Ormat Technologies, Inc. Q3 FY2022 Earnings Call

Good morning, and welcome to the Ormat Technologies Third Quarter 2022 Earnings Conference Call. All participants will be in a listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note that this event is being recorded. I would now like to turn the conference over to your host, Sam Cohen, with Alpha IR. Please go ahead.

Thank you, Operator. Hosting the call today are Doron Blachar, Chief Executive Officer; Assi Ginzburg, Chief Financial Officer; and Smadar Lavi, Vice President of Investor Relations and ESG Planning and Reporting. Before beginning, we would like to remind you that information provided during this call may contain forward-looking statements relating to current expectations, estimates, forecasts and projections about future events that are forward-looking as defined in the Private Securities Litigation Reform Act of 1995. These forward-looking statements generally relate to the company's plans, objectives and expectations for future operations and are based on management's current estimates and projections, future results or trends. Actual future results may differ materially from those projected as a result of certain risks and uncertainties. For a discussion of such risks and uncertainties, please see Risk Factors as described in Ormat Technologies Annual Report on Form 10-K and quarterly reports on Form 10-Q that are filed with the SEC. In addition, during the call, the company will present non-GAAP financial measures, such as adjusted EBITDA. Reconciliations to the most directly comparable GAAP measures and management reasons for presenting such information are set forth in the press release that was issued last night as well as in the slides posted on the website. Because these measures are not calculated in accordance with GAAP, they should not be considered in isolation from the financial statements prepared in accordance with GAAP. Before I turn the call over to management, I would like to remind everyone that a slide presentation accompanying call may be accessed on the company's website at ormat.com under the Presentation link that's found on the Investor Relations tab. With all that said, I would like to now turn the call over to Doron. Doron, the call is yours.

Thank you, Sam, and good morning, everyone. Thank you for joining us today. Ormat's third quarter operating performance and financial results demonstrated strong growth to our consolidated top-line driven by continued momentum in our electricity and energy storage segment, along with a notable improvement in our product segment. This marked our fourth consecutive quarter of revenue growth, which continues to expand both operating and net income, which grew by 8.1% and 21.5%, respectively. We are seeing positive momentum and progress in line with our strategic initiatives, which is evidenced by solid growth across our three business segments. The significant milestones we have reached since the beginning of this year with the addition of 73 megawatts of new capacity supported the continued growth in our Electricity segment. Additionally, newly signed contracts within the Product segment have improved our margins while simultaneously strengthening our backlog by 150%. After the prolonged impact of the COVID-19 pandemic on our Product segment, we are pleased to see this positive trend in development and the momentum that it is creating across the business. In the Storage segment, we continue to capture the benefits from high energy prices in all of our markets as we advanced our strategy of building an energy storage portfolio balanced between contractual fixed revenue and merchant exposure. We recently signed a 15-year PPA, which I will elaborate on later in the call. We expect the positive momentum in our Storage segment to continue in 2023, as we benefit from the regulatory tailwind created by the Inflation Reduction Act and the availability of ITC credit for storage projects. We continue to see strong global tailwinds from renewables, specifically in the U.S. and Indonesia. The elevated global price environment for fossil fuels and increased focus on energy security supports our long-term plans, and we are confident in our ability to continue delivering on our healthy revenue and earnings growth trajectory. We expect our combined geothermal energy storage and solar generating portfolio to reach approximately 1.5 gigawatts by the end of 2023 and to deliver an annual adjusted EBITDA of approximately $500 million on a run rate basis towards the end of 2022. Now before I provide further updates on our operations and future plans, I will turn the call over to Assi to review the financial results. Assi?

