Is Drax Group acquisition of Opus Energy good?

Drax Group handles 7% of electricity generated in the UK. Despite, Drax efforts to “decarbonised” it has struggled to maintain earnings stability. That led to the share price drifting off at £3.30 per share from a high of £8.20. Before we understand why the shares fell, let’s address the elephant in the room.

Drax acquires Opus Energy

Drax made a recent acquisition of Opus Energy for £340m. That enhances their green credentials. Opus supplies gas and electricity by purchasing from wind, solar, hydro, and AD generators.

Here is a brief summary of Opus Energy:

OPUS ENERGY

The Financing of this acquisition is through borrowings via a new acquisition debt facility of up to £375 million (the “Acquisition Facility Agreement”). The interest paid is 5.25% to 6.5% that is the applicable margin. Plus, you need to add the LIBOR rate of 0.5% on top.

Assuming average interest is 6.25%, then Drax needs to pay £23.43m in interest costs. (For more on debt, see Drax’s balance sheet.)

 

The Evolution of Drax Group Business Model

One reason for the collapsing shares is the fall in oil price. (I’m aware it doesn’t produce oil)

That effect caused the government to cut back on subsidies because it is uneconomical.  The FT has provided this chart, along with a timeline of events happening at Drax Group.

  1. Apr 23, 2014, Drax shares hit by UK subsidy move
  2. Aug 7, 2014, Drax shares fall after Court of Appeal ruling
  3. Dec 18, 2014, Drax appoints Phil Cox as new chairman
  4. Nov 18, 2015, Investors recoil from Drax after energy speech
  5. Feb 23, 2016, Drax profits dive after government changes
  6. May 16 Drax shares slump as link to oil rally breaks down
  7. Jul 26 Drax profits halve amid UK policy U-turns.

Let’s go into details.

Remember the Climate Change Levy exemption, that knocked £30m from Drax underlying earnings. Tumbling energy prices means the economics behind providing subsidiaries aren’t there.

The consumers aren’t under pressure to go green if the costs of energy keep on declining.

For Drax, it means electrical output from their Generation business dropped to 19.6 terawatt hours (TWH) from 26.7TWH in 2015. As the company’s coal-fire units were out of merit.

Drax is moving into being an energy provider, as well as using wood pellet to provide renewable energy.

Some people view that wood pallet destroys forest and is not a sustainable renewable source of energy. They, also alluded that the government provided subsidies of £1.5m per day for this form of energy.

 

DRAX’s Profit and loss Account

Capital intensive businesses tend to be cylindrical. So, when times are bad, you see lots of large exceptional charges or impairments. These impairments distort operating and net profits figures.

One way is to study the top half of the (P&L) statement.

DRAX GROSS PROFIT

The continued fall in gross profits underlines the weakness in Drax’s business model. That is despite revenue doubling in size!

If you look at Drax’s profits, they are volatile and unpredictable. That because of FX hedging and derivative contracts gains/losses on commodities pricing. These are unrealised earnings and treated as “mark-to-market”.

Speaking of Drax’s operating profits. You can compare its core earnings by excluding its unrealized (losses)/gains from derivative contracts. First, let’s look at Drax original operating profit numbers.

 DRAX unadjusted operating profits

They are volatile and lacks consistency. It hides any weakness from their core business. Now, you get Drax’s adjusted operating profits without these unrealised gains and losses.

DRAX Adjusted operating profits

Drax’s core business has been declining since 2010. They even recorded an operating loss in 2015 of £47.7m. And the company made a profit in 2016. 

Despite this adjustment, the derivative contracts were a smart move to avoid unexpected falls in commodities prices.

 

DRAX’s Balance Sheet

Measuring Drax’s asset quality, we get this:

 DRAX ASSET QUALITY

Sales and assets are proportionate in size when it came to asset turnover (without the cash). But compared revenue with capital employed you see a slight deterioration in 2016.

N.B.: See “Assessing the Reasons Behind its Acquisition of Opus Energy” for more on Drax’s assets.

 

Drax’s debt level has changed thanks to their latest acquisition of Opus Energy. The funny thing is Drax has lost competent with their lenders.

Whereas, acquiring Opus means Drax will pay an average of 6.25% in interest rates. Their original debt facility negotiated in 2015 means interest rates of 2.2% and 2.4% (175 basis points or 1.75%, plus LIBOR).

That would mean annual interest costs of £30m-£40m.

Also, total debt is around £750m to £800m, instead of £322m in 2016.

