FPI - 3 Ways To Exploit The Inflation Reduction Act

2023-06-12 15:03:30 ET

Summary

• The IRA is resulting in massive spending.
• These dollars are allocated to a relatively small section of the business world.
• These companies are positioned to get outsized benefit.

The Inflation Reduction Act, or IRA as it is commonly referred to, was intended to be a major piece of legislation around $400B, but the uncapped nature of its subsidies is taking it closer to $1.2T. I understand this is a highly politicized topic, but I am not here to pick sides or discuss the merits or demerits of the legislation. Instead, my goal is merely to uncover the investment opportunities created by the IRA. Regardless of your opinion on the matter, the fact is that when $1.2 trillion dollars is injected into the economy, there are going to be some financial implications. In this particular case, the $1.2 trillion is being injected quite unevenly, with some areas getting the biggest subsidies ever seen.

How the IRA got so big

When legislation is budgeted it has a tendency to look at historical volume, so the calculation of the absolute dollar amount of subsidy was based on the historical production volumes.

Well, when you introduce a massive subsidy that in some cases multiplies the margins of production and in others makes positive margins where they were negative, it tends to increase the number of units produced. One needs to look no further than a standard supply curve to figure this out. At a higher price, the equilibrant quantity produced is greater.

So in one sense, the IRA succeeded in cranking up production, but by the same token, it's causing it to come in at roughly triple the budgeted cost.

Since the subsidies are on a per unit basis, the producers of the subsidized items can scale their subsidies by producing more. This is the opportunity. Certain companies are positioned to dramatically grow revenues and margins. The key, in my opinion, is to find the IRA beneficiaries that are not obvious to the market. We will lead off with TSLA as a counterexample of something that is obvious and already priced in.

Special Mention - Tesla ( TSLA )

Tesla is the company that is likely to receive the largest absolute dollar amount of subsidies. Over $400 billion of the IRA is going to EVs or related battery technology, and TSLA is the disproportionate beneficiary due to its U.S.-based production.

I wanted to lead this list with Tesla because it is a great placeholder for all the companies that are extremely obvious beneficiaries. The gains they will experience as a result of the Act are real, but because they are so obvious, I suspect the benefits are already priced into the stock. Thus, despite benefiting, it is not clear to me that TSLA stock is opportunistic. I'll leave that discussion to analysts more dedicated to EVs.

It is the other three opportunities on this list that I find far more interesting because they will get significant revenue and margin gains, but the market doesn't seem to see it yet.

#1 Array Technologies ( ARRY )

Array sells the mechanical parts and software involved in tracking systems which allow solar panels to flex toward the sun. These increase the efficiency of utility-scale solar farms, reducing the levelized cost of production.

While I think it is known that the solar industry is a large beneficiary of the IRA, ARRY will benefit disproportionately for three reasons:

1. The subsidies on the physical parts in tracking systems are absurdly high.
2. Array sources a significant portion of its production domestically, which unlocks a higher level of subsidy.
3. Use of ARRY's tracking systems will increase the U.S. percentage for their customers, which will in turn increase demand for ARRY's product.

This is a triple whammy of higher revenues, higher margins and greater market share. The net result is enhanced growth, which is starting to show up in the consensus numbers.

Note that ARRY trades at $22.65 today, so it is a mere 26X current year earnings or 12X 2026 earnings.

That is a fairly cheap multiple given the growth rate. I think there is potential for ARRY to significantly beat analysts estimates as the qualification parameters of the IRA are hammered down in 2024. Some of the delayed demand will start flowing.

#2) Industrial REITs. Specifically, Plymouth ( PLYM ), Prologis ( PLD ), and STAG Industrial ( STAG )

According to the IRS, solar panels do not qualify as real estate because they perform an active function. Thus, solar panels are not "REITable" assets with respect to REIT tax law. Any income derived from the solar panels would have to be classified as non-REIT income and placed in a taxable REIT subsidiary. The IRS distinction of real estate as performing a passive function has historically kept solar power generation out of the hands of REITs, but like most portions of the tax code, there is a loophole.

In fact, REITs have come up with a variety of solar loopholes, and in each case, the result is incredibly lucrative economics. If it also happens to benefit the environment, that is great too and is likely a reason that there is no appetite to close the loophole. Over time, this could result in over $100 billion dollars of REIT investment opportunity.

The evolution of solar in REITs

REITs have been dabbling in solar for the better part of a decade and I have been trying my best to cover the developments as I think it will eventually prove to be a great opportunity.

• Back in 2019, we wrote about how Farmland Partners ( FPI ) had the opportunity to lease its land for solar use.
• In 2020, we discussed how REITs could structure solar to make it a major part of their asset base.

As of today, industrial real estate seems to be the most active in the space. Consider an industrial warehouse that is typically about 500,000 square feet with a flat roof. All of that square footage gets direct sun exposure, and so far it is going largely unused because solar panels are not REITable assets.

So all that roof square footage is going to waste, generating zero revenue.

Well you can still lease the roof to a solar company and the REITs are figuring it out. Recently, there has been an explosion of interest coming out of the industrial REITs.

James Connolly of PLYM:

"We have advanced our solar program considerably over the last year by concluding our initial feasibility with the identification of over 4.2 million square feet of rooftop that will accommodate solar arrays capable of generating approximately 42 megawatts of power. The first phase of this solar program comprised of 2.2 million square feet to be leased across 10 rooftops has been submitted to the Illinois community solar program and is expected to be operational in early 2024."

It is a very capital light approach.

• 4.2 million square feet of rooftops leased.
• $0 incremental investment.
• $1 million incremental FFO.

PLYM is a small company. $1 million of extra FFO at no extra cost is a significant sum, and 4.2 million square feet is just a fraction of their square footage.

Prologis is a much bigger industrial REIT and has plans to do it on up to 1.2 billion square feet of their rooftops.

Tim Arndt of Prologis at the Raymond James conference in March 2023:

"So we have 1.2 billion square feet of roofs around the globe, and our roofs are a great place to put solar panels. Today, we are the second largest producer of solar power in the U.S., on-site solar power on 4% of our roofs. We haven't even begun to really tap the opportunity. And I would say in the last 10 years, we kind of did that off the side of our desk, our developers might put solar on. It was sort of a part-time activity. We have completely flipped that on its head. We have an energy team in now, dozens of people strong, really going fast at this energy business, which is going to be complemented with the next pillar you see here, mobility, EV charging is essentially here."

So where does the IRA come in?

Well, it makes it more economical for the solar producer to build these panels, which turns all of these previously unused roofs into legitimate leasing opportunities. Any time previously unused space starts to produce 100% margin revenues, it is a big deal.

Thus far, the largest solar producing industrial REITs as a percentage of their assets are PLYM and STAG, while PLD has the greatest absolute amount.

#4) Consolidated Water ( CWCO )

At least $4B of the IRA is to be allocated to drought relief, which is on top of the $8B allocated in the latest infrastructure bill. A significant portion of the water funds will be allocated to the U.S. Southwest, where drought is increasingly a problem as the Colorado River level gets lower.

Solving the water crisis will involve a combination of conservation, recycling, and desalination. CWCO, through its AEREX, and PERC divisions which it now fully owns, is one of the leaders in this space. CWCO is responsible for the majority of clean drinking water in the Cayman Islands. It has recently announced a $204 million desalination plant in Hawaii, along with a large deal in Arizona. All this is being done by a company with a $345 million market cap.

While the stock is up 52% on the year, I don't think the magnitude of the opportunity is priced in. The earnings multiple is already reasonable and its volume of business is rapidly expanding.

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