Thank you, Doron. Let me start the review of our financial highlights on Slide 5. Total revenue for the third quarter was $175.9 million, up 10.7% year-over-year, reflecting strong growth across our Electricity, Product and Energy Storage segments. Third quarter 2022 total gross profit was $61.1 million. This resulted in a gross margin of 34.7%, up 475 basis points from an adjusted gross margin of 30% in the third quarter of 2021. When excluding the $15.5 million insurance settlement proceeds related to the Puna power plant that were recorded as a reduction to the cost of goods sold in Q3 2021, net income attributed to the company's stockholders was $18.1 million or $0.32 per diluted share in the quarter. This compares favorably to the results of $14.9 million or $0.26 per diluted share in the same quarter last year. On an adjusted basis, net income attributable to the company's stockholders was $18.8 million or $0.33 per diluted share, with net income attributed to the stockholders up 5.3% and diluted adjusted EPS up 2.5% versus the same period last year. The increase in net income and adjusted net income was mainly as a result of a strong increase in operating income, driven by all three operating segments. Adjusted EBITDA of $102.2 million increased 0.6% in the third quarter compared to $101.6 million in the third quarter last year. The small increase was largely driven by an 8.1% rise in operating income, driven by the good performance of our three segments as well as a reduction in the G&A expected caused by lower legal expenses versus last year. This increase was offset by the absence of insurance settlement proceeds received in the third quarter last year. Excluding the $15.8 million insurance settlement proceeds, adjusted EBITDA was higher by 19.1%. Moving to Slide 6, breaking the revenue down at the segment level. Electricity segment revenue increased 7.1% to $552.8 million. This increase was driven by higher revenue at Puna due to higher generation and electricity rates. The commercial operation in July 2022 of CD4 and the contributions from the Tungsten enhancement project, which began commercial operation in April of 2022. Revenues in this segment were partially offset by the ongoing shutdown at our Heber 1 plant. In the Product segment, revenue increased 35.1% to $14.2 million and represented 8.1% of total consolidated revenue in the third quarter. The growth in our Product segment revenues was primarily due to our project in New Zealand, which we started to record revenues in the third quarter of 2022. Energy Storage segment revenues increased 56.2% to $8.8 million when compared to the third quarter of 2021. This meaningful increase was driven primarily by higher energy rates in most of our storage assets due to the higher overall merchant prices, coupled with added capacity in CAISO from the new 5-megawatt/20-megawatt hour Tierra Buena facility. Moving to Slide 7, the gross margin for the Electricity segment was 36.5%. Excluding the one-time business interruption insurance proceeds of $15.5 million related to our Puna project that was recorded in the third quarter of 2021, the third quarter of 2022, Electricity gross margin increased by 4.5%. In the Product segment, gross margin was 18% in the quarter compared to 12.8% in the same quarter last year. The increase in gross margin was driven by new agreements, of which we were able to capture stronger margin. The Energy Storage segment reported a gross margin of 31.5% compared to the gross margin of 12.2% in the third quarter last year. This increase was positively impacted by the significantly higher rates and availability at most of our storage assets. Looking at Slide 8, the Electricity segment generated 95% of total consolidated adjusted EBITDA in the third quarter. The Product segment generated 1% and the Energy Storage segment generated about $4 million of EBITDA, representing almost 4% of the total adjusted EBITDA. Reconciliation of EBITDA and adjusted EBITDA are provided in the Appendix slide. Looking at Slide 9, our net debt as of September 30 was $1.8 billion. Cash, cash equivalents and restricted cash and cash equivalents as of September 30, 2022, was approximately $263 million compared to $387 million as of year-end 2021. The slide breaks down the use of cash for the nine months, illustrating Ormat's ability to reinvest in the business, service our debt and return capital to our shareholders in the form of cash dividend and shares buyback. We note the decrease of cash has been funded from cash generated by operations and our strong liquidity profile that we keep and maintain. Our total debt as of September 30, 2022, was approximately $2 billion net of deferred financial cost. Its payment schedule is presented on Slide 30 in the Appendix. Our average cost of debt is down to 3.9%. We think it is important to note that as we prepare to deploy capital to fund our multi-year growth, nearly all of our debt liabilities remain fixed rate in nature, which we believe will help continue to position Ormat competitively in the rising global interest rate environment, particularly as we execute our Puna strategic plan to deploy capital and progress towards our multi-year target. In addition, we expect to finance part of our future CapEx spend with the support of the ITC and PTC under the new IRA, the Inflation Reduction Act, which leads me to the next slide. Let's move to Slide 10. On August 16 of this year, a new Inflation Reduction Act was signed, and we expect to benefit from it in many aspects. This act combined with the recently signed PPAs for our geothermal and our storage assets, is expected to improve economics in both segments, reduced capital needs in the U.S. even further than anticipated. First, the IRA extended the tax credit for geothermal by three years at potentially higher rates than before, which enables Ormat to get into tax equity transactions and fund a higher percentage of our investment. This should reduce our capital needs and increase project economics. We expect the geothermal project that will start operation in the next five to six years should be eligible for production tax credits. Second, for the first time, our investment in our Storage segment going forward will be eligible for between 30% and up to 50% of ITC at commercial operation versus no incentive prior to the Act. The expected ITC proceeds will reduce significantly our capital needs and should improve the economics of the project. All projects under construction with COD of 2023 and beyond should be eligible to benefit from the Inflation Reduction Act. Lastly, the IRA significantly simplified our ability to sell the tax credit to third-party entities, enabling us to capture potential higher value of the tax benefit. Moving to Slide 11. Year-to-date in 2022, we have invested nearly $408 million in CapEx to advance our growth. We have $750 million of cash and available line of credit. Our total expected capital for the last quarter of 2022 includes approximately $160 million of capital expenditures, as detailed in Slide 31 in the Appendix. Overall, Ormat is very well-positioned from a capital resource perspective with excellent liquidity and ample access to additional capital at attractive rates to fund future growth initiatives. On November 2, 2022, our Board of Directors declared, approved, and authorized the payment of a quarterly dividend of $0.12 per share to all holders of the company's issued and outstanding shares of common stock as of November 16, 2022, payable on November 30, 2022. That concludes my financial overview. I would like now to turn the call over to Doron to discuss some of our recent developments.

