If receiving government energy subsidies were an addiction, then Drax would be hooked. To its credit, the operator of Britain’s biggest power station is hardly in denial. It has been working on self-help measures that it hopes will stand it in good stead when access to its fix is unceremoniously removed in less than a decade’s time. Whether shareholders are ready to believe that it can make a success of going clean is another matter.
Drax’s main asset is its eponymous power station near Selby in North Yorkshire, which is fired by a mixture of coal and biomass. It also makes compressed wood pellets in several locations in the United States that are transported back to Britain to burn at the power station to help to generate electricity. It also owns Haven Power, a supplier of electricity to large businesses, and Opus Energy, which supplies electricity and gas to small companies.
The shares have been listed since 2005, when the company floated after a financial restructuring. This was overseen by its owners at the time, a group of creditors who took control after the collapse of one of Drax’s main customers led to a crisis.
Drax made revenues last year of almost £3.7 billion, but suffered a
pre-tax loss of £183.2 million. The shares, which were off 6½p at 361p yesterday, are worth less now than they were at the time of the listing 13 years ago.
Here’s the dilemma. The government is phasing out coal-fired power and, as of 2025, Drax no longer will be able to use two of the six boilers at the vast Selby site. Even worse, two years later, it will no longer benefit from a lucrative subsidy scheme that it agreed with the government in exchange for converting its boilers from coal to more sustainable biomass fuels. Its subsidies totalled £729 million last year, although this will reduce steadily over time.
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If that’s the habit, Drax believes it can be overcome. It has successfully converted four of its boilers to enable them to burn its American-produced wood pellets and it bought Opus and Haven so that it could diversify its customer base.
The company plans to convert its remaining two boilers into gas-fired generators and also wants to install a giant battery that would mean it could switch its gas generators on and off extremely swiftly.
At the weekend Drax confirmed that it was in talks with Iberdrola, of Spain, about buying Scottish Power’s gas and hydroelectric power plants. This would give it hydroelectric turbines in Scotland and gas turbines in the north of England and close to London, which would make its ability to produce and supply power even more flexible.
Drax is so confident about its prospects that last year it set a target of more than tripling its earnings before interest, tax and other items to £425 million by 2025, including £300 million at the core power generation and supply business, in part by cutting pellet production costs.
While this is all potentially very interesting, it is also uncertain. The new gas generators, and the battery, are dependent on Drax winning a contract from the government in a capacity market auction at the end of the year.
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We’ve also yet to see firm evidence of lower costs in producing pellets, while debt, and the cost of servicing it, are high. Hopes of a deal with Iberdrola are just that . . . hopes. They could yet flounder. Other opportunities, such as selling carbon dioxide, are at present no more than a theory.
The shares, which yield about 3.4 per cent, are barely 6 per cent higher than they were when Drax set its earnings targets more than a year ago.
ADVICE Avoid
WHYDrax is taking all the right steps for life after coal but still has much to prove
Pennon Group
Pennon Group is one of those companies that investors tend to look on favourably because, as a utility whose investments and profits are regulated and predictable, it is seen as being a reliable payer of dividends, and healthy ones at that.
From even a basic glance at the traditional valuation metrics, it does look good: Pennon trades at an affordable multiple of 14.8 times earnings and offers a yield of a highly respectable 5.4 per cent. It is more than simply a regulated utility and it’s tempting to conclude that the share price doesn’t show it.
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Pennon consists of the merged water companies South West Water and Bournemouth, supplying water and wastewater services to about 1.7 million customers in Cornwall, Devon, Dorset and Somerset, and water only to about 500,000 in Dorset, Hampshire and Wiltshire. This accounts for just over 70 per cent of its profits.
It also operates Viridor, a growing waste management division collecting and recycling waste, including for more than 150 local authorities, plus companies and individuals. It burns the waste that it can’t recycle to produce electricity. Both bits of the business are doing well, with cost savings at the water division and growth at Viridor helping to improve last year’s pre-tax profits by 24.9 per cent to £262.9 million on slightly higher revenues of just under £1.4 billion.
In a trading update ahead of its half-year results yesterday, Pennon gave investors every encouragement. Continued efficiences at South West Water suggest that it will beat its targets again this year, while growth continues at Viridor, which has eight electricity-producing facilities, with a further four to come. This part of the business is clearly the growth engine.
Like its peers such as Severn Trent and United Utilities, Pennon has to have its business plans approved every five years by Ofwat, the regulator. Its proposal for 2020 to 2025 has gone in and a final decision is expected by the end of next year.
Proposing to lift investment by almost a quarter to more than £1 billion and still pitching to be able to give investors a return of between 1.5 per cent and 8.8 per cent seems none too shoddy, though.
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ADVICE Hold
WHYGrowth at its waste management division is strong but not spectacular