Polaris Infrastructure Inc

TSX:PIF

Earnings Call Transcript 2018-Q2

[Operator]

Good morning. My name is Ian, and I will be your conference operator today. At this time, I would like to welcome everyone to the Polaris Infrastructure 2018 Second Quarterly Results Conference Call. [Operator Instructions]Mr. Downey, you may begin your conference.

[Shane Downey, Chief Financial Officer]

Thanks, Ian. Good morning, ladies and gentlemen. Welcome to the 2018 Second Quarter Earnings Call for Polaris Infrastructure.In addition to the press release issued on August 7, 2018, you can find our financial statements and MD&A on both SEDAR and our website at polarisinfrastructure.com. Unless noted otherwise, all dollar amounts referred to are denominated in U.S. dollars.I'd like to remind you that comments made during this call may be -- may include forward-looking statements within the meaning of applicable Canadian securities legislation regarding the future performance of Polaris Infrastructure Inc. and its subsidiaries. These statements or current expectations and -- as such are subject to a variety of risks and uncertainties that could cause actual results to differ materially from current expectations. These risks and uncertainties include the factors discussed in the company's annual information form for the year ended December 31, 2017. Certain measures referenced in this call do not have any standardized meaning as prescribed by International Financial Reporting Standards, and therefore, are considered non-GAAP measures. In the company's earnings releases, consolidated financial statements and MD&A, unless noted otherwise, all financial information is prepared in accordance with IFRS.EBITDA is a non-GAAP metric used by many investors to compare companies on the basis of ability to generate cash from operations. The company uses adjusted EBITDA to assess its operating performance without the effects of, as applicable, current and deferred tax expense, finance costs, interest income, other gains and losses, impairment loss, depreciation and amortization of plant assets, share-based compensation and other nonrecurring items. The company adjusts for these factors as they may be noncash, unusual in nature and are not factors used by management for evaluating the performance of the company. The company believes the presentation of this measure will enhance an investor's understanding of its operating performance.I am joined this morning by Marc Murnaghan, Chief Executive Officer of Polaris Infrastructure.At this time, I will walk through our Q2 2018 financial results and comment on our recently announced quarterly dividend. After which, I will turn the call over to Marc for additional commentary with respect to San Jacinto operations, the conclusion of the 2017/'18 drilling program, and of course, to accept questions.As mentioned previously, I refer our listeners to the company's recently filed financial statements and MD&A for the quarter ended June 30, 2018, for a more complete presentation and discussion of the company's financial position and results of operations.During the second quarter of 2018, San Jacinto operations delivered just over 139 gigawatt hours, an average of 63.7 megawatts net versus delivery of 129 gigawatt hours in the prior year.This improved level of production reflects sustained incremental contribution from recently drilled production wells, which is being facilitated by the removal of separating capacity constraints that occurred when HPS3 was commissioned on April 30, 2018. Accordingly, the second quarter of 2018 effectively includes 2 out of 3 months with these additional steam flows. This is reflected in net generation figures of approximately 66, 67 megawatts in May and June versus closer to 56 megawatts in April.Marc will comment in further detail on San Jacinto operations and specifically how we view current production levels relative to our theoretical capacity. On a year-to-date basis, the San Jacinto plant generated 255 gigawatt hours, up from 238 gigawatt hours in the prior year. Given these levels of generation, we recognized $17.7 million in revenue during the second quarter of 2018, up from $15.9 million in the prior-year period. The 11% quarter-over-quarter increase in revenue was driven by the combination of the increase in generation as well as the 3% annual increase in tariff under our PPA.On a year-to-date basis, we recognized revenue of $32.4 million versus $29.3 million in year to date 2017. Given revenue growth combined with ongoing cost containment, the company generated adjusted EBITDA in Q2 of 2018 of $15.1 million versus $13.6 million in the prior-year period, and on a year-to-date basis, $27.5 million versus $24.5 million in year to date 2017.The company reported net earnings in Q2 2018 of $3.9 million versus $1.2 million in the prior-year period and $4.4 million for year to date Q2 2018 versus just $37,000 in the prior-year period.Net earnings during the second quarter of 2018 were impacted by the revaluation of the share-based compensation liability, which is a noncash item and accordingly, not reflected within adjusted EBITDA.We do, in any event, anticipate that 2018 will be the company's second consecutive fiscal year with positive net earnings.As at June 30, 2018, the company had a cash balance of $34.5 million, of which $12.4 million was held in debt service reserve accounts related to the San Jacinto project.Finally, before turning it over to Marc, some comments with respect to our latest quarterly dividend, which was declared by the Board of Directors on August 7, and will be paid on August 27 to shareholders of record on August 15. The $0.15 dividend reflects the 34% payout ratio based on Q2 2018 results. On a year-to-date basis, payout ratio comes in at 42%, and when adjusted for the impact of downtime for turbine maintenance completed during Q1, we estimate the year-to-date payout ratio closer to 37%.We have always envisioned dividend growth to come firstly from growth in cash flow generation and secondly from a possible increase in payout ratio. This philosophy continues to hold true, particularly in light of new production wells that have recently come online and will begin driving incremental cash flow generation. Accordingly, in terms of capital allocation, we will balance the appropriateness of further dividend increases with efforts to grow the business. With that, I will turn things over to Marc.

