Key company data: See page 2 for company data and detailed price/index chart. Drax Group DRX.L DRX LN EUROPEAN UTILITIES EQUITY RESEARCH S Castles in the air Drax shares pricing in optimistic biomass scenario; we downgrade to Reduce November 30, 2011 Relative rating Down from Neutral Reduce Target price Increased from 380 485p Closing price November 18, 2011 568p Potential downside -14.6% Impressive performance in 2011 from Drax on biomass potential Since Drax’s preliminary results on 22 February 2011: • The UK government has set the mechanism for the carbon floor (estimated impact on valuation: -19%); • Dark green spreads have improved (+16%); and • The Renewables Obligation Certificate (ROC) banding for Drax’s biomass co-firing project has been proposed at 1.0 ROC/MWh. Over the same period, Drax outperformed the DJ Stoxx Utilities Index by 70%, and the FTSE 100 Index by 60%. Hence, we think the stock is pricing in value creation from Drax’s proposed conversion in the 100p- 200p range – which would imply average bark spreads of GBP 20- 25/MWh being achieved through the life of the project. Key share price drivers likely to disappoint The value that the proposed conversion adds will depend upon long-term trends in bark spreads, but we think the near-term drivers will be: 1) The conclusion of the ROC banding review, due in Q1 2012. There is a risk that the ROC banding level could be altered owing to feedback received in the consultation, including that from the markets – for example, a 0.1 ROC/MWh decrease could imply a share price fall of up to 5%. 2) Biomass pricing. According to Drax, the biomass supply chain is limited by collection, processing and transport facilities. There is a risk that much of any subsidy is passed to pelletizers and others while they build out the supply chain, resulting in disappointing bark spreads for Drax. Market is not justified in pricing in such a positive outcome – Reduce We set a probability-weighted valuation for Drax of 485p up from 380p, and adopt a Reduce rating, down from Neutral. Year end:12-2010 2010a 2011e 2012e 2013e Currency GBX Actual Old New Old New Old New EBITDA 391 295 330 265 330 131 185 EV/EBITDA 4.5 N/A 5.4 N/A 5.4 N/A 11.1 EPS (p) 64.00 N/A 51.18 N/A 53.78 N/A 21.21 P/E 8.6 N/A 10.8 N/A 10.3 N/A 26.0 DPS (p) 32.0 22.5 25.6 20.3 26.9 6.8 10.6 Dividend Yield 5.8 4.1 4.6 3.7 4.9 1.2 1.9 FCF/Share (p) 95.60 61.33 27.00 54.20 39.99 20.28 -61.45 FCF Yield (%) 17.3 11.1 4.9 9.8 7.3 3.7 -11.1 Source: Company data, Nomura estimates Research analysts European Utilities Jonathan Constable, CFA - NIplc j[email protected]+44 20 7102 0950 Christina Ward - NIplc [email protected]+44 20 7102 1556 Martin Young - NIplc [email protected]+44 20 7102 1536 Javier Suarez j[email protected]+39 02 7646 4698 Karan Parmanandka [email protected]+91 22 4053 3790 Vu Nguyen - NIplc [email protected]+44 20 7102 4776 Industry specialist Roger Reynolds - NIplc [email protected]+44 20 7102 2389 See Appendix A-1 for analyst certification, important disclosures and the status of non-US analysts.
Transcript
Key company data: See page 2 for company data and detailed price/index chart.
