Wellington West Analyst Sean Peasgood covers the geothermal, plasma gasification and "Smart Grid" subsectors of the alternative energy (AE) market. He believes there's room to make some dough in each of them but believes investors may need to be patient as these growing markets gain traction. "As these (geothermal) projects come online and are proven out, the reward to investors is going to be large," Sean says. He even reveals some names to help you earn your reward in this exclusive interview with The Energy Report.

The Energy Report: Sean, can you tell us a little about yourself and your coverage area at Wellington West?

Sean Peasgood: I've been covering the technology and clean-technology sectors with Wellington West now for about 10 months. Before this, I was with a bank-owned dealer for about four years covering the technology sectors as an associate analyst. I now cover the alternative energy space, focusing on geothermal, plasma gasification and the Smart Grid markets.

TER: Could you give us an overview of those alternative energy subsectors and their respective outlooks?

SP: Let's start with geothermal. While the stocks in this sector have been relatively weak over the last few quarters, we have a positive long-term view on the space. It takes significant capital and time for these projects to come online. I believe that early stage investors will benefit as projects generate significant free cash flow in the future. Eventually, they will look more like utilities and less like exploration companies. Investors who get in today will benefit from capital gains in the short term as projects come online and then from dividend-yielding equities in the future.

Given the baseload nature of geothermal, we believe utilities are more interested in signing attractive power purchase agreements (PPAs) than relying on more intermittent sources of renewable power, such as wind and solar.

We also cover the Smart Grid market, which is essentially the deployment of Internet protocol (IP)-based communication networks across the existing power grid. The goal is to increase efficiency, enhance control and provide visibility across the grid for utilities. The lack of infrastructure and maintenance upgrades over the last several decades, along with increasing demand for power, have reduced the reliability and quality of power not only in the U.S. but around the world. This problem is only being exacerbated as the world looks to add renewable energy sources to the grid. While some of these upgrades have already begun, we believe this deployment will take place over the next 5–10 years. This should translate into strong revenue and earnings growth for a variety of IP communications-infrastructure companies both wireless and wired.

Finally, as I stated, we cover the plasma-gasification market, which is an emerging alternative technology being used in waste-to-energy projects, as well as producing cellulosic ethanol. Plasma gasification reduces emissions and produces a synthetic gas that can be used to generate power. In cellulosic ethanol production, this synthetic gas is fermented and converted to ethanol. There are a number of projects getting underway in North America, and we're seeing interest for this technology in India and China, as well.

TER: Given the speculative nature of these alternative energy plays, what type of investor should be looking at this sector?

SP: I think investors should look to balance their traditional energy exposure by adding newer alternative energy companies to their portfolios. In many cases, these new technologies are just emerging; so, while they have more risk than more traditional energy plays, when they begin to gain traction, investors could be handsomely rewarded. That said, there are ways investors can reduce this risk exposure. For example, investing in early stage geothermal companies is, obviously, more risky than investing in some of the larger players that have a portfolio of projects and stronger balance sheets. We believe risk-averse investors should look to the larger players in the market to gain exposure to these growing markets.

Investors in the geothermal market need to have a multiyear time horizon, as development can take several years. As these companies bring projects online, I expect the share prices to continue to increase as a reflection of lower exploration and development risk. Then, as they start generating stable free cash flow, they will trade more like utilities and, eventually, provide dividends.

TER: What's the timeframe on that?

SP: Generally, projects take about three to four years to develop. Depending on who you're looking at in the space, most companies that we cover—I'm talking about Magma Energy Corp. (TSX:MXY) and Ram Power Corp. (TSX:RPG)—have a portfolio of projects that will come online over the next few years, leading to a steady increase in megawatts (MW) online. Ram, in particular, has a 32 MW project in Nicaragua that will come online in the second quarter of 2011, which will immediately provide them with an increase in their top and bottom lines. Two quarters later, they're going to bring an additional 32 MWs online, meaning the company will be generating 72 MWs in total by the end of 2011.

Companies have been developing things in sequence. So you're going to see multiple projects coming online every year, which will be positive for the stocks and help fund future growth.

TER: In looking at your research, some of the price targets in your recent reports are a bit more aggressive; but some targets you set earlier this year were rather conservative. For example, in a report on RuggedCom Inc. (TSX:RCM) dated May 28, 2010, your target price was a mere 21% above the existing price. Using that as an example, are your conservative targets more indicative of your approach or sector weakness?

SP: Generally, I try to weigh the growth opportunities with the risk factors and be as fair as possible. As far as RuggedCom is concerned, I've become more aggressive on it lately given the recent slide in the stock, the company's leading market position and the significant growth opportunity in the market. They are actually benefiting from not only Smart Grid opportunities but also from other industrial ethernet markets like transportation and infrastructure.