Thank you, Assi. Turning to Slide 14 for a look at our operating portfolio. Generation growth was positively supported by the inclusion of Tungsten and CD4 and the generation of the Dixie Valley power plants, alongside an increase in the operation of Puna. This was partially offset by the Heber 1 fire. As you can see on Slide 15, we added 73 megawatts this year to the Electricity segment portfolio, a 7.2% increase in total generating capacity. As noted on Slide 16, in the third quarter, our Puna Geothermal power plant operated at an approximate 23-megawatt level. Currently, PPA prices continue to be elevated as a result of higher global energy prices. We are still in discussions with HELCO to improve fixed-rate PPA pricing within our existing contracts. Turning to Slide 17. First, in our Olkaria power plant in Kenya, we are currently starting our drilling campaign, which should allow us to increase plant production during 2023. Second, regarding Heber 1, we are optimizing the complex through repowering work, which is expected to be fully completed in the second quarter of 2023. Finally, the Dixie Valley power plant is back in service and is performing at a higher capacity than before. Turning to Slide 18 for an update on our backlog. We saw a 150% increase compared to last quarter. We were able to sign contracts totaling approximately $100 million during the quarter in Indonesia and New Zealand and expect improved margins on this profit. Moving to Slide 19. The Energy Storage segment delivered another strong quarter, supported by high energy prices at most of our energy storage assets and increased capacity in California. Despite short-term delays for some of our Energy Storage assets, we see improvement in profitability as a result of the higher merchant market. As I mentioned earlier, we signed with the California utility our first-ever battery storage PPA, also called the tolling agreement. This 15-year agreement secured 100% of revenue for the 80-megawatt, 320-megawatt hour Bottleneck facility, and the agreement is subject to CPUC approval. The Bottleneck project is our largest project currently under construction, and we expect revenues and EBITDA from this project to align with our growth plans outlined in our March Investor Day. We also expect this project to benefit from the ITC from the Inflation Reduction Act. The fixed nature of the Bottleneck PPA supports our long-term growth objective of building a balanced Energy Storage portfolio, which will mitigate our risk exposure to merchant prices and will shift the portfolio more towards contracted fixed revenue arrangements. Moving to Slides 21 and 22. As we have communicated all year, 2022 is a significant builder year for Ormat. The foundation we laid this year will support our robust growth plan, which is expected to increase our total electricity generation to approximately 1.2 gigawatts by the end of 2023. Growth across all segments has been impacted by supply chain delays, availability of raw materials including batteries, and lower availability of local contractors, among other items. These have caused some delays in projected commercial operation dates, and we may need to shift some of our goals and targets further in the year to account for those impacts. Even with these challenges, we are still on track to reach 273 megawatts, which is 640 megawatt-hours in our Battery Storage portfolio by the end of 2023 and expect continued positive growth in our other segments. Slides 23 and 24 display the six geothermal and five hybrid solar PV projects currently underway. We are on track with COD of North Valley and Heber 2, both of which we expect to bring online by the first quarter of 2023. Heber 1 is expected to be completed in Q2 2023. In Guadeloupe, we received the required permits to start our construction. At Ijen in Indonesia, we have made meaningful progress and have already started the design of the power plant. In our solar PV portfolio, we completed the Tungsten Solar project and released the Steamboat Hills solar unit for construction. Moving to Slide 25 and 26. The third layer of our growth plan comes from the Energy Storage segment. Slide 25 demonstrates the Energy Storage facilities that have started construction. Upton is close to completion with several other projects planned for completion in Q1 of 2023. As you can see, there are slight delays in commercial operation dates, but we are on track with our year-end 2023 growth targets. Please turn to Slide 27 for a discussion of our 2022 guidance. In the first nine months of 2022, Ormat has delivered meaningful year-over-year growth across our revenues, operating income and adjusted EBITDA. Heading into the close of the year, we are updating and narrowing our guidance ranges to reflect our performance through three quarters and expectations for the fourth quarter. We now expect full-year revenues to range between $720 million and $735 million, increasing our midpoint of the range. In turn, we are slightly narrowing adjusted EBITDA guidance within the previously articulated range, anticipating results to be between $430 million to $442 million. We remain confident in our ability to manage our business and assets to deliver on our guidance and to drive future growth in 2023 and beyond as we exit our integrated business model. I will end our prepared remarks on Slide 28. This was a solid quarter demonstrated by continued financial and operating momentum with strong progress against our long-term goal. While the global markets are experiencing challenges related to supply chain disruptions and raw material shortages, including batteries and solar panels, we continue to benefit from the acceleration in demand for renewable energy in the U.S. and globally and from our own improvements in operations. The broader migration toward renewable electricity sources, supported by the recently approved Inflation Reduction Act should enable us to capture additional tax benefits in the U.S., which will further boost the economics and validate our decision to allocate the majority of our customers to be invested in the U.S. in both our Electricity and Storage segments. With a growing pipeline and numerous projects under development, we remain confident in our long-term plan to increase our combined Geothermal Energy Storage and Solar generating portfolio to approximately 1.5 gigawatts by the end of 2023 and to deliver an annual adjusted EBITDA of approximately $500 million run rate. This concludes our prepared remarks. Now, I would like to open the call for questions. Operator, please.