Drax Group DRX.L DRX LN
EUROPEAN UTILITIES
EQUITY RESEARCH
S
Castles in the airDrax shares pricing in optimistic biomass scenario; we downgrade to Reduce
November 30, 2011
Relative rating Down from Neutral ReduceTarget price Increased from 380
485p
Closing price November 18, 2011 568p
Potential downside -14.6%
Impressive performance in 2011 from Drax on biomass potential Since Drax’s preliminary results on 22 February 2011: • The UK government has set the mechanism for the carbon floor
(estimated impact on valuation: -19%); • Dark green spreads have improved (+16%); and • The Renewables Obligation Certificate (ROC) banding for Drax’s
biomass co-firing project has been proposed at 1.0 ROC/MWh. Over the same period, Drax outperformed the DJ Stoxx Utilities Index by 70%, and the FTSE 100 Index by 60%. Hence, we think the stock is pricing in value creation from Drax’s proposed conversion in the 100p-200p range – which would imply average bark spreads of GBP 20-25/MWh being achieved through the life of the project.
Key share price drivers likely to disappoint The value that the proposed conversion adds will depend upon long-term trends in bark spreads, but we think the near-term drivers will be: 1) The conclusion of the ROC banding review, due in Q1 2012. There is a risk that the ROC banding level could be altered owing to feedback received in the consultation, including that from the markets – for example, a 0.1 ROC/MWh decrease could imply a share price fall of up to 5%. 2) Biomass pricing. According to Drax, the biomass supply chain is limited by collection, processing and transport facilities. There is a risk that much of any subsidy is passed to pelletizers and others while they build out the supply chain, resulting in disappointing bark spreads for Drax.
Market is not justified in pricing in such a positive outcome – Reduce We set a probability-weighted valuation for Drax of 485p up from 380p, and adopt a Reduce rating, down from Neutral.
Year end:12-2010 2010a 2011e 2012e 2013eCurrency GBX Actual Old New Old New Old New
Introduction – a crossroads for Drax Drax is a highly-efficient, well-managed 4GW coal power station in North Yorkshire, UK, which supplies about 7% of the UK’s electricity requirements. Although policy developments in the UK appear hostile to coal power stations, Drax will likely have a key role in the UK’s energy mix for many years to come as it is a comparatively efficient and flexible plant. However, it is not clear what that future will look like as Drax is considering a conversion project that could see biomass constituting around 50% of its fuel – or more if the support is right.
Drax Group also owns Haven Power, a small but growing commercial electricity supplier.
Policy environment – tough for coal generators As is the case for any utility asset, the policy environment is crucial for Drax. We highlight here the key areas of relevance to the company.
Electricity Market Reform (EMR) The UK government is in the process of reforming the electricity markets in the UK, and published a White Paper on the subject in July. We summarised the key points in our note A step in the right direction, 13 July 2011; of these the main areas of relevance to Drax are:
• Carbon price floor: this scheme was implemented as part of the March 2011 budget. It supplements the EU carbon scheme with a tax, to the degree that the carbon prices fall below the UK government’s carbon price target. The carbon price target was set in the UK government’s response to the consultation at GBP 15.7/t for 2013, rising to GBP 30.0/t in 2020, both in 2009 terms. The level of the tax (to be applied over and above the permit price) has been established at GBP 5/t for the year from 1 April 2013.
• Capacity payments: the UK government is considering introducing a scheme of capacity payments to help make sure there is enough generation capacity in the UK. Both targeted and system-wide mechanisms are being considered, with the government’s preferred mechanism due to be set out in a technical update paper due by the end of 2011.
Renewables Obligation (RO) Renewables generation, including biomass, is remunerated under the UK Renewables Obligation. This requires electricity suppliers to ensure a certain proportion of the electricity they supply comes from renewable sources. Renewable generators earn certificates, which they can sell to suppliers to meet their obligations. As we highlighted in our note of 20 October 2011, Review looks supportive for Drax conversion, the UK government has issued an ROC banding review consultation document that established a new proposed banding for enhanced co-firing biomass. That the UK government issued a ROC banding review. We believe Drax’s conversion project would fall within this category, which would receive 1.0 ROC/MWh under the proposals. The ROC banding review is scheduled to be legislated on during 2012, following consideration of responses to the consultation due to be received by 12 January 2012.