For the geothermal space, while we are bullish long term, investors need to understand the risks involved in these projects. There's financing risk, which has recently been improving, and political risk, as government grants can enhance the value of projects and some of the projects are in foreign jurisdictions. As projects advance and get de-risked, then I will become less conservative. But I think at this point, it's fair to provide investors with the full set of risks and that's reflected in my forecasts and price targets.

TER: You've mentioned Smart Grid a few times. Everyone has heard of the grid, but what's a Smart Grid? And why should investors look specifically at this alternative energy subsector?

SP: Essentially, the Smart Grid is the deployment of a communications backbone over the existing power grid—all the way from power generation out through transmission and distribution, and then into the home. Most of the infrastructure out there really hasn't changed in 100 years. What we have now is significantly higher demand for electricity across a decaying grid infrastructure that is becoming less reliable and efficient. The idea of the Smart Grid is to deploy a communications backbone, so utilities have full visibility across that grid.

Over the last few years, there's been a real focus on putting smart meters in homes. Smart meters provide the user with visibility and the ability to switch their habits to use more power at off-peak times and also provide the utility with information about electricity demand patterns. For example, with a smart meter, the utility can charge a little bit more for running your dishwasher during peak times and try to encourage you to run that dishwasher at night. That's the first phase.

But we believe the next phase is the more important part of the Smart Grid, where communication infrastructure is being placed in substations across the grid, so utilities have even greater visibility and control. Right now, if power goes down, the utility has no visibility and must wait until customers contact them to let them know. The Smart Grid provides the opportunity to put a communications network in place, so utilities know if they've just lost a whole block and immediately take action. This should reduce power outages, which negatively impact GDP and are becoming more frequent.

This is where RuggedCom has been focused for about seven years—putting routers and switches and IP-communications equipment into substations. Currently, in most substations, there is no infrastructure to alert utilities, which can result in a fault in the substation. But with this equipment, all of those things can be monitored in real time; and the equipment will make the appropriate adjustments with very little need for human intervention. This full communications backbone is the real solution to providing utilities with the visibility to meet growing demand, increase efficiency and reduce greenhouse gas emissions.

RuggedCom has a strong management team, backed by a number of individuals from General Electric Company (NYSE:GE). I really like this stock (we have a Strong Buy rating on it and $20.50 price target), and I think it's a good way for Canadians to play the Smart Grid. Currently, there aren't many public companies in Canada that are exposed to this space like RuggedCom. The major risk for investors is the potential for lumpy quarters, which can lead to volatility in the share price. To gain a better understanding of the business, investors should look at results on a trailing four-quarter basis, which illustrates the consistency in revenue and earnings growth over the last several years.

TER: What countries are deploying this technology at a rapid rate?

SP: There's been a lot of attention on smart meters in North America and Europe. Substation automation is happening globally; however, the upgrade process has been one or two substations at a time, rather than the mass smart-meter deployments we have seen to date. When utilities upgrade a substation, they'll upgrade all the communications equipment inside at the same time. Given utilities' risk aversion and new technology, the sales cycle for these products can be 12–18 months. To put this in context, last year the market for substation automation-communications infrastructure was roughly $150 million. If you just look at all of the substations in the world and assume that 20% of those have been upgraded, which is probably a conservative view, to upgrade the rest of the substations would be about a $4 billion opportunity.

TER: That's not an overly huge market though.

SP: That's just the substations—just one piece of the overall Smart Grid opportunity. It shows you where the market could go. I mean it's very, very small right now as utilities are really only upgrading a few substations at a time. Could it multiply significantly over time? We believe it will, but it's really going to be about how quickly these utilities adopt this technology across their footprint.

TER: You mentioned Asia earlier. In other sectors like mining, China has changed the way businesses operate. Last year, according to an alternative energy report that came out earlier this week, $34 billion was spent on solar and wind projects in China. What sort of impact is China having on the AE sector?

SP: As one of the world's fastest-growing economies, China is going to be an important part of this market for many years to come. Right now, about 90% of China's energy is from nonrenewable sources. The Chinese government wants to get that to 18% by 2020. Electricity demand there is growing significantly, so you know this is going to require significant investment. We're already starting to see that in wind and solar. We believe all of the markets we have spoken about so far should benefit from that region.

TER: What are some companies other than RuggedCom that have significant exposure to China?

SP: One would be Alter NRG Corp. (TSX:NRG; OTCQX:ANRGF), which is in the plasma-gasification market. The company just signed an agreement with Wuhan Kaidi Holding Investment Co. to develop a number of waste energy plants in China. They're going to start with a small demo plant, which is expected to be online in mid-2011. Then they're going to look to develop up to 50 additional plants in the future. Alter NRG is also in discussions with other parties in the region that want to take advantage of the waste-energy market. Currently, most waste sites are still using landfills and incinerators. These Chinese engineering companies are looking to use plasma-gasification technology to eliminate waste and generate electricity.

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