We'll now begin the Q&A session. The first question is from the line of Noah Kaye with Oppenheimer. Please proceed.

Good morning, and thanks for taking the questions. Could we start with just some clarification around the statement on Slide 10? The new geothermal project receiving up to $0.3375 per kilowatt-hour based on the new law. Can you help folks walk through that a little bit, what requirements have to be met? And how many of your projects under development do you think would actually qualify for that level of subsidy?

Hey, Noah, first, good morning and thank you for the question. This is Assi. When we look at the new PTC regulation, it looks like Ormat on all of its broad projects will be eligible for $27.5 per megawatt, over 10 years of production for PTCs. That's basically five times the minimum rate that was established by the regulator. The reason why we are able to get the five times minimum rate is because we plan, and we will use contractors that meet the regulation, including the rates that we'll have to pay them and the number of observers that we have as part of our operation at the time we build the project. So the $27.5 is already a higher number versus where we are today. There are two other ways to get a higher rate. One can take you to around $30 per megawatt and one can get to around $33 per megawatt. We assume that most of our projects will not be eligible for $30 and $33. To get to $30 per megawatt, what we will have to do is utilize local contractors and meet local content requirements during our construction. We now know that we are using equipment that comes from overseas. However, there are some exceptions that if you do not produce the equipment locally, you may be able to get a higher amount. So this is one option to get higher. The second option is to operate in an area that has historically been impacted by the energy community. These are typically energy communities that used to have coal or natural gas that didn't have any operations going forward, and then you can qualify for a higher rate. I will say that in our plan, as we see it now, most likely we will get $27.50 for all projects that will commence in the next few years and we will finish probably in the next five to six years. I will just tell you that if you consider the 10 years of PTCs on a nominal basis, they are equivalent to more than 50% of the cost to build a power plant.

