Features July - August 2001 Reporting

An alternative analysis

Investors are now spoilt for choice when it comes to investment bank research on alternative energy stocks. Mark Nicholls reports

Only a year or two ago, investors looking to make an investment in a renewable or alternative energy company would have had little advice on which to base their decision. But as interest in the sector has taken
off, so has the volume of research and analysis produced by
investment banks.

Almost every major bank and a large number of smaller ones now include this burgeoning sector in their research effort. The sector includes a wide range of technologies such as solar and wind energy, fuel cells (which produce power from hydrogen), superefficient microturbines and energy storage, as well as companies supplying related components and software.

“In the summer of 1999, when I was researching our first environmental technology fund, there were only a handful of analysts covering the sector,” says Bruce Jenkyn-Jones, fund manager at Impax Capital, a Londonbased investment bank specialising in environmental technology.

But a search for Ballard Power Systems – the Canadian fuel cell manufacturer that has become the alternative energy sector’s bellwether stock – on a Bloomberg terminal now throws up no fewer than 27 equity analysts covering the company.

So which do investors prefer? Unsurprisingly, they turn first to the big Wall Street banks. Goldman Sachs, Merrill Lynch and Bank of America’s alternative energy research output are all singled out by fund managers.

Goldman Sachs showed interest in the sector relatively early: it began dedicated coverage of the alternative energy market in November 1998, setting up a power technology team which covers the whole range of alternative energy stocks.

In the US its research effort sprang from its utilities coverage while in Europe industrial analysts moved over to the new group, which now numbers five in New York and London.

“This is a common trend on Wall Street,” says Mas Siddiqui, one of the bank’s New Yorkbased analysts. In North America, the sector is dominated by smaller, more entrepreneurial companies that have sprung up as the power markets have been deregulated. While fuel cell stocks such as Ballard are the best known, there is a growing number of more specialised companies, developing microturbines or energy storage technologies or producing the necessary components.

In Europe, however, the sector is dominated by wind power companies, which have developed out of the engineering, capital goods or industrial sectors. Furthermore, divisions within large conglomerates have led the way in Europe, says Siddiqui.

One important difference between analysts is their approach to valuing the companies they follow. Goldman Sachs has taken a conservative approach to valuations, according to Siddiqui.

“We take a more realistic view of what’s going on in the sector – last year, for example, we made a big negative call on fuel cell stocks before the NASDAQ [index] collapsed,” says Siddiqui.

Valuing fuel cell-related stocks, which often have non-existent or insignificant revenues, poses a problem for analysts, especially following the discrediting of the valuations of dotcom companies (which often had similar business models) last year.

Here Siddiqui takes a characteristically cautious approach.“We value off multiples of future earnings,” he says, but not using the discounted fair value model adopted by some other analysts.The main problem with the latter, he says, is that it relies on projections going out up to 10 years.

“[Some analysts] are betting on numbers that are so far in the future that you can’t have any confidence in them,” he says.“We’ll value companies off 2003 numbers, but no further forward.

”Christine Farkas, Siddiqui’s counterpart at Merrill Lynch, takes a different view.“We use a long-term discounted cash flow model, and we’ll go out to eight to 10 years in some cases. 2003 merely represents early sales for some companies – these are not a true measure of their potential.” She adds that she uses higher discount rates in these cases.

Merrill Lynch is also named as one of the leading research houses by investors. The bank only established its energy technology group in early 2000, but the analysts involved boast a longer track record in following companies in the alternative energy sector.

Farkas has been following fuel cell companies – from a chemicals sector background – since 1995, and her colleague, Sam Brothwell, has a background in utilities. The team also includes two analysts in London covering energy technology stocks part-time from within the capital goods area.

James LoGerfo, vice president at Bank of America (BoA) Securities, says his firm is reviewing its coverage of European companies. Although investors speak highly of BoA’s research on the sector, its output is currently limited to stocks listed on US exchanges.

LoGerfo is “actively pushing” for European coverage but notes that, with a standalone energy technology group in operation for over 18 months, BoA has already dedicated more resources to the sector than many of its competitors.

The two-man research team (LoGerfo and Ali Agah) is mirrored by a corporate finance group that has attracted primary market business for the bank, including lead-managing the $40 million IPO of Evergreen Solar last November, and a $200 million post-initial public offering (IPO) financing round for American Superconductor in February 2000.

But it’s not only the Wall Street behemoths that investors are turning to for analysis.The analyst most frequently mentioned is Peter Tertzakian, the senior energy technology analyst at Raymond James, a leading US financial services firm.

Tertzakian – who leads a group of three analysts – has been covering Canadian energy technology companies for around three years, previously at Goepel McDermid, a Canadian independent investment bank acquired by Raymond James at the end of 2000.

His formal coverage – of Canadian firms – is modest. But the value of his analysis, say investors, is its grounding in broader macro-economic trends affecting the prospects for alternative energy companies.

