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If you were optimistic about Plug Power (NASDAQ:PLUG) before, you will be more optimistic about the company today, given all the positive news about the company. This article aims to provide an update to Plug Power after its 2Q22 results as well as its recent announcements made to determine how these affect my investment thesis for the company.
Investment thesis
I have written previous articles on Plug Power that can be found here. Since the last article, my conviction in Plug Power as a future leader in the hydrogen ecosystem has grown. The company continues its vertically integrated strategy, providing end-to-end solutions for hydrogen solutions and has been gaining traction with large customers and seeing an expansion of business with its existing customers. Furthermore, the industry is benefiting from the Inflation Reduction Act that helps encourage green hydrogen production in the United States. As a result of the incentives provided, it is expected that Plug Power will then reach positive cash flows and profitability earlier than expected. The recent customer wins continue to provide evidence of the value proposition that Plug Power has a technology leadership in hydrogen Proton Exchange Membrane (“PEM”) fuel cell systems. All in all, I continue to have conviction in Plug Power, in its ability to execute and grow according to management’s strategies as it looks set to take up significant share in the hydrogen economy.
Green hydrogen agreement with Amazon
As part of Amazon’s (AMZN) efforts to decarbonise their operations, the company went into a supply deal with Plug Power for the company to provide 10,950 tons per year of green hydrogen. This will start in 2025 and as part of the terms of the deal, Amazon was granted a warrant to acquire 16 million shares if the warrant vests in full when Amazon spends $2.1 billion on Plug Power’s products over 7 years. This represents a less than 3% dilution based on the number of outstanding shares today.
Since 10,950 tons per year is equivalent to 30 TPD, this only makes up 6% of the 500 TPD goal it set for itself for its green hydrogen production capacity by 2025. However, in my view, what this deal signifies is the implicit long-term agreement for Plug Power and Amazon’s working relationship as well as Amazon’s long-term commitment to hydrogen.
Furthermore, I think that this is just the start of the relationship with Amazon, as the company might take on other potential applications for hydrogen with Plug Power as a key partner in its decarbonisation journey.
Successful validation with Microsoft
As a result of successful validation of a stationary power unit of 3MW with Microsoft (MSFT), this opens up a new $40 billion market opportunity for Plug Power in stationary power and is highly positive for the company, in my view.
With Microsoft looking to hydrogen fuel cells as backup power for its data centres, with the validation of Plug Power’s product offerings, this could mean a huge market opportunity for Plug Power in the stationary power space in relation to both Microsoft’s data centres and more broadly, for data centre applications across companies.
By 2024, Plug Power expects to ship 200 to 250 MW of high-powered units and this could be skewed to the upside should more companies see the value add in Plug Power’s stationary power offering for their unique needs.
As a result of the increasing pace of deals being announced with both Amazon and Microsoft, I think that this gives the company more confidence in being able to achieve its 2025 target of $3 billion in revenues and could even be revised to the upside if the momentum continues and Plug Power reaches an inflection point.
2Q22 results
While Plug Power’s results were slightly above my expectations for its second quarter revenues, they were below market consensus as a result of most of 2022’s revenues expected to be weighted towards the second half of 2022, as $151 million in revenues were reported for the second quarter. The softer revenues compared to consensus were a result of fuel cell shipments and hydrogen installations being lower than expected, as well as the effects of seasonality as almost 70% of revenues are expected to be second half weighted.
As for Plug Power’s margins, I think that it is within expectations that their margins continue to be challenged. Given that margins are once again facing headwinds from the higher fuel and service costs, I think that it is expected that with the higher natural gas prices as well as a challenging supply chain situation, margins will come in worse than expected.
Looking forward, I think that for the second half of 2022, we will start to see margin improvements. Management is also confident that moving into the second half of 2022, as their revenue mix will shift towards more equipment, and given the growth that the company is seeing, they expect that margins will improve in the third quarter and could move towards the positive range and even hit the double-digit range if mix is favourable. The company is seeing improvements in the service costs, as the team managed to work towards 70% part reductions. Thus, I think that the company will see significant improvements in margins moving into the second half of 2022 and into 2023 as the company continues to improve on service costs, increase equipment margins and as the effect of the production tax credits from the Inflation Reduction Act come into play in 2023.
Management reiterated their 2022 revenue guidance of $900 million to $925 million as well as their 2025 revenue target of $3 billion. Furthermore, the company remains focused on their path to profitability, ensuring that they are executing well in that direction. Also, on the recent policy updates from the Inflation Reduction Act, this will help the company accelerate their plans to become profitable, as well as achieve positive cash flows.
Electrolyzer business grows at a shocking pace
In particular, I thought that the electrolyzer business was rather strong as it already surpassed the target of achieving 1GW by the end of the year, as it achieved 1.5GW in the second quarter. I think this highlights the very strong demand for Plug Power’s electrolyzers and that the demand for their electrolyzers exceeded management’s own forecasts for the year. A substantial order came from H2 Energy, which ordered 1GW from Plug Power, announced earlier. I expect that Plug Power will see the business make up about 30% to 40% of its total business mix in 2024 and almost 50% of the total business mix by 2025.