That's incredibly helpful, Assi. So yes, $33 per megawatt, that actually, I think, sounds like $0.033 per kilowatt-hour, if I'm dividing it correctly, but there just maybe a typo there. But that certainly, I understand the higher benefit potential capture there and the impact. If we talk a little about project timing, I think the solar panel battery storage; those supply chain delays that are industry-wide are well known. Can you talk to us a little bit about the geothermal side and what you're seeing in terms of timing for projects? It looks like maybe a little bit of shift on a few projects here and there. But at this point, do you see any significant either supply chain or permitting hurdles to meeting your year-end 2023 goals and what should we be watching for?

Hi Noah, thanks for the question. It's Doron. We don't see supply chain or material supply chain issues on the geothermal part. This is obviously something that we are leading and well aware of with the different suppliers and making sure that we have the right inventory as needed. Permitting is always a challenge, and interconnection is always a challenge in the U.S. So we do see some small delays in maybe North Valley. But in general, our plans are such that we expect to meet and should not be impacted by supply chain issues.

Okay. That's very helpful. And then last, congratulations on, I think, $100 million in products. Can you talk to us a little bit about a) the timeline for converting that backlog into revenue? Is that really more of a 2023 story in terms of the inflection? It seems like that may be. And then just the potential depth of demand behind that, what the pipeline looks like in products for additional contracts?

In general, I would say EPC projects that we signed, and that's what the projects in New Zealand are. EPC projects usually are between 18 months to 24 months, tended more towards the first 12 months compared to the second 12 months. Supply contracts are typically within one year, but the big projects we had in New Zealand are EPC, so they will spread over 18 to 24 months. In the pipeline, we have a few potential projects that we are discussing with customers. I think the largest or the most interesting place is New Zealand. There's a lot of growth potential. We have a very big player there. We have supply built in several pockets there and will see some more opportunities. I'd say the next large players where we see a lot of potential is in Indonesia. We see quite a lot of drilling and development being done by various developers, including ourselves, but we're talking about the product side. We expect to see quite a few tenders coming out over the next few months and quarters. Let's say these are the two main areas, and there are other places, but I think these are the two largest.

Okay. I mean, it's good to see that turning from a revenue headwind that has been for several years into a tailwind. It looks like over the next couple of years, and we'll look for more. Thanks for taking the questions.

Thank you.

Thank you. The next question comes from the line of Mark Strouse with J.P. Morgan. Please proceed.

Yes. Thanks very much for taking our questions. Just a couple on Energy Storage, if I can. So it looks like some of the CODs that you were projecting for Q4 are now in early 2023, which is not surprising, as Noah said, just given the industry headwinds. But curious about the year-end 2023 target now seems to be at the lower end of the range that you were previously expecting. Is that really just because of kind of the slower start to 2023? Or are you signaling that you're expecting the supply constraint to last through the year?

Well, I think the lower range is mainly because of what you and Noah said. We see some issues with the supply chain. So we have the project that should come online, and we also discussed Bottlenecks that we have secured through a contract in all the batteries, so it should be online by the end of 2023. Apart from that, we are continuing with our plans. The main issues are the supply of batteries, but also permitting is a major barrier in the U.S. that we are dealing with across our segments.

Okay. And then more of a modeling question for my follow-up. Just going back to your comments around the profitability of your Storage business benefiting from the higher merchant pricing. Any commentary you can provide over the coming quarters on how we should think about margins for that business?