[Marc Murnaghan, CEO & Director]

Okay. Thanks, Shane. I'll go by the -- you've obviously seen that the quarter, I will jump into really where we're at now, but I would just like to say that last year and the first quarter of this year were big milestones for us, and that we drilled the best injection well that's ever been drilled on this -- the property and have 3 new wells, particularly 12-5, which is the strongest of the bunch and that's been online. So I think -- and we did all of this on time, on budget. So we're very happy with that program and where we've ended up. And so where we've -- where we are today, I think I'm going to walk through some numbers and I think it's important for people to understand some things about parasitic well and availability to arrive at what are realistic net numbers. And I think it's -- we're even getting a little bit smarter on this because this plant has never been pushed to capacity, and we effectively did that starting mid-April. So there have been a few things that we've learned as well, which I'll talk about now.So call it nameplate capacity of 77 megawatts gross. However, the way that we run things is that we -- each -- well, there's 2 turbines and we do maintenance on each turbine every 24 months. So every year, we have 1 period where we take down one of the turbines and do a 3-week -- 2- to 3-week maintenance period on it. When they come out of that maintenance period, they are -- they can run at, the 38.5 megawatts gross, no problem because they've been effectively tuned. However -- and unit 3, which was the one we did in February, it is running effectively at 38.5 megawatts now. So it's running at its nameplate capacity. But given 12 months, 15 months, it will be very hard for it to be running at that. So you likely need to -- and it still would only makes sense to do each one of these turbines every 12 months, it wouldn't make sense to take them both down once a year. So if you take that 77 megawatts, realistically, the most that we could be doing out of given time is 76 megawatts gross.If you then back off -- our parasitic load is reasonably fixed. It's not a variable number and it's 5.5 megawatts. So if you take that out of 76 megawatts, you're at 70.5 megawatts. We said in our press release about over 99% availability. I think -- so take 1% off of that, that's -- we can beat that, but 1% -- or 99% availability is still very high. That gets you to 69.8 megawatts. The other one thing that we are noticing is that in our unit 4, there is -- we could do better from an efficiency perspective. We think that we're -- we are -- well, we are going to be taking unit 4 down for about 24 to 48 hours in this September to do some work on the condensing unit, which we think will improve our conversion efficiency and that would -- should give us about 1.5 megawatts. If you back that off of 69.8 megawatts, you get to 68.3 megawatts. And then -- and we still have 9-3 online, which is the well that cycles, and even though it's on from a capacity perspective, call it, 4 to 5 megawatts from a deliverable energy perspective, we probably lose around 1.5 to 2 megawatts. And that gets you down to sort of the 66 to 67 megawatts, which is basically where we're at for the current -- for quarter to date net delivered. We will do this downtime in September. So we'll lose a little bit there, but we -- so we would think that, call it, for Q4, that 66, call it, 66.5 should be the 1, 1.5 higher. So we're budgeting about 68 for Q4, assuming all those other variables. So I think it's important for everybody to understand those numbers. So -- and that would, again, be a record quarter. So if we continue on where we are for this quarter, it'd be a record quarter, and then if we get those efficiencies in September, Q4 would be a record quarter.In terms of -- I'm going to comment on political stability, then the dividend and I'll open up for questions. So in terms of the political situation, obviously, everyone's aware that it's affected our share price. From what it looks like on the ground, things have been more stable -- much more stable in the last 3 to 4 or 2 to 3 weeks. There's no roadblocks anymore. There still are some demonstrations, but the roadblocks are done. It's important to note that power demand in the country has been effectively flat. This is a residential load. Primarily, there's not a huge amount of big industrial users of power, that the industry there is low-power intensive. So the power demand hasn't really changed in the country. We are being paid. We are paid up to date, as of today. So we haven't had problems there. So things do seem to be returning to normal. And from a business perspective, we have had no operational issues whatsoever and have run 24/7. Our logistics are reasonably low. We don't have highly complex operation and have suffered absolutely no outages nor a downtime from a manpower perspective. So "business as usual there."I'll comment on the dividend. What I would say is that with the payout ratio, obviously, is lower than history. I think given the share price, but -- and even just the nominal level of dividend, I think it's actually -- we kept it sort of simple here is that I think the dividend is sufficient enough to attract, whether it's a dividend fund or people that are -- that want dividend income. Given the yield right now, I really think that it's big enough that we aren't excluding a universe of potential buyers on our shares because of a dividend that's too low. Our view is that there still is growth. And our preference is to be a growth company that pays a healthy dividend as opposed to a dividend-only company. And that to the extent we get to a point where we don't think there is reasonably priced growth, then we will for sure start to repatriate even more capital back to shareholders through either increased dividends and/or normal course issuer bids. We don't think we're at that point now. I would remind people that while we have taken a pause in the binary unit, it is for sure not off the table completely. We are looking at the possibility to do a smaller binary unit to deal with the parasitic load, which we think is technically possible and would be very profitable. So we do have opportunities in country to grow the business, and -- that we think is very attractive returns. And we still see opportunities outside of Nicaragua. And what I would remind people is for good projects, there are other sources of -- we have our own capital, we are generating cash, but also, there are other sources of capital other than public equity that we can look to tap if we see something that's interesting. So -- and we do see opportunities that are interesting. So that's where we're at for right now. So with that, I'll open it up for questions.