“My premise is that you can’t understand the new unless you understand the old.These new technologies are challenging the established flow of energy and long-established incumbents,” he says. So, rather than comparing one fuel cell company with one of its peers, his analysis looks at it in the context of existing fossil fuel-based competition.

This macro view allows him to consider the prospects for companies outside his direct area of coverage, he says. “This is a global industry, so we need to understand all the players in the landscape.Verbally, we can offer views on anything, be it wind power companies, microturbines, or energy storage firms.”

Tertzakian also wins fans for his novel approach to company valuation.“The problem with traditional discounted cash flow analysis is that you can tweak the model to come up with almost any price you like. It’s impossible to know what will happen in 2006.”

The starting point for his model is uncontroversial: that today’s stock price is a function of investors’ expectations of future earnings. These expectations flow from: the size of the market the company is addressing; the time to commercialisation of the product; and the size of market share it is likely to capture.

So, with Ballard, which is developing fuel cells for the car industry, the size of the potential market is well understood. Ballard has a series of alliances with car manufacturers who currently control 40% of the global market. And it expects to have a commercial automotive fuel cell on the market in 2003–5.

These variables are modelled alongside a fourth factor – the movement of the wider market – to quantify investor expectations, helping Tertzakian look beyond the high volatility in the stocks that he covers to something approaching fair value.

He says that the model proved itself last year, when Plug Power, the US fuel cell manufacturer, announced a delay in its commercialisation schedule. The subsequent drop in its share price was “in line with our model,” says Tertzakian.

Across the Atlantic, European banks are also building up their research and corporate finance capabilities in alternative energy and renewables.The European market is dominated by wind turbine manufacturers and developers, such as Denmark’s Vestas.

One of the most successful firms, particularly in primary market deals, is Dresdner Kleinwort Wasserstein (DKW), the investment banking arm of Germany’s Dresdner Bank. In common with its European competitors, it does not have a stand-alone team covering the sector. However, four analysts within the electrical engineering group cover European renewable energy companies, with an analyst in New York (who sits within the energy team) covering fuel cell firms.

The London-based effort, led by James Stettler and Marcus Storr, has been developed over the last two years, and has helped DKW win financing mandates from wind firms such as Vestas, Germany’s Nordex and Gamesa in Spain. It was recently also involved in the IPO of Farmatic Biotech Energy, the German biogas company.

Other European banks with strong reputations in the field include Germany’s Westdeutsche-Landesbank. Michael West Hybholt covers wind-turbine manufacturers from Copenhagen, with three colleagues in London covering fuel cells and microturbines, and a further three in Dusseldorf also contribute to its coverage – although all of the analysts (who sit in the high-tech engineering group) also cover other stocks.

Schroder Salomon Smith Barney (SSSB), the European investment banking arm of Citigroup, is also increasing its focus on alternative energy. In May, it released a 444-page report, The New Electric Economy.

The team, led by Glen Liddy in London, sits within SSSB’s engineering group, but draws on resources from other sectors and countries, including chemicals and utilities and an analyst in Madrid, he says. As well as five analysts in London (not all of whom are full-time), Salomon has a full-time analyst in New York looking at alternative energy stocks, and three others spending a growing proportion of their time on the sector.

But, while many investment banks began or increased their coverage of the sector following involvement with IPOs, the Netherland’s ABN Amro has taken a different tack – developing a research capability in advance of corporate financing business.“This is such a strong growth sector, we decided we needed a bigger presence,” says William Stormont, a Londonbased analyst in ABN’s strategy team.

In March, the bank published its first standalone report on alternative energy, called Small Cap Plays on the Environment. Analysts in Copenhagen and Germany cover wind companies, while fuel cells have been covered from New York and San Francisco since November – although no analyst focuses purely on companies within the alternative energy sector.

Some investors have welcomed ABN analysts’ independence. “The bank came to the market late in the day, and can be more objective – it’s not where the analysts are coming from, it’s whether they’ve got a deal to sell,” says one investor.

Analysts within investment banks naturally deny any undue influence from corporate financiers keen to place a client’s shares. And Stormont at ABN would be happy to lose this particular competitive advantage. “We’d certainly like some business in the primary [IPO] market in this sector. It’s no secret that research coverage helps to build your credibility,” he says.

But, for all the resources thrown at the sector by the banks and brokers, some investors are still forced to do their own legwork when it comes to newer areas of investment. “In areas like biomass [generating power from organic matter], where there are very few stocks, we tend to do our own research and bounce it off analysts,” says Chris Jenkins, director of global equity at Rothschild Asset Management in London, which runs a number of funds with alternative energy components.

“Where some of the analysts could do better is coming up with more new ideas,” he adds. “But it’s a question of the cart coming before the horse: if they aren’t approaching an IPO, there won’t be much research.”

He also points out that there is little research done on the renewable or alternative energy divisions of the large oil companies. BP and Shell, for example, both have significant renewable energy operations. But, because these make up a fraction of the groups’ revenues, they are largely ignored by oil company analysts.