Friday, 14 January 2011

Muck and Brass at Drax?

There is a saying in Yorkshire that goes along the lines of "where there's muck, there's brass".

Beautiful? Source: Drax website
Drax Group plc (DRX), based in Yorkshire, operates the largest coal-fired power station in the UK, providing some 7% of the UK's energy needs via the wholesale market. Plenty of muck then, but what about the brass? And under-valued brass at that.

The current share price of 380p (as at 11 January 2010) gives the company a market value of £1.39bn. Based upon the 2009 basic EPS of 31p, this represents a PER of 12.3x. 

Source: Drax website

In the past five years, the shares have hit a high of 968p (August 2006) and a low of 329p (May 2010).  However, there were share consolidations in between, and to have a true comparison, one needs to apply a factor of about 1.15x - eg 1,155 August 2006 shares are equivalent to about 1,000 May 10 shares. 

The interesting point to note is that the share price has seriously under-performed the FTSE 100 in the past 18 to 24 months - almost being a mirror image. DRX is listed in the FTSE250 and is roughly the 60th largest company in that index by market value.

For the record, my average cost per share is 384p and, after dividends equating to 18p per share, my break-even cost is 366p per share.


Potted history
  • 1974 - first stage of the plant built (second stage in 1986);
  • 1990 - came under ownership of National Power (following regulation of electricity industry);
  • 1999 - acquired by AES Corp (US) for £1.87bn as vertical integration and a need for divestments came into play;
  • 2003 - ownership transferred to a number of financial institutions following "customer issues" (Drax's largest customer went into administration, leading to severe financial problems);
  • 2005 - refinancing and listing on the London Stock Exchange (December);
  • 2009 - acquired Haven Power as a route into supplying business customers directly; and
  • 2010 - £106m of new equity to pay-down debt.
Business Model

Drax burns coal and sells the electricity onto the wholesale energy market. Its revenues come in three flavours: spot ('Balancing Mechanism' - to meet hourly demand), short-term (demand for next 24 hours) and forward contract (up to several years before).

The prices in the wholesale energy markets are driven partly by the price of oil. Gas prices are typically linked to oil prices, so when oil prices rise, gas prices rise. Gas is the major source for delivering energy in the UK (45% in 2008), and a higher gas price tends to lead to higher wholesale electricity prices. NB coal generated 32% of UK electricity in 2008.

In 2009 (and 2010) wholesale gas prices have been relatively low, despite a more buoyant oil price, which has led to a relatively low wholesale electricity price. Gas-fired generation becomes cheaper and coal-fired generation margins are lower to the extent that the price of coal does not fall as low as gas price. Gross margins fell in 2009 as the average price for electricity on the wholesale market fell by 10% whereas the cost of coal was virtually unchanged versus 2008.

On a positive note, Drax enters into forward contracts to ensure some stability to future revenues, and as at the end of 2009 had two years' worth of future revenues contracted. These contracts are 'marked-to-market' each year (ie profit or less arising on contracts yet to be delivered based on current price are taken into account), which should help to smooth earnings. Furthermore, the Company entered into a five-year supply agreement with Centrica in 2009, which appears to be longer in duration than the norm, and sounds positive as a consequence if the industry is moving this way. 

The Company is also developing a biomass-fired generation business (essentially burning straw rather than coal), which will help to reduce CO2 emissions. The Company has been dabbling in bio-mass for about seven years and it represented 3% of the fuel burnt by Drax in 2009. The Company has the facilities in place to develop this further, but this is being held back by issues of how it gets funded and what are the incentives (ie subsidies) for doing so. It appears that the Drax hasn't seen eye-to-eye with the UK government on this...yet.

Risks & Challenges
  • essentially a single-site operation;
  • spot prices and resultant margins are driven by the price of oil, gas and coal markets - meaning that the Company is to some degree beholden to the vagaries of world's energy markets, although this is mitigated by hedging and forward contracts; and
  • geo-political desire to reduce CO2 emissions, but which alternative energies are going to succeed and how will they be funded? (direct investment, subsidies, price of carbon etc) 
Check out the website: for more detail.

The Rules

The starting point for the analysis is the Annual Report for the year ended 31 December 2009 (FY09).

1 - Assets - the NAV at December 2009 was £1.03bn versus a market cap of £1.39bn, meaning that the market value is trading at a 35% premium to net assets.