[Operator]

[Operator Instructions] Your first question comes from the line of Steve Kammermayer.

[Stephen John Kammermayer]

So you talked about optimizing the plant here. You talked about on the call here doing some maintenance on the condenser unit. Is there any other optimization plans that you have going forward? And just wondering what the cost of that will be?

[Marc Murnaghan, CEO & Director]

So that's really the big one, Steve, and that's -- the cost is downtime, which is 48 hours of one of the units and manhours. So there's no cap cost with that one. The other one -- the other -- there is one other one which is not in the short-term plans, but that is something that deals with noncondensable gases, which -- think of this as some of the wells that we have, 12-4 and 12-5 have come with marginally higher, not much, but marginally higher noncondensable gases and 12-3 has some. There is a couple projects around the world have something, whereby it's like you turn a 10-megawatt well into a 12-megawatt well because you can get rid of those -- some of the noncondensable gases before they hit the turbines. So that is something we're looking at. But I would think that's more of a mid-term thing and that there would be capital associated with that. So that's another mid-term.

[Stephen John Kammermayer]

Okay. And so you talked about acquisitions, again, number -- number on the table, you mentioned. So with the new share price, if we can call it that, that has not affected your acquisition strategy? Is that correct?

[Marc Murnaghan, CEO & Director]

That's correct. Yes, I think what it has done is because -- the ones that we've been looking at, or the primary benefit of Polaris looking at it was our capital and our capital position has not changed. And to the extent that any of these, there is a share component, we are looking at different, what I call, project-type direct alternatives as well. So we haven't stopped with that.

[Stephen John Kammermayer]

Okay. And just the last one for me, you mentioned you're still getting paid, you're getting paid up to date. Has there been any trouble repatriating capital to Canada? Or do you expect any? Or is that -- everything is still fine there as well?

[Marc Murnaghan, CEO & Director]

Yes, we -- no, there has been absolutely no issues there, whatsoever. But most of the capital, when it comes in, it heads to Citibank in New York, and even before we started repatriating capital, call it, equity dividends, from the company in Nicaragua to Canada, that's one form of repatriation of capital, but the -- we have always been repatriating capital for the lending -- for the lenders, right? That's why we're famous. And so no, there have been no issues with that either.

[Operator]

[Operator Instructions] Your next question comes from the line of Mac Whale.

[MacMurray Davidson Whale, Analyst of Institutional Equity Research]

Most -- the changes to the condenser that you work on thus far, are those changes permanent to the -- like the 1.5 megawatts, is that permanent thing? Or is that something that is subject to like an annual maintenance or the 24-month maintenance?

[Marc Murnaghan, CEO & Director]

Yes, think of it as permanent, Mac. It's -- that we should be able to deal with it going forward on the typical maintenance schedule. So that we would be -- if you consider it permanent, it's something that we do for both of the condenser units, when we do the maintenance, right, typically. But what happened this time is that we did get some sulfur buildup in the condenser unit as a result of putting the new wells on. And that's what -- so we -- just to made the -- so we could wait till February, but the maths just doesn't make sense to wait.