So I'll take this. Good morning. It's Assi. I will say that the third quarter really enjoyed the higher prices due to natural gas prices increase in the East Coast. PGA market was our leading market, and month-by-month, we see that. When you look year-over-year, our revenue is up over 50% with almost no increase in assets. We only added the 5 megawatts of Tierra Buena. Q4, we already gave you guidance of $30 million for the year. So as you can see, it's not going to be as good as Q3 because prices are not as high as of at least the first month of the fourth quarter. I will say we expect slightly lower margins in Q4. When we look forward, as a company, we should see an overall increase as we increase our capacity in our gross profit and EBITDA margin. You can look, for example, at the Bottleneck project, which we just signed. We gave an example in our Investor Day of an 80-megawatt, 320-megawatt hour project. The one in the Analyst Day is roughly $16 million of revenue and almost $13 million of EBITDA. So when we look forward, I will tell you that the EBITDA margins for this segment should continue to increase year by year. However, for Q4, I don't expect it to be as good as Q3, but things can change as commodities are moving really fast. At least in October, we have seen a better market than last year but not as good as Q3.

Thank you. The next question comes from the line of Ryan Levine with Citi. Please proceed.

Good morning. Thanks for taking my questions. In terms of the delays in the Storage and Solar segment, what are the implications in terms of your contractors and partners with the timing delays? Is there any recovery or penalties associated with any of these timing shifts? And how does that impact your financing plan and other capital plans?

Hi, Ryan. Thank you for joining us. Currently, we are experiencing minor delays of a few weeks, possibly extending to a month or two on construction. We are managing this situation effectively. We will not proceed with releasing projects until we confirm that we have secured the batteries, which are crucial for Energy Storage. Contracting can often present challenges, but with the ITC in place, there is an obligation to pay fair wages, which I believe will encourage more people to work as contractors. As for liquidated damages, this is not significant for us. Occasionally, we do face some LDs with our suppliers, but we generally maintain long-term relationships with them, and we have ongoing discussions about these matters. Therefore, this is not a critical issue for us. Regarding financing, we have not yet financed the standard projects; we have only financed one stand-alone storage project, and we do not view this as a concern.

Okay. And then, in terms of the product backlog, I think you highlighted the 150% increase over last quarter. Can you tell me which regions are seeing the growth or what types of customers are you seeing the biggest increase in your backlog?

I think the main two areas seeing growth today are in New Zealand and Indonesia. These are the two places pushing forward geothermal projects. I think in the short term, it's more New Zealand, while in the longer term or medium term it would be Indonesia. So these are the two largest ones. Additionally, I can tell you that we are responding to issues in Taiwan, Japan, Honduras, El Salvador, and Mexico. So many projects are on the table. The significant areas are New Zealand and Indonesia. We hope the Turkey economy will recover, as that market has a very high potential for growth.

Is the growth of New Zealand and Indonesia predicated on certain macro developments, or what's really driving that expansion?

No, New Zealand is a question of negotiating contracts and winning tenders; the same goes for Indonesia. They have the resources, land, and willingness to develop, and financing is a question of negotiating one-on-one contracts versus responding to tenders. New Zealand projects have been well prepared during the COVID period, waiting for conditions to improve. Now they are back in the market.

Okay, great. And then last question, in terms of the IRA impact on your core business, you highlighted more on the development side, but are there any expansions or repowering that may qualify for the ITC or PTC for geothermal?

In the geothermal part, if it involves expanding an existing power plant like Beowawe, that we had one project, and we are significantly increasing its capacity, then the addition, the expansion should be eligible for the PTC and ITC.

Thank you. Our next question comes from the line of Jeff Osborne with Cowen and Company. Please go ahead.

Yes, great, and good afternoon. A couple of questions on my end, Assi, I was wondering if you could just go over the current portfolio of Storage. Is that a 100% merchant or could you give us a sense of the mix?

Sure. When you look at the current portfolio, we do have only in California what we call RA contracts. They usually cover up to 40% of the revenue. So in our current portfolio, the Pomona 1 asset has a contract, Vallecito has an RA contract, and Tierra Buena has an RA contract. All the remaining Ormat contracts are basically on a merchant basis. So when you look at Ormat's current operations, the majority of the revenue is coming from merchant revenue. That said, when you look at what we expect to bring online between now and the end of 2023, we are actually shifting to more contractual revenue. The Bottleneck contract is a leading example of this. This is an 80-megawatt, 320-megawatt hour project. The size per megawatt is larger than anything that we currently operate, including everything that we plan to build next year. This project will have fixed revenue for 15 years, which will help us balance between merchant and fixed revenue.