Industrial Emissions Directive (IED) Extending and consolidating the EU Large Combustion Plant Directive (LCPD) (which covers the period to 2015, and with which Drax is compliant) is the IED. IED imposes further restrictions on emissions of pollutants from power plants such as Drax over the period 2016-23. It is our understanding that Drax will probably need to make an investment, estimated by the company at around GBP 200m-220m, whether it decides to make the enhanced biomass co-firing conversion or not, to opt in to IED.
The UK government is proposing to subsidise enhanced co-firing biomass with 1.0 ROC/MWh
Outlook for UK power – gas to win out after dash for cash As we argued in our July note UK power – gas set to reign, 20 July 2011, the UK power market is characterised by oversupply as a result of weak power demand growth since the beginning of the recession in 2008, and the continuing build-out of projects initiated prior to the crash. As a result, gas generation spreads (‘spark spreads’) in the UK are poor.
Coal plants in the UK, however, are enjoying a golden era as low carbon prices combine with a high gas curve to make them highly competitive. Those facing limited hours and closure by 2015 under the LCPD are incentivised to accelerate their output while dark green spreads are good in a ‘dash for cash’.
However, the UK has an upcoming system tightening that is not present in other European markets, as the coal plants due to close by 2015 under the LCPD make up a significant proportion of the mix in the UK (about 8GW of coal plants versus about 100GW of total generating capacity in the UK.) Our modelling suggests that in the absence of a strong downturn in power demand this would have a material positive effect on thermal generation spreads by 2015. We build this into our forecasts and valuation for Drax.
In the medium/long term, we expect modern Combined Cycle Gas Turbines (CCGTs) to prove much more competitive than they are now, as the carbon price floor steps up over time and flexibility becomes more valuable.
Recent share price performance – impressive In Figure 1, we have plotted Drax’s share price performance since its preliminary 2010 results on 22 February 2011. We have also included the DJ Stoxx Utilities Index on the chart, as well as the 2012 dark green forward spread. We observe that while the strong rally in the Drax share price is contemporaneous with a widening in the dark green spread over the period, most of the Drax rally occurred prior to the rally in the dark green spread. We consider the components that may have driven the Drax share price over the past few months in more detail in the next section.
Fig. 1: Drax has strongly outperformed the sector, but we think biomass has more to do with it than dark green spreads Drax share price performance versus DJ Stoxx Utilities Index, 2012 UK dark green forward
Source: Bloomberg, Reuters, Nomura estimates
We are still expecting a material improvement in thermal generation spreads by 2015 as capacity retires under the LCPD
What’s in the price for biomass? Drax has outperformed strongly in 2011, up 70% versus the DJ Stoxx Utilities Index and 60% versus the FTSE 100 Index since our last publication on 23 February 2011. It would be useful to strip out the credit the market is giving Drax for its potential biomass conversion from the other key news items that have affected Drax during the year, such as the announcement of the UK carbon price floor and the rally in global gas prices. So in this section, using our new model, we present an NPV reconciliation from 23 February to date, estimating the impact of the other key factors on the Drax valuation, and backing out what the market is pricing in for Drax’s proposed biomass project.
Valuation at 23 February 2011 The results we obtain by running our new model backwards to 23 February (the date of our previous publication immediately following 2010 prelims) are illustrated in Figure 2. At the time, the details of the UK carbon price floor were yet to be revealed and we believe the market was not giving Drax much credit for its potential conversion to enhanced co-firing of biomass.
We highlight that the valuation implied by our model using the information available at the time (402p) is close to the share price at the time (397p).
Fig. 2: Valuation using 23 February inputs is close to share price at the time Model using inputs as at 23 February 2011
Source: Reuters, Bloomberg, Company data, Nomura estimates
Step 1: Impact of carbon price floor We believe that the power markets priced in the impact of the carbon price floor very quickly; this is best illustrated by reviewing the development of forward spreads in Figure 3. Our market model suggests that the GBP 5/t tax will be passed through to the power price at a carbon intensity of 0.6 t/MWh, and is applied from 1 April 2013, suggesting an incremental step of around GBP 2.2/MWh in 2013 forward prices versus 2012. This was borne out in the divergence between the 2012 and 2013 spark spreads in the week following the UK budget date on 23 March 2011.