[MacMurray Davidson Whale, Analyst of Institutional Equity Research]

Okay. Are there anything else? I'm not sure, I'm not familiar with the actual assets where the orbit is. Is there anything else you can do to get a few megawatts that are around on the -- like I know it's the way that condenser works, but I'm wondering if there's any other types of like secondary sort of systems that allow you to kind of to extract a little bit more here and there?

[Marc Murnaghan, CEO & Director]

So I did mention the -- these noncondensable gas ejectors like there already are ejectors in the system, but there's ones that you almost front-end loaded before it gets into the turbine house. They have them in Costa Rica, they have them in a few other places where we think there's may be 2, 3, 4 megawatts there. So we are sizing it up, but that's like a $4 million to $5 million CapEx spend.

[MacMurray Davidson Whale, Analyst of Institutional Equity Research]

Right. Right. And how the...

[Marc Murnaghan, CEO & Director]

What that does is -- what it does is, it doesn't change your steam, obviously. It just changes your conversion efficiency. So from a -- usually we -- you run this sort of 8x a steam per megawatt, maybe that, and we're a bit lower than that, but you would lower that by maybe 0.1, 0.2 net, so that you'll need less steam to produce your capacity. So we will look at that. We just -- it's not as if we have a tonne of noncondensable gases. So we just need to measure it for a little while here to see how much we have and then if it does make sense, we would for sure look at it. Because even though as we do mention, we're now going to be in a very low CapEx in the short-term sort of mindset. We are setting aside money in the MMRA. And to the extent that this sort of makes sense, we'll probably know it little later in the year. And realistically by Q1, we'd actually probably have the money sitting there in other account for it.

[MacMurray Davidson Whale, Analyst of Institutional Equity Research]

Right. And how are the new equipments that you added, the steam separators and all the new -- the additional equipment you've put on, everything is operating fine? Sounds like it is...

[Marc Murnaghan, CEO & Director]

Yes, it's all working really well.

[MacMurray Davidson Whale, Analyst of Institutional Equity Research]

Okay. And how about any update on Casita or anything from World Bank or any progress there? Or is that something that's sort of been maybe put on a little bit hold or not at all? I'm just wondering whether there's any comment there.

[Marc Murnaghan, CEO & Director]

Yes, I think the comment to this is that, I would say, informally, on pause. I don't think they don't want to stop it, but they also -- the people that are running the file at the World Bank, I don't think they want to go get the final vote. Everything is done, like believe it or not, up until literally a month ago, there was still paperwork that we were doing, which has effectively been nailed down. But they don't want to go to their board to see that.

[MacMurray Davidson Whale, Analyst of Institutional Equity Research]

Okay. And then these other projects outside of Nicaragua, presumably, they would be invested in at the corporate level like -- so that's any cash is patriated at like -- it's out -- it comes out of Nicaragua goes to literally to you guys corporately and then you'd make that investment, it's not through the subsidiary in Nicaragua?

[Marc Murnaghan, CEO & Director]

Correct. And I think it's important to note that -- so we do -- we have some cash actually in Nicaragua, but when we talk about cash and the project, it's important to note that that's in New York city, Citibank, for the most part, right? So that -- so for instance, our debt service reserve account -- our major maintenance reserve account are in New York. And then also, we carry a reasonable amount of cash in Canada already. So we would run -- our operating cost on a monthly basis in Nicaragua is like USD 500,000. So we -- the aim is to carry like 3, 4 months. That's it in terms of cash sitting in Nicaragua.

[MacMurray Davidson Whale, Analyst of Institutional Equity Research]

Okay. Yes. So that gives you...

[Marc Murnaghan, CEO & Director]

But any other investment, effectively, would come through Toronto, ours, yes.

[MacMurray Davidson Whale, Analyst of Institutional Equity Research]

Okay. Yes, I just thought -- I'd never asked that before, so I was -- I thought I would just ask.

[Operator]

Your next question comes from the line of Jeremy Rosenfield.

[Jeremy Rosenfield, Equity Research Analyst]

Couple of questions. Just first in terms of the operations. And you mentioned it off the top that hasn't been any impact from the political situation in terms of demand, but I'm just wondering if the grid operator has seen any impact on the transmission system? And whether or not that has impacted the operations? Or whether or not, they are asking you for more flexibility in terms of production? Or basically they're just taking all of the power and very happy for it?

