An Option on the Future of Alternative Energy

Adapting to an alternative source of power can be quite cost prohibitive to both businesses and the average household in an economy where every dollar counts. After all, it’s all about returns when it comes to making any investment and making the transition from mainstream energy sources to an alternative is an investment to say the least.

Some of the considerations already “on the grid” include:

• Solar (photovoltaic, solar thermal)
• Wind
• Geothermal
• Biomass
• Biogas (e.g., landfill gas/wastewater treatment digester gas)
• Low-impact hydroelectricity

A focus on the development and implementation of these renewable energy sources carries with it a number of significant benefits.

• Reduction in greenhouse gas emissions and air pollution
• Much less invasive to Mother Nature
• Diversification of energy supply
• Reduction of dependency on the importation of fuel
• Creation of jobs related to the manufacturing, installation and maintenance of the facilities

The most significant challenge has been price competitiveness and regulations, and in addition:

• Barriers faced by new technologies competing with mature technologies
• Price distortions in subsidies and unequal tax burdens
• Failure of the market to value the public benefits of renewable
• Inadequate information
• Lack of capital to invest in research and the transition over to the new power source

Despite the challenges, studies are showing that the costs of transitioning over to alternative energy sources are dropping. GTM Research, a solar power industry trend follower out of the United States sites that the average cost of residential solar in the first quarter of 2013 fell by 15.8% compared to the previous year. In addition, the number of installations have doubled and in even tripled in many states. Industry data here in Canada is showing some growth, but it is clear that Canada lags in comparison to many other countries. Canada is still moving forward in this sector; however it appears as though other countries are simply outpacing us in growth and implementation.

The lack of pace, I am sure, has a lot to do with our vast economical dependence on the global demand for oil. However, the more society embraces the idea of change and more importantly, the greater the need for new job creation, the more capital will pour into alternative energy research and the subsequent probability of a broad based, affordable solution with attractive government incentives is quite high.

That brings me to an interesting longer term opportunity in the Canadian renewable energy sector. Innergex (INE- TSX) is the only options eligible company with in this particular space. Because of our ability to construct option strategies around the shares of this company, it becomes a very interesting idea for longer term growth.

Innergex has been in business since 1990, owning and operating hydroelectric facilities as well as wind and photo voltaic farms in Quebec, Ontario, British Columbia as well as Idaho U.S.A.

From an investment perspective, the stock debuted on the market at $14.00 back in 2008 and subsequently migrated south to a low of $2.60 in 2009. The stock saw a more recent high of just over $11.00 in 2012 but now sits just above an $8.00 support level.

Innergex INE-TSX Monthly Chart

Admittedly, from a technical perspective, this stock is not screaming “BUY.” However, a dividend of $0.58 per year at today’s price of $8.60 offers the investor a 6.73% yield. The challenge with some of these small cap companies (market cap of $804.54 million) is that the changes to the dividend payout can often come about without much notice.

With options listed on INE, we are provided with another mechanism for enhancing yield while we wait for the shares to appreciate over the longer term…the Covered Call.

An investor looking to generate cash flow on a longer term holding could sell a January $9.00 strike call option at the bid price of $0.20 per share, while the option writer may place a sell limit between the bid and ask and receive a better fill, $0.20 represents the current bid.

The next dividend date is scheduled for September 26^th, 2013. The investor can anticipate $0.14 per share during the 128 days until the options expiration date. This brings the cash flow or yield with in the life cycle of the written call up to 4.03%, or an annualized rate of return of 11.45%.

If the shares rally beyond the written strike by the January expiration, the investor would enjoy an 8.42% return, considering the appreciation of the shares, the collection of the call option premium as well as the dividend.

There are 3 outcomes that the investor must consider:

1. The shares drop below the breakeven point, which is determined by subtracting the premium from initial purchase price. You may also account for the dividend as well, but recognize the different tax implications. In this case, the investor would be sitting on an unrealized loss and may continue to write calls and collect the dividend as the shares recover.
   
2. The shares rally beyond the written strike as mentioned previously. In this case, the shareholder can accept assignment, realize the profit and re-purchase the shares or roll the $9.00 call up to a higher strike and out to a further expiration month to avoid having to deliver the shares. In addition, the shareholder benefits from the shares trending higher.
   
3. It is also possible that the investor may experience early assignment ahead of the ex-dividend date. If the cost of purchasing the call option and exercising to own the shares makes financial sense, a call holder may choose to do so. In this case you would sell the shares at the written strike, keep the premium, but would not get the dividend.

In addition, if the investor feels that there is short term risk in purchasing the shares at the current levels, a protective put out to October at the $8.00 strike could be purchased at the ask price of $0.15. This would effectively collar the stock for the next month, offering the investor a limited and identifiable risk exposure while INE-TSX tests support at the $8.00 level.