As with the company’s gigafactory in Rochester, they remain on target to achieve full production by the fall of 2022, with an annual run rate of 2.5GW of total capacity and 1.5 GW of electrolyzer capacity.
Beneficiary of the Inflation Reduction Act
As a result of the hydrogen production tax credit prosed in the 2022 Inflation Reduction Act, companies like Plug Power involved in hydrogen production are key beneficiaries of the favourable government policies and incentives rolled out to help the United States improve energy supply and resilience.
For example, the 2022 Inflation Reduction Act allows for up to $3 per kg of hydrogen production tax credit for the production of green hydrogen each year. As a result, this will benefit Plug Power as the company will be eligible for the full credit up to the full period of 10 years for the policy. In particular, Plug Power is a key beneficiary because the company is expected to bring online 70 TPD of green hydrogen plants by the end of 2022 and 500 TPD by the end of 2025.
The most direct impact to the company will be the improvement in margins that comes from these incentives, specifically, for every dollar per kg of hydrogen cost, I estimate that this will affect Plug Power’s gross profit by about $10 million to $12 million. As a result of the hydrogen production tax credit, this will really accelerate the company’s improvement in gross margins, and along with the vertical integration strategy, its hydrogen business should achieve more than 30% gross margins by 2024. Also the tax credit could also encourage other companies to build more green hydrogen plants which will then also improve the demand for Plug Power’s electrolyzer business.
All in all, the policy incentives from the Inflation Reduction Act can actually help the company bring in $500 million in incremental cash flows each year and bring forward the company’s pivot towards profitability by 6 months. Also, the payback periods for the hydrogen plants are expected to be half the time taken without any incentives, as per conversation with the management, reducing this to about 5 years. As such, the Inflation Reduction Act is a game changer for Plug Power and as such, the company is a key beneficiary of it.
Valuation
My 1-year target price for Plug Power is $32, implying 52% upside from current levels. I assume an EV/EBITDA multiple of 30x on Plug Power’s 2025F EBITDA numbers, and apply a discount rate of 16%.
For Plug Power’s valuation, I think that premium on Plug Power’s multiple is required relative to other hydrogen peers. This is because, in my view, that the company continues to execute well across segments, showing great progress on obtaining new businesses from large clients as well as bringing in new clients. Also, I think that the company continues to have a long runway in the hydrogen road map as we are only at the early stages of an inflection point for Plug Power.
Risks
Margins and cash flow risks
While management may be confident in margin improvement in the second half of 2022 and for 2023, I think there is still a risk that their margins and cash flows may fall short of market expectations. If so, this could pose increasing challenges for Plug Power as the market will want to see improving profitability at the company after it has demonstrated strong revenue momentum.
Multiples re-rating
There is a risk that the multiples in the industry may continue to trend downwards as it has over the past year. As a result of investors turning more risk averse in the current market conditions as well as with the rising interest rate environment, if the multiples a de-rated significantly, this will definitely affect Plug Power’s valuation.
Competition from other hydrogen players
As policies for the hydrogen industry get more favourable, there are bound to be more new entrants in the industry. As a result of new competitors entering the space, they could compete directly with Plug Power. Thus, this can affect Plug Power’s growth profile and margin progress.
Execution risk
As the company has rather ambitious targets in an emerging hydrogen industry, Plug Power could make missteps along the way. If the company does not execute well on its growth initiatives, or if certain segments do not pick up as well as management expects, the company could fail on certain initiatives.
Customer risk
While management is showing great progress on the customer front, if Plug Power is unable to retain customers or bring in new customers at the rate that is expected, there is the risk that investors may stop believing in their growth story and thus assign a lower multiple to the company.
Oil and gas price risk
As a result of the higher gas as well as oil prices today, this has accelerated the shift towards hydrogen and a change in attitude towards hydrogen. However, if gas and oil prices were to come down, this might slow down the pace of hydrogen adoption as the relative benefits and costs of adopting hydrogen is reduced.
Conclusion
Plug Power’s recent green hydrogen agreement with Amazon shows the latter’s commitment to its hydrogen strategy and further strengthens the relationship between he two companies. Furthermore, with the validation from Microsoft for the use of Plug Power’s products as backup power for data centres, this brings about a huge market opportunity for Plug Power. More importantly, the Inflation Reduction Act looks set to provide the essential incentives needed by Plug Power, accelerating its path to profitability as well as positive cash flows. I think that Plug Power continues to execute well in a rather early-stage hydrogen industry as companies and governments around the world prioritise their decarbonisation journey and transition towards green hydrogen. My 1-year target price for Plug Power is $32, implying 52% upside from current levels.
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