fires and unreliable grids, I think there would be tremendous appetite for this company in the public markets and it would be the only pure play storage company at scale. However, most sell-side utility analysts have ascribed zero value to Fluence. I’ll be the first to say I have no idea what the private mark will be, but most of the clean tech analysts I have surveyed expect a 5x-10x revenue multiple if Fluence were public today. While there is no true public peer, a group of high growth energy storage related companies like Enphase, Generac or Solar Edge trade for an average of 7x revenues while fuel cell companies trade north of 10x. I expect Fluence can get to at least 7x revenues if they grow at +40% by the time of the IPO in 2020.

Valuation

These price targets are based on a SOTP’s methodology using pro-forma 2022 EBITDA contributions at yearend from all segments. I also assume all cashflow from now until 2022 is either paid out in a dividend or reinvested into the backlog of projects.

Base Case: $32 Price Target in 2022. Total return of 60% in 2 years. Assumes current +6 GW of backlog is built out and EBITDA reaches $4.3B by the end of 2022. I assume double-digit after-tax returns on the renewables backlog which equates to $150k/EBITDA per MW at a build cost of around $1.4mm/MW. I also assume project funding at 4% and is split 80/20 debt/equity implying $1.9B of equity investment for AES for the next two years. This level of EBITDA implies EPS of $1.78 in 2022. My estimates are a little higher than consensus for 2022 (and the 7-9% earnings growth guidance), but I’m not factoring in the $900mm of planned asset sales which would bring my numbers more inline. Assuming the current year EBITDA multiple of 10x is held constant, core AES should be worth $25/share. Add that to Fluence value of $5/share plus two years of dividends and I arrive at $32/share of total value in two years. These assumptions seem conservative for three reasons: (1) Pro-forma EBITDA only assumes conversion of current backlog, not the 2-3 GW per year growth target. (2) Fluence could see a near term inflection in backlog (3) This price target for core AES incorporates ZERO multiple expansion and implies 10x EBITDA and 14x earnings, which are roughly the same multiples as today and below the blended peer multiples I calculated in the previous section.

High Case: $48 Price Target in 2022. Total return of 152% in two years. Assumes EBITDA expands by an additional $200mm from my base case and Fluence reaches $1.2B in revenue. This could easily happen if backlog continues to grow at current levels for both core AES and Fluence. Value the EBITDA at 11x, which is closer to US peers since that will be the main growth driver. Then value Fluence at 10x revenue given the higher growth profile. This implies core AES value at $38/share which would be 20x EPS of $1.90, inline with XLU averages. Fluence and the dividend would add another $10 of value getting to a $48 price target.

Low Case: $16 Price Target. Downside of 16% from current levels. Assumes EBITDA only expands to $4.1B and EPS grows at or below the bottom end of the company guidance range. This seems highly unlikely given current backlog levels, but could happen if expected renewable returns fall short. This would only value Fluence at $2/share and assumes core AES trades back to 8x EBITDA (where it lived for years while going through the turnaround phase). Basically valuing the backlog at almost zero. I think there would be a lot of support at these levels given insider buying YTD and the staggering progress the company has made in the last few years on the balance sheet and earnings stability.

Risks

Interest rate and general utility valuation risk. This can be offset by shorting the XLU.

Geopolitical risk is real, but foreign currency exposure has been dramatically reduced over the last few years. There are a number of South American utilities that can be shorted for this risk as well.

Leverage has historically been an issue, but the vast majority of debt is non-recourse and parent debt should be investment grade by yearend.

I think a Biden presidency would be icing on the cake for AES, but a set back in green policy making would be a headwind to my upside case.

Disclosures:

We are long AES.

Catalyst

See catalysts section