Description

All currency in Canadian Dollars unless otherwise stated

Summary

Alter NRG ("NRG") has been substantially de-risked and 2015 will be an inflection year for the Company, positioning it for sustained, highly profitable, open-ended growth for an extended period of time. We led the Company’s private placement in April and our analysis leads us to believe that under reasonable assumptions, a 10X+ return over the current stock price is achievable within a ~4 year time frame.

The latest Company presentation as well as the transcript of the last earnings call give a good overview of the business.

Background

Alter NRG owns the industry leading Westinghouse Plasma Gasification technology with over $100mm of R&D investments, proprietary IP, technical know-how, active worldwide patents and a 10+ year head-start over any competitor in the space. The company can convert all types of waste into eco-friendly syngas, which can be used as a replacement for LNG in gas turbines or converted into electricity / other liquid fuels. Areas of the world with either high power prices or tipping fees (i.e. costs to dump at landfill sites) are good project site candidates. In addition to the obvious environmental benefits, plasma gasification projects have vastly superior economics relative to competing waste disposal methods and technologies and earn mid to high teen unlevered IRR’s without any government subsidiaries. Plasma gasification recovers 500% and 150% the energy of landfilling and incineration, respectively, using the same volume of waste feedstock. Conventional gasification technology (i.e. coal and petroleum coke) can only handle homogeneous, pre-processed feedstock that operators must pay for - as opposed to the tipping fee that plasma gasifier operators receive for taking its waste feedstock - and generates byproducts that cost more to dispose of.

Burning question

The main question any investor looking at this Company would have is: if this company has all these tailwinds behind it, why is the stock bouncing along its lows and where is the profitability?

There are two main reasons for the historical performance:

• Long Sales Cycle: Lead times for equipment sales are 3-7 years and projects are prone to delays due to the nature of the permitting, financing and regulatory processes, which result in fluctuations and variability in results

• Proving the Technology: Because these projects are large in size and take a significant amount of time, money and effort to develop, operators want to see working sites proving the technology before adopting them. This creates a chicken and egg situation

What has changed

The Company has a) built a $1.5 billion sales pipeline, b) proven technology through reference sites and c) developed market applications that have shorter sales cycles and expand the TAM by tenfold:

Order pipeline is robust and growing: After twenty years of developing its technology, constructing reference facilities and expanding product design, the Company is now finally at a point where it has visibility on $1.5 billion of potential revenues. These revenues are based on projects that have selected NRG’s technology and are being actively developed. The pipeline projects are bucketed into three categories (1, 2 and 3) based on criteria including: the operator’s size and quality, project returns, progression through permitting/regulatory processes, possession of key agreements such as offtake and power and expected equipment order timeline. A portion of this pipeline representing revenues of $140mm (up 300% over last year) is classified as Category 1 and is comprised of projects that are near financial close and that can generate revenues within 12-24 months.

Technology is proven: Although NRG has proven the technology at some smaller reference sites, Air Products’ 950 tpd, $500mm, 50MW Tees Valley (TV1) project in the UK completed construction in Q3 2014 and is a game changer. This project is now involved in commissioning and will come online in the first half of 2015. Air Products has been so enthused that it started the adjacent, identical TV2 project even though TV1 is not yet operational, which speaks to their confidence in the NRG technology that is the heart of this collective $1 billion effort. “Customer days” hosted by NRG at this reference facility have generated tremendous momentum and have resulted in the growth in sales pipeline we are seeing. Projects will become increasingly attractive for investors/operators as project development de-risking pushes down build-out costs and returns and equity contributions demanded by lenders. By year end 2015, TV1 will have been operational for 6 months and have generated eagerly awaited data that a number of incinerator customers will use to obtain corporate approval for their projects. This is expected to further swell the sales pipeline.

New market applications with shorter sales cycles:

LNG to syngas turbine fuel replacement: A multi-year effort to have syngas replace LNG as the fuel for GE’s gas turbines culminated in a joint marketing presentation with GE in Abu Dhabi last month. The presentation included a study showing that turbines can not only operate on syngas but can do so at superior performance levels. Economics for a turbine operator are very compelling: NRG’s syngas will cost $2-3 / mmbtu (including the benefits of using the operator’s own waste as feedstock) to produce versus the ~$15 / mmbtu cost of LNG in some parts of the world. The presentation was extremely well-received and the company is returning to the Middle East in December to meet with some heavy hitters (e.g. Saudi Aramco).