Virtually all of the NAV (and more besides) is in relation to fixed assets - freehold land, buildings and plant & machinery, which are valued at a book cost of £1.2bn. It is arguable that the market value of the newest, largest and cleanest coal-fired power station in the UK could have a strategic element to it and could be higher (or lower!) than the book value. Given the nature of the asset, there is not a readily available market price. From a value perspective, I am not keen on assets being valued at a premium, but I note the relative uniqueness of the asset and can live with a modest premium to book value.  Pass(ish)

2 - Market Value - £1.39bn. Pass

3 - Cash Flow - (a) net current assets of £232m bodes well and (b) operating cash was £306m after working capital movements and interest. Out of this we need to provide for replacement capex (estimate of £50m based on depreciation charge), tax (£50m based on 2009 P&L charge), which leaves the best part of £200m to cover debt repayment (£30m due within 12 months), 'new' capex (new biomass capex and clean energy technology) and dividends (£50m based on 13.7p). After all this, I am content that the Company's capital structure can be serviced and that there is room left over to support an increased level of dividend, although future capex could impact on this.  Pass

4 - Debt - (a) net debt as at December 2009 totalled £109m versus balance sheet equity (£1.02bn), resulting in a debt:equity ratio of 1:10 and (b) an EV/EBITDA ratio of 4.9x, based on an EV of £1.5bn and adjusted EBITDA of £305m (EBITDA of £355m less replacement capex of £50m), which squeezes under the 5x ceiling by a smidgen. Pass

5 - PER - based upon a 2009 basic EPS of 31p, the PER is 12.3x.

We would want to look at a 10 year average EPS to look at long-term earnings, but the Company has only been listed for five years. The five year average EPS is 90p, but this does not take account of the share reorganisations in 2006/07. If we look at PBT for each of those five years, apply an average tax rate and divide by the shares currently in issue, we get a five year average EPS of around 80p. Using this, the PER based on five year EPS of 80p is a far more reasonable 4.8x, bring us into value territory. Pass

6 - Yield - the 2009 DPS was 13.7p, which equates to a yield of 3.6% and is above the target hurdle of 3.5%. However, this does not represent the whole story. The Company has paid out bumper special dividends in the last five years and 2009 represents the most measly as far as dividends are concerned.

The Company recently revised its dividend policy to be 50% of underlying earnings. If we take this to be basic EPS, then DPS in 2009 would have been closer to 16p. If we get carried away and consider EPS of 80p to be reasonable, we start getting target dividends in the range of 30-40p, and the dizzy heights of a yield greater than 10% based on the current price.

Based upon basic EPS of 31p, the 2009 dividend was covered 2.25x. Given the stated target  policy of paying out 50% of earnings, dividend cover will be in the region of 2x going forwards. Pass

7 - ROE - the 2009 ROE was 16%, which beats the target. The five year annual average ROE comes out at 58% (per Sharelockhomes), which seems high, and is probably a reflection of having a low equity base to start with and paying out high levels of dividends. Pass

8 - Directors - the three executive directors are interested in about 1m shares, of which the CEO is in for 0.5m (£2m) and the FD and Production Director about 0.25m each (£1m). Broadly speaking this represents about 2x annual remuneration, which is not peanuts, but a lot of these 'interests' have been generated through bonuses, options and various the directors have not had to have forked out at the same price/cost as an ordinary shareholder. That said, I am content that their interests are aligned with the ordinary shareholders. Pass

9/10 - Buy or Bye? The five-year average EPS is 80p and the five-year average PER is 7.2x, which gives a five-year 'fair' price of 576p, some 50% above the current price. The rationale for using long-term averages, ideally 10 years, is that it should cover earnings throughout a whole business cycle. It is arguable whether we get that through a five-year average, but, to my mind, we appear to have seen some boom and bust within the last five years to get a flavour of the good and bad years.


The results for 6 months to June 2010 were released in August and pointed to improved margins due to higher demand for energy and an interim dividend of 14.1p (50% of underlying earnings). Repeat: the interim 2010 dividend was higher than the full-year FY09 dividend.

On 14 December 2010, the Company announced in a pre-close statement that EBITDA and underlying EPS will be slightly ahead of current market consensus (EBITDA to be ahead of £376m?).

Two Non-Execs acquired their first shares in December 2010 (c£50k in total)


On a score-card approach Drax does well, meeting all of the rules. The caveats to this are the premium to net assets (not a Graham stock) and the fact that 'long-term' earnings are are only measured over five years. I expect average long-term earnings to reduce when FY10 is added in, but should still represent a significant premium to 2009 earnings. 

The Company is always going to be subject to the headwinds of the global economy and the vagaries of the global commodity markets, but at the end of the day, the UK needs a substantial amount of power, and Drax currently provides about 7% of it; this not going to change any time soon. The Company is also positioning itself for the future with a growing switch to 'green' through necessity and choice.

In terms of value, the current price is probably fair value if you believe that the current environment (2009 earnings) will be the norm going forwards. However, I consider that we are at a relative cyclical low point currently (2009 earnings) and that, in time, energy prices will rise as global economic growth continues. For me, the shares are a BUY at 380p, with a long-term fair price of 576p. The added bonus (by design) is that we get bumper dividends thrown in.

In the long-term, the returns might be even more valuable than brass!

The FY10 results due on 22 February, after which I will publish an update.  

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