[Marc Murnaghan, CEO & Director]

Yes, so the latter. There have been, absolutely, no issues with any transmission or distribution in the country. We have not received any requests to curtail or do anything like that, and they're taking all the power they can get. And actually, the demand really -- all of the plants are basically that were in the country, not just us, but are running as they were. So it's not just us.

[Jeremy Rosenfield, Equity Research Analyst]

Okay. Just from a finance perspective, it seems like the principal retainment picked up in Q2 and I'm just wondering if there was a specific reason for that increase if anything stood out?

[Shane Downey, Chief Financial Officer]

It was actually as simple as a small insurance claim proceeds that stemmed from our 2017/'18 drilling efforts. So it was about $660,000 that was regrouped and then, yes, was applied against principal. So you'll see in Q3 it will revert back to the amortization schedule itself, which is precisely were paid in Q1.

[Jeremy Rosenfield, Equity Research Analyst]

Okay. Perfect. That explains that. Then Marc, I guess, you talked about the preference for external growth first, and then potentially share buybacks and clearly the dividend remains a priority, but the shares are not being rewarded, obviously, for the dividend level at this point I think. So can you just sort of comment in terms of valuations that you're seeing in terms of acquisitions or investment opportunities? And what types of returns on equity investments outside of Nicaragua and other jurisdictions you're seeing?

[Marc Murnaghan, CEO & Director]

Yes, I mean, I would say that if you even pick -- I'll pick a bigger theme, which is that we are looking more, and call it the small- to medium-sized hydro, because most of the big companies, they're looking at solar and wind, you can do a 200- to 300-megawatt wind project from a development perspective. It's reasonably simple, obviously, solar is even simpler. I think real cost of capital gain that we can't play in, but conversely, they don't really want to -- the complexity around running river hydro assets is just too much for them given that if they can move the needle, right? They all want to buy them once they are up and running, okay? So the jurisdictions we are looking in tend to be -- tend to, say, anywhere from, let's just say, it's a bit of a wide range, but it's, I'd say, 12% to 18% in terms of the IRRs that you can get on some of these hydro projects. And -- but if it's, I'd say, above a certain size, those things -- even a 20 megawatt, once they're up and running, those things are going to trade at 10, 11, 12, 13x EBITDA for sure. And so we can't go in and buy something that is, call it a fixed project, 20-megawatt projects with no growth and they just want to monetize because there is a pretty strong market for that, no matter which country you're in. So we aren't -- we see opportunities to repower things with a contract already, things that are in the middle of construction, believe it or not. So that -- so we do have to look in some areas that are not straight up the middle, but we won't be able to do anything here that's a pure acquisition of, call it, 20-megawatt hydro project that has absolutely nothing color around it. So we are looking at things in order to get those types of returns on our capital that, I mentioned before, on a 12% to 18% on a lower risk basis. And we do see opportunities out there, because the big guys are looking around.

[Jeremy Rosenfield, Equity Research Analyst]

Okay. And do you think -- maybe just finally, do you think the current political situation in Nicaragua, does that prompt the company to -- prompt you and the board maybe to want to move more rapidly or to try to move more rapidly to invest elsewhere?

[Marc Murnaghan, CEO & Director]

In short, yes. Well, I was going to say, sure yes. But the reality is, it is something that we've wanted to do for a while now. So we'll just keep moving at where we were. But yes, absolutely.

[Operator]

Your next question comes from the line of [Ashif Pilani].

[Unknown Analyst]

I was just curious, you look at opportunities elsewhere outside the country. And so want to -- presumably that pipeline of opportunities will be there 6 months from now, a year from now, but the opportunity in the current share price may not be there 6 months from now or a year from now. So I mean, how do you weigh that timing when you consider how accretive share buybacks could be right now?

[Marc Murnaghan, CEO & Director]

I'm not sure exactly I understand the question, but I would say, we've notionally given ourselves, call it, 3 to 6 months to allocate some capital because we do think -- and I, as a shareholder, would prefer to trade at a higher multiple, quite frankly, and I see opportunities through that. And so that's what I'm going to try to do. And yes, I understand that NCIB would be accretive, I guess, but I think if you think longer term, and it sure maybe would help in the short term, maybe I don't have a ton of confidence in that, but I would prefer to put my capital into some opportunities that I think are fantastic. And we'll give ourselves a period of time to do that. That's...

[Operator]

There are no more questions over the phone lines at this time. I turn the call back over to the presenters.

[Shane Downey, Chief Financial Officer]

Okay. Thank you, everyone, for joining. We look forward to speaking again soon.

[Operator]

This concludes today's conference call. You may now disconnect.