The overall market opportunity is tremendous: upgradeable gas turbines number in the thousands and consist of not only GE’s Model 6, 7 and 9s – numbering over 5,000 units – but potentially those of other manufacturers such as Caterpillar and Siemens. Projects have lower buildout costs of $50-100mm, $20-25mm of which would represent equipment revenue to NRG, and generate IRRs for operators in the mid-20’s or higher depending on energy prices and tipping fees. In addition to requiring less capital, the sales cycle is expected to be much shorter since these projects only need a permit amendment to retrofit an existing facility instead of a new permit that a green-field development would require. The first equipment orders are expected to meaningfully start in the early 2016 time frame. No revenue from this market vertical is included in the company’s pipeline yet.

Incinerator turbocharger units: Earlier this year, NRG entered into an agreement with China based GTS Energy to jointly market turnkey “turbocharger” facilities that bolt onto existing incinerators. Approximately 3,000 potential host incinerators have been identified. The units process the incinerator’s toxic fly-ash byproduct, eliminating disposal costs and allowing the operator to either sell the produced syngas or reintroduce it back into the incinerator to increase energy output/efficiency. Capital costs are much more palatable at either ~$3mm ($2mm gross profit) for fabrication work only projects (generally found in China) or ~$12mm ($5mm gross profit) for projects that carry the Westinghouse banner. The Shanghai demo facility has been toured by dozens of potential customers and held an extremely well-attended open house this month. This market application also has a much shorter, 1-2 year sales cycle as they are smaller in project scope and require only permit modifications instead of full green-field developments.

Recurring Revenue Stream

The difficulties associated with long sales cycles and the acceptance of a new technology have been the bane of NRG’s existence. However, this dynamic turns into a strength as blue chip customers adopt NRG’s technology, creating a very difficult challenge for any potential entrants. Once a customer adopts this technology for their first unit, they then expand it to multiple units. Air Products’ development of TV2 during TV1’s construction is an example of this dynamic. The plans of some of NRG’s customers that are outlined below highlight the recurring nature of the order flow once the initial hurdle of technology adoption is overcome.

• Greenworld Energy Solutions (GES) advances plasma waste to energy projects in China. NRG has completed 81% of engineering for GES’ first 650 tpd project in Bijie, China. The facility was officially designated as a “key project” by the local government and is currently awaiting its final stamps permit before placing its equipment order, which is expected in late 2014 / early 2015. GES plans to immediately double the capacity of the Bijie facility following commissioning and develop another 7 projects thereafter

• China Everbright is China’s largest waste management company and recently selected NRG technology for its first 500 tpd project in Nanjing. The order is significant in that it represents - in an industry often resistant to change - the first plasma gasification facility development by a company that currently incinerates all of the 40,000 tpd of waste it processes. Equipment revenue for the order is expected during the back half of 2015. The company is actively building out 15 projects

• Waste2Tricity is a UK based developer actively advancing 200 tpd plasma projects in the UK and Thailand. W2T has obtained a Thailand country license from NRG and is currently raising capital to advance two projects there with possible sales in 2H 2015. W2T’s project in Bilsthorpe, England is currently in the concept design study phase

• Wuhan Kaidi is a Chinese energy company operating hundreds of biomass to power facilities. It recently built a 100 tpd plasma gasification demo facility and has identified more than 100 possible facility sites. A US$5mm exclusive biomass feedstock license for China is currently being negotiated

• SMS Infrastructure is Central India’s largest infrastructure company and had constructed two of NRG’s plasma gasification reference facilities in Pune and Nagpur, India. SMS is currently developing a large pipeline of 30-100 tpd projects in India and the Middle East, with two currently in the formal regulatory approval phase

• PGP Terminal was formed to develop 50-100 tpd projects in the Czech and Slovak Republics. PGP purchased five site licenses from NRG in 2012 for its five planned projects

• Annual replacement part sales worth approximately 5% of the original equipment costs are expected every year, providing a high margin (50%) recurring revenue stream

In addition to the above, there are several dozen undisclosed customers in various stages of project development. In any case, the total market opportunity ($174 billion+) is massive relative to the company’s current market cap and is expanding.

Additional market verticals are also in the works. Wuhan’s operating demo facility is pioneering the conversion of syngas into diesel fuel in a process already in use with other gasification technologies.

Business Model

For each project, revenue consists of a combination of license fees, engineering studies, equipment fabrication, and recurring parts sales.

Equipment fabrication revenue comprises the lion’s share of project revenue. NRG’s gasifier units come in two primary sizes (the 100tpd P5 unit and the 1,000 tpd G65 unit). The former generates $10-15mm in equipment revenue for NRG and the latter can generate anywhere from $10 to $25mm based on individual project scopes.

Engineering revenue is earned from the initial feasibility study required for permitting and detailed engineering work performed for the facility’s buildout.