That's great to hear. I see in the footnotes to the Bottleneck slide, which is helpful, that it requires CPUC approval. Do you have a sense of when you would anticipate that, just given you're hoping to have it up and running by the end of next year?

We have started the construction. We expect the CPUC approval within 60 to 90 days; I think that's what we were told. We know that they have been given an expedited approval process. So we hope to get it in 60 to 90 days.

Excellent. And my last question is just not as part of your 2023 outlook, but more for your mid-decade. M&A was a part of that. I was just curious if you could opine on where M&A valuations are on both Geothermal and Storage. My sense is that Storage had been a bit inflated a year or so ago; I didn't know if that's cooled off at all?

On Geothermal, we don't see today any assets in the market, but we are constantly discussing with owners whether or not they would like to sell or to enter some kind of an M&A transaction. Regarding Storage, you're right. Over the last year and previously, prices were significantly inflated. I think the increased interest rates will bring them to reality. It hasn't happened yet, but we do expect it to happen. Once they reach reality, we are in the market and constantly looking to acquire Energy Storage assets.

Thank you. The next question comes from the line of Justin Clare with ROTH Capital Partners. Please proceed.

Yes. Hi, thanks for taking our questions here. So first off, in Q3, we saw the gross margin for the product segment rebound meaningfully here. I was just wondering if you could share a bit more detail on what drove the improvement. Was it largely pricing-related, or did you also see improvements on the cost side? And then, just looking forward, how should we think about the product segment margins? You have a much larger backlog here. Could we see further improvement on the margin side?

Thank you for the question. In 2021, we signed two contracts in the Product segment that, when we bought the raw material, including transportation, incurred additional costs mostly related to supply issues and also, I would say, in general commodity market uplift. As a result, we saw the margins decrease throughout the previous year. In the third quarter, we’re actually seeing that these projects from 2021 are nearly at the end of their cycle and are closing out. The new contracts we signed will dominate mostly 2023, and they are at higher margins. Historically, we have suggested that we think we can get anywhere from 24% to 27%, 28% margins in the Product segment. I would say that we're not there yet, probably in the low 20s at this point. But we’re seeing some phenomena of a slight decrease in raw material costs. The hope is as we sign new contracts and purchase raw material, we will benefit, similar to how we lost money when the raw material prices increased. I think we will be in the low 20s, but we're not at our target just yet, but we're making progress.

Okay. Color is really helpful there. And then just wanted to understand your expectations for the level of the ITC you think you might be able to capture in the Storage segment given there's this 30% to 50% range. I think part of that is a result of meeting domestic content requirements. So do you think you can meet those requirements in either the 2023 or 2024 timeframe? Any context there would be helpful.

I think as you said, going up from 30% to 50% is a bit tougher and requires some additional definitions. The detailed guidelines by the IRA have not all been issued. The question of domestic content is influenced by how it is defined. As we all know, most of the battery cells are manufactured outside of the U.S., but in other areas and other countries, the definition of whether something is manufactured locally or not is still open for interpretation. Additionally, the other 10% is location-specific. We have some locations that might qualify. We're not sure yet. We're examining other locations that we know are not eligible for the extra 10%. So it's really a project-by-project analysis. However, the Inflation Reduction Act took us from 0% to 30% ITC immediately, which is a significant upside.

Okay, great. And then just one last one. You reiterated the plan here for reaching a run rate for adjusted EBITDA of $500 million towards the end of this year. I was just wondering what is factored into that? Are you including the potential upside from the tax credits for the PTC in that number? And then, also, have you factored in the ITC for Storage into that number, or could those be upside as we look into 2023?

As we outlined in the investor discussion that we had in March, Ormat always anticipated PTC to be part of our life, and most of the projects that conclude in 2022 and 2023 will be eligible for PTC regardless of the new regulation because constructions started a few years ago. PTC was already included. The ITC, however, is still a topic of debate; the four major accounting firms each have a different perspective on how we need to account for the ITC, especially when we're able to sell them through a transfer mode versus the ability to sell them as part of an ITC tax equity transaction. We are uncertain if it will flow through the EBITDA line or potentially to the tax line item. As a result, we did not include any significant dollars related to ITC in our $500 million target.