Now, let’s move onto its cash flow. Here are Drax’s cash earnings:

(Nothing to add)

The interesting chart includes the pattern change of dividends, net cash financing and free cash flow.

 Drax's dividends and free cash flow

It’s obvious when free cash flow looks exceptional that dividends are steady. But as soon as free cash goes negative for a few years, dividends payment is put on the back seat. Drax went into cash conservation mode. 

 

Assessing the Reasons Behind its Acquisition of Opus Energy

Apart from boosting their green credentials and diversifying away from government subsidies. Are there other reasons why Drax Group want to acquire Opus?

One angle to take is to assess the company’s asset depreciation. There are four areas on this topic, they are: –

  1. Depreciation rate (%); – This tells us how quickly an asset is being depreciated.
  2. Asset Age (Years); – Assess the age of the company’s asset. If older, then it is cutting back on investing which might have to be put right with a large capex plan in the future.
  3. Cumulative depreciation ratio; – tells you how much the assets got depreciated.
  4. Worn out ratio; – tells you how much value was written down.

 

Starting with Drax’s depreciation rate and we can say the company’s assets have longevity.

DRAX DEPRECIATION RATE

The useful life of its assets ranges from 25 years to 35 years. When you do the reciprocal of 25 and 35 years, you get 4% and 2.85% depreciation rate.

Drax’s assets are ageing, and there was a jump from 9 years to 14.5 years between 2014 and 2015, before falling to 11.7 years.

DRAX Assets age

Still, it is above 10 years and makes Drax look old. At the same time, the % of assets at 11.7 years rose to 35.7%. That is above the historical average of 25%-28%. So, more of Drax is looking old!

Onto the cumulative depreciation ratio, and Drax been writing off asset value. Now, Drax’s asset is worth 64% of original values as oppose to 73%.

 drax cumulative depreciation ratio

As the worn-out ratio is the oppose of cumulative depreciation ratio. Then, Drax has written off 36% of total value. 

drax worn out ratio

Valuation

Drax’s market value of £1.3bn looks reasonable. That’s because it recently took on new debt to fund acquisitions. Also, Drax Group is in a transition period, so unexpected costs may arise.  

Drax’s valuation fell as low as £850m at the start of 2016.

Given we don’t know the outcome of their turnaround, you can’t place a value. Allow it one to two years for full implementation of their objectives.

 

Assessment for 2017

Let’s look at what in store for Drax in 2017, bite by bite.

  1. Opus Energy acquisition; – the high interest costs equate to £24m. Few investors know the extra interest is equal to free cash flow generated. Then, Drax needs to find some cost-savings to earn profits.
  2. Debt Rising; – Debt will rise to £750m to £800m with interest costs will run at £40m to £55m (see reason below).
  3. Foreign Exchanges gains won’t recur; – In the last two years, FX gains totalling £27.9m. It helped to lower net interest costs, therefore boosting net profit. These gains are over because the GBP is at historical lows since 1985. Unless the GBP goes below 1.2 to the USD, then further gains won’t happen.
  4. Expect smaller derivative gains or even losses; – Unless commodities prices took a further tumble, then don’t expect it to boost operating profits this year.
  5. Finally, it is the year of the turnaround for Drax!

 

What are the analysts forecasting?

From Markets FT, 17 analysts following Drax Group gave the following assessment (as of May 05, 2017,):

-More analysts are giving the stock a buy rating (4) this year, then last year (2).

-No one has given a sell signal vs. last year (2).

-The share price forecast range from £2.50 to £4.10. It is currently £3.28 per share.

-Analysts are confident that dividend payment will increase to 9 pence per share in 2017 and rise to 14 pence, a year later.

-EPS is expected to rise to 9 pence this year and jump to 17 pence a year later.  

-Revenue is forecast to grow by £3.5bn this year and rising to £3.62bn.

If what the analysts say are true, then you should be filling your boots with Drax’s shares.

Personally, the Opus acquisition won’t add too many earnings to Drax (Opus’s net income is £14m). Add in the effect of lower FX gains and derivative contracts gains (they could turn to losses), then EPS will struggle in 2017.

 

So, what do you think of Drax Group? Is it a recovery play? Or, is it too soon to determine the outcome of success?

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Disclosure

The opinions expressed by the writer is for entertainment and research purposes. It does not constitute professional investment advice. Data is correct on available information at the time.

Finally, the writer does not own the company’s stock, unless stated otherwise.