Replacement part sales worth approximately 5% of the original equipment costs are expected every year, providing a high margin (50%) recurring revenue stream.

License payments can be for site, feedstock (e.g. MSW, biomass) or country rights. While we haven’t seen it yet, some projects in process contemplate the payment of site-level licenses in the form of or in combination with feedstock volume royalties and/or profit sharing arrangements. Per-ton royalties are being negotiated for Cahill’s Barbados project and W2T’s first Thailand project. A profit sharing arrangement would split project economics above a certain hurdle rate for the operator.

It’s important to note that the sequence, magnitude and timing of each revenue type can vary by customer and project over a typical sales cycle. For example, some customers prefer to pay licenses upon facility commissioning versus up front and some would rather give up margin on the fabrication work rather than on the license. As the cadence and volume of active projects pick up, the business will reach a level of maturity where revenue will smooth out and not be driven solely by one-off projects.

COS consists of project-level direct labor, materials and component / fabrication costs. Proprietary components are sourced to and assembled at NRG’s facilities. The remaining components are sourced from a variety of different countries (e.g. primary steel gasifier unit is built in Malaysia by K&M; modules are built in Thailand by UHDE; power supplies are sourced from Canada). Gasifiers consist of 56 pieces of machinery in total and, besides the proprietary components, all equipment is sent directly to the facility site for assembly.

Management is targeting a blended gross margin of 40%, which is sustainable due to NRG’s significant pricing power. Essentially no competitors exist and, by the time equipment fabrication pricing is being negotiated, the customer will have already invested significant resources into a project developed around NRG’s technology, which is vitally important yet represents a relatively small portion of total project cost.

Current overhead run rate is $10mm per annum and consists of G&A and selling/distribution expenses. The business is highly scalable and overhead increases are expected to be minimal, with management guiding to a $1mm increase in overhead per approximately $20mm of additional revenue.

NRG is comfortably capitalized, allowing the company to present a healthy balance sheet to prospective partners. The business model is capital light: no remaining product development is needed and customers pay deposits up front, allowing the company to run with negative working capital.

Also of note is the large ownership of billionaire Roman Abramovich, who has investments in companies down-stream (e.g. Waste2Tricity) of NRG as well as in companies with complementary technology. The strategic relationship is expected to accelerate development activity and drive technological improvements.

Investment Vehicle Potential

We believe, given its market position as project gatekeeper, NRG has upside potential to generate recurring revenue streams by acting as GP in certain high-return projects and investing relatively small amounts of capital.

For example, NRG is advancing an investment SPV as GP with a large NYC-based infrastructure fund as the anchor LP. Four European projects ranging in size from $120-400mm with unlevered IRR’s of ~20% have been earmarked for the vehicle. NRG can commit capital after project regulatory approvals are obtained (which two of the four projects have done) and the project is substantially de-risked.

After projects are operational, NRG can turn around and sell the annuity streams to monetize the cash flow and crystallize a substantial discount rate spread. This can be done on a piecemeal basis or as a yieldco entity portfolio spin-off. The spread between cost of capital and the ROI of deployed capital should only widen as NRG’s business de-risks and its cost of capital declines.

Current Status

The Company recently provided the guidance outlined here, which doesn’t include any contribution from expected replacement parts or GP interest.

The above guidance was lowered from previous guidance, based in part on advice from shareholders to set expectations at beatable levels and to account for the delays and hiccups that are part and parcel of the business. Consequently, the sum of the high end of the revenue guidance range for the next two years is 15% less than the $140mm category 1 revenue pipeline. We can account for the high end of 2015 guidance based solely on existing projects that the Company has already disclosed for next year as shown here.

Valuation

While quarterly results will be lumpy for the next two to three years, we are convinced that the Company’s technology will see steady adoption and fluctuations will be tempered by year four or five. Assuming $50mm of EBITDA in 2018 (around the mid-point of guidance) and applying a 15X multiple, we get to a $26 per share stock price that’s roughly 10X current levels. The 15X multiple could prove conservative if the Company realizes the adoption we expect and has an open-ended, high-margin growth runway, a fortress competitive position and large recurring revenue streams. This Company enjoys the dynamic of having more opportunities to accelerate its growth the larger it gets.

We also view the company as a prime take-out candidate for a myriad of potential suitors as the tech is further proven out and the pipeline grows.

Risks

Lumpy and fluctuating quarterly results in the near term

Delays in project development

Unexpected hiccups in TV1

Events limiting access to capital markets for developers

Catalyst

Successful operation of TV1

Turbine fuel replacement sales

Incinerator turbocharger sales

Increase in pipeline and transfer of orders to category 1

Dual listing on NASDAQ expected in 2015