Monday, December 19, 2011

Warren Buffet Goes Long Solar Energy

"Who's to say that your mind won't change
Yesterday's excuses just aren't relevant today
It may take time it may take a strong will
But we don't have to swallow such a bitter pill
Better to have tried
Better to have learned
Better to take that risk"

- In My Eyes, "Take the Risk"

For the second time in two weeks, MidAmerican Energy Holdings, a subsidiary of Warren Buffett's Berkshire Hathaway, has acquired an interest in a large photovoltaic solar farm project when it announced the acquisition of a 49% stake in the Agua Caliente Solar Project, a 290 MW photovoltaic project in Yuma County, Arizona from NRG Energy. The first deal, announced on December 9, was the acquisition of the Topaz Solar Farm, a 550MW photovoltaic project in San Luis Obispo County, California, from First Solar. Both projects are being built by First Solar, and both will sell their power to Pacific Gas and Electric through a 25 year power purchase agreement (PPA), which will help California achieve its mandate of generating 33% of its power from renewable sources by 2020. The major difference between the two projects was that the Topaz Solar Farm was not backed by a U.S. Dept. of Energy (DOE) loan as First Solar was unable to close the loan guarantee by the September 30, 2011 deadline, whereas Agua Caliente Solar Project is backed by a $967 million DOE loan guarantee.

Given the horrible performance of photovoltaic (PV) stocks this year, with the universe of stocks down about 75% year to date, many people are asking what does Warren Buffett see that's so attractive in solar technology that the stock market doesn't see?

To start with, MidAmerican acquired a solar PV farm, not a PV cell or module maker: falling PV panel prices are good for the power producers and bad for the PV panel manufacturers. Since both the Agua Caliente and Topaz projects negotiated their PPAs before the collapse in PV panel prices, the falling prices would be a benefit to the owner of both projects. Second, it is likely that MidAmerican was able to negotiate transaction terms that were very favorable. First Solar has been struggling financially and has been seeking buyers or investors in its large scale projects for the last several months, and had previously sold its 660 MW Desert Sunlight project to NextEra Energy Resources and General Electric, its 280 MW Antelope Valley project to Exelon Generation, and the Agua Caliente project to NRG Energy in August. When First Solar lost the $1.9 billion DOE loan backing on the Topaz Solar Farm project, it needed to find an investor quickly to keep the project on schedule and minimize its own financial impact. The estimated cost of the Topaz project was over $2 billion, and it would have been difficult for First Solar to finance given the cratering of its stock price and the fact that it's profitability is under pressure given the brutal price pressure in the PV panel market. Although the financial terms were not disclosed, one would logically assume that a smart buyer and an increasingly motivated seller would negotiate a deal that had some favorable features for the buyer.

By closing the deal in 2011, MidAmerican gets to take full advantage of existing tax credits and accelerated depreciation that the project qualifies for, including the U.S. Treasury Grant Rebate program which returns 30% of the system's cost to the owner regardless of the earnings and tax liabilities, and which was set to expire at the end of 2011. That represents at least a $600 million benefit to MidAmerican which significantly improves the IRR of the investment. Given the facility's guaranteed energy output of at least 1,066 GW-hrs annually, PG&E's favorable PPA terms, and the very significant tax credits and accelerated depreciation benefits, a rough estimate of the unlevered IRR for the Topaz project indicates it is >15% for a very low risk endeavor, a heck of lot more than MidAmerican could get from any other equivalent risk investment.

A final factor may be that investment tax credits for wind power are set to expire at the end of 2012, and MidAmerican owns several wind power facilities, whereas solar power ITC's will not expire until 2016. Entering the solar power market today will provide a new tranche of ITC's with a longer horizon to replace the expiring wind power subsidies at the end of next year.

In time, I strongly believe that photovoltaic electricity generation will continue to grow as a percent of total electricity production as its costs continue to drop and approach grid parity with other technologies. It will exist in both centralized (e.g. solar farms) and distributed (e.g. rooftop) configurations, and costs will decline as PV cell efficiency improves, secondary efficiency enhancement products appear (for example total internal reflection distributed optics systems), more efficient power conversion technologies are developed (e.g. microinverters), PV panels are integrated with home structures and building materials, and economies of scale develop as the installed base grows. Other ecosystem improvements must come along with it, such as a more flexible, intelligent grid to handle varying load conditions as solar electricity becomes a larger factor in total power generation, but these areas are attracting significant investment capital and are moving rapidly as well.

Solar electricity will survive and become an integral part of our long term, clean renewable energy strategy. The market factors that are causing the pain felt by PV panel makers will eventually resolve themselves - PV panels are a cyclical commodity business very much like DRAMS, as I have pointed out. There will eventually be a shakeout, as a cyclical commodity industry cannot support too many competitors, and market share will consolidate among the top 4 or 5 major PV panel producers. But the industry will continue to grow and will provide opportunities for innovative downstream companies, which is where the best investment opportunities exist. That is where Warren Buffett chose to invest.

Warren Buffet is famous for recognizing undervalued companies with significant intrinsic value that can generate above-market returns over time. It looks like MidAmerican's recent foray into the PV solar power generation market is an opportunistic move to capitalize on some motivated sellers enhanced by some attractive cash flow generation with very little technical, execution or market risk. It is a validation of the PV solar industry as a source of utility scale power generation, at least with the existing state and federal financial incentives, but it is not a statement of any sort about the current state of the PV module industry, which is still struggling with crushing excess capacity of polysilicon and PV modules. However, Buffett is also known for investing in companies with long term sustainable value - it is unlikely that MidAmerican bought into the solar farm business as a short term financial opportunity driven by outsized tax incentives - it is likely that underpinning the opportunistic investment is a long term belief in the viability of solar electricity as a sustainable growth, profitable business. And that's good news for the solar energy industry.