Thank you. The next question comes from the line of Julien Dumoulin-Smith with Bank of America. Please go ahead.

Hi, good morning, team. Thank you. I want to revisit the $650 million EBITDA target by 2026, which you previously outlined at the Analyst Day before the IRA. You mentioned various potential upsides on both development and on projects that are already in progress and contracted. How do you view the potential for exceeding the $650 million target, or in other words, what additional flexibility might you have on the balance sheet once you reach this target? Additionally, regarding the contracted projects, are they leaning more towards the Geothermal side? What is the extent of the additional value from the IRA that you are currently seeing?

Hi, Julien. I'll start with that. Regarding the IRA and who ultimately receives the full value, obviously, suppliers, developers, utilities, and all parties in the transaction are aware of this upside. It differs between projects that are already in development with signed contracts and CapEx versus new contracts that we believe the market will stabilize on a new set of numbers for merchant pricing, CapEx pricing and development over time. Regarding the target we've set in the Analyst Day five years from today, it isn't something we constantly update. Obviously, in March, when we held the Analyst Day, no one was aware of the Inflation Reduction Act. However, everybody expected the PTC for geothermal to continue and that was always part of our modeling. So the PTC is included in the geothermal part, while ITC for storage is a new consideration that came after that and was not included.

Can you clarify just in terms of the $650 million, how do you think about when you come back and provide a more comprehensive update? Again, I get that you don't have full line of sight as exists with the current projects necessarily to get out to there. But how do you think about just the accelerating nature of opportunities? Even more to the point, forget the $650 million. How do you think about the timeline for coming back and providing a medium-term update on opportunities arising from this? I get that a lot of the storage is merchant in nature and therefore, is driven by you from a timing perspective. A lot of the geothermal is driven by the pace of RFPs and procurement. Shouldn't we be seeing an accelerating effort on that front, both because California and the West are broadly short and need resources on a timely basis, as well as these elevated IRA opportunities for the time being?

Julien, we have been, even before the CPUC targets were set, pushing exploration and development of geothermal projects. We are continuously doing this. We see extensive demand in California for geothermal assets. So whatever we can develop and move forward, we have invested this year more in exploration than we've done in previous years and will likely invest more next year. For storage, the main barrier to developing new projects in the U.S. is the interconnection queue. Cluster 14 in California came up, and the queue had 90 gigawatts of potential projects. I think the entire usage in California is 50, but the queue for new projects was 90 gigawatts. This is becoming the biggest barrier, even more than supply chain issues. We are pushing forward. The IRA didn't change our plan to develop as many energy storage projects as we can. If we need to provide a more detailed analysis and updates in the future, we will.

Julien, this is Assi. I think there are two parts to the plan that we are analyzing as we speak. First, it looks like the capital needs we had in mind of $2 billion to execute our plans will be reduced because the ITC will provide in the storage segment anywhere from 30% to 50% in tax benefits to us. Thus, the cost to execute the five-year plan will be lower, which will lower our interest costs and leverage, which is beneficial for the plan. Second, as I mentioned earlier, if we get significant ITC that impacts EBITDA, we must consider how to account for it. We aren't sure if the ITC will flow through to the EBITDA line or directly to the tax line item. Once we reach an agreement on how to account for the ITC, we can reevaluate our $650 million target. However, the bottom line is that we will find that ITC benefits will cover the additional financing needed to grow. In the Analyst Day, we expected to spend roughly $0.5 billion on storage over the next four years, and if 30% to 40% of that will be supported by the IRA, it will significantly reduce our debt cost.

Yes, I hear all of your points. Thank you, and good luck. We'll speak to you soon.

Thank you.

Thank you. There are no additional questions at this time. I will pass it back to the management team for closing remarks.

Thank you. Thank you all for joining us. This was another good quarter for Ormat and we are now focusing on developing and pushing forward our growth and exploration targets as we end the call. Thank you all.

That concludes today's conference call. Thank you. You may now disconnect your lines.