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We look at the renewable energy sector and how investors should approach it.
This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.
2019 was the UK’s cleanest year on record. For the first time ever, more electricity was delivered from clean energy sources than fossil fuels. An important milestone but we’re only at the beginning - renewable energy remains the focus of many policymakers, businesses and investors alike.
Global electricity demand is expected to increase by 62% by 2050, which means if we’re going to keep the lights on, global generating capacity will have to triple. Fossil fuels still provide the majority of energy worldwide, but renewables are set to take the crown by 2050. That’s expected to see renewable investments reach around $10 trillion.
As a sector, renewable energy is clearly going to grow significantly over the coming years. But investors should be cautious – great revenue growth does not necessarily make a great investment.
Take the airline industry. The Wright brothers invented the plane in 1903. A little over a 100 years later and the sector is flying billions of passengers every year. Globalisation and the rise of international travel continues to be a great growth story, but despite record numbers of travellers, it’s difficult making money as an airline. Price competition is fierce, there are massive fixed costs and strong labour unions. Profits are far from stable and that’s led Warren Buffet to call airlines a “death trap” for investors in the past.
We’re not suggesting the same is to be said for renewables. But when looking at structural growth stories, it’s important to look before you leap. What part of the ‘story’ are you investing in and how does your investment benefit? Is the business unique, with unique assets, or can it be easily replicated? After all, it’s hard to keep the sun, sea and wind all to yourself.
This article is not personal advice. All investments can fall as well as rise in value so investors could make a loss. If you’re unsure, seek advice.
Wind is one of the fastest growing sources of renewable energy and is set to attract the most investment - half of the $10 trillion investment up to 2050 is headed for the sector. At the moment wind generates 5% of the world’s electricity but by 2050 that’s expected to rise to 26%. For the UK, wind will make up as much as 64% by 2030.
If you see a wind turbine on your travels, there’s a good chance it’s made by Vestas. The Copenhagen listed group is one of the biggest wind turbine manufacturers in the world and also has a services business - giving turbines the specialist TLC and maintenance they need.
Vestas’s order book hit a record €32.8bn in the third quarter of 2019, a €9.1bn increase on the year before, with orders split almost equally between turbines and servicing.
While the group currently makes most of its sales in manufacturing onshore wind turbines, it’s become less profitable over the years. Onshore Wind is an established and competitive market, which means suppliers compete on price. These factors mean group operating margins are actually expected to decline this year.
It’s a different story in the services business. The group offers day-to-day maintenance and provides spare parts, as well as products to increase efficiency and extend the working life of turbines. As the manufacturer, Vestas is a natural choice as the service provider.
As the installed base grows, Vestas should be well positioned to benefit. Bolting on service contracts reduces the pain of price pressures in the onshore business, essentially extending profits over a longer period of time.
Turbines spinning in a grassy field paints a simple picture, but investors should bear in mind that renewable energy is still quite a complex business. Funding provided through Government policies can change, affecting demand for new wind farms. Contracts tend to be complex too and like much of the construction industry, Vestas can take on the liability of overruns.
Vestas is well placed to benefit if the wind story plays out, but there are a few more ‘ifs’ than we’d like. However, the shares currently trade at 17.9 times future earnings, below their longer run average of 20.7, which could be attractive if the services strategy can deliver.
For those looking for something a bit closer to home and a more diversified take on renewable energy, SSE might be worth a look. Most of us know it for its role as an electricity utility, with its Networks business delivering power to homes across the UK. But SSE’s got more going on. Around 30% of profits are generated by its renewables business and it plans to treble renewable output by 2030 to 30 TWh a year (enough to power Scotland for a year).
SSE’s renewable energy currently comes from wind and hydroelectric power , but they’ve also made moves into the waste-to-energy space. This is not to say the Networks business won’t have a part to play in the renewables story too. Quite the opposite, its distribution networks and undersea cables will be fundamental to the UK’s transition to a low carbon economy. Take electric vehicles for example, SSE plans to be able to accommodate 10m electric vehicles by 2030.
As it stands SSE still makes most of its money as a Networks business, and it’s this part that’s regulated. Profits are set by the regulator, making them predictable but unlikely to grow quickly. By comparison, renewables is a significant growth opportunity and probably goes a long way towards explaining why the shares trade on 15.6 times future earnings, above a longer run average of 12.
There are challenges though, and for SSE one of the big ones is cash generation. In the past it’s had to rely heavily on borrowing to fund investment and pay the dividend. If the dividend’s going to be sustained, cash flow will need to improve. The recent sale of its Retail business to OVO will help, but it’s only a splash in the £10bn debt pond.
As a regulated business, SSE’s fortunes are not wholly in its own control. Having avoided nationalisation in the recent election, tougher price regimes loom. Again not great news for the dividend. But if the group can turn the cash position around a prospective dividend yield of 5.5% could well be attractive.
Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.
This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.
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