Key inputs Unit 2010A 2011E 2012E 2013E 2014E 2015E Outputs Unit 2010A 2011E 2012E 2013E 2014E 2015E
Scenario 0 0 - No conversion Output TWh 26.49 26.49 25.56 25.56 26.49 26.491 - Biomass conversion, no boiler upgrade
DPSBenefit from balancing mechanism GBP / MWh 1.00 1.00 1.00 1.00 1.00 Nomura p / s 32.0p 20.1p 25.1p 9.0p 20.1p 29.4p
Cons p / s 32.0p 23.3p 20.9p 9.8pFuel prices - market % diff -14% 20% -8%API2 Coal - spot (ex port to plant) USD / t 116.8API2 Coal (ex port to plant) USD / t 91.3 117.6 121.0 122.6 122.0 105.0 Valuation as at 31 Dec 2012 401.8pEUA EUR / t 14.4 15.2 15.9 16.9 14.0 23.0 Share price 552.0pBiomass EUR / t 128.6 135.9 134.1 134.8 137.0 137.0 % diff -27%
Fig. 3: UK power markets priced in carbon floor rapidly UK calendar forward spark spreads
Source: Reuters, Nomura estimates
The implementation of the UK carbon price floor was a negative for Drax. Not only did it have a negative impact on margins from 2013 onwards (Drax has a carbon intensity of around 0.8t/MWh while the tax is being passed through at 0.6t/MWh), but ceteris paribus it also brought forward the time at which Drax would become uncompetitive in the power markets.
As we illustrate in Figure 4, we estimate the impact on the Drax valuation without a biomass conversion to be around (76p), equivalent to a valuation of 326p. We contrast this with the share price reaction at the time – Drax’s share price fell 38p from 410p on the day before the announcement to around 372p on 24 March 2011, its lowest closing price since the announcement. While it appears the markets partly recognised the effect of the carbon price floor on Drax, there appears to have been some optimism at the time that Drax would be able to make up some of the lost returns from some other means (for example, through capacity payments or the proposed biomass conversion).
Fig. 4: Carbon price floor announcement was a major negative for Drax Model using inputs as at 23 February 2011, but including impact of UK carbon price floor
Source: Reuters, Bloomberg, Company data, Nomura estimates
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Jan11 Mar11 May11 Jul11 Sep11 Nov11
2012 Forward Spark 2013 Forward Spark
Key inputs Unit 2010A 2011E 2012E 2013E 2014E 2015E Outputs Unit 2010A 2011E 2012E 2013E 2014E 2015E
Scenario 0 0 - No conversion Output TWh 26.49 26.49 25.56 25.56 26.49 26.491 - Biomass conversion, no boiler upgrade
DPSBenefit from balancing mechanism GBP / MWh 1.00 1.00 1.00 1.00 1.00 Nomura p / s 32.0p 20.1p 25.1p 2.1p 2.1p 20.8p
Cons p / s 32.0p 23.3p 20.9p 9.8pFuel prices - market % diff -14% 20% -78%API2 Coal - spot (ex port to plant) USD / t 116.8API2 Coal (ex port to plant) USD / t 91.3 117.6 121.0 122.6 122.0 105.0 Valuation as at 31 Dec 2012 325.8pEUA EUR / t 14.4 15.2 15.9 16.9 14.0 23.0 Share price 552.0pBiomass EUR / t 128.6 135.9 134.1 134.8 137.0 137.0 % diff -41%
We think the divergence in 2012 and 2013 spark spreads from the UK budget date of 23 March 2011 (calculated excluding carbon tax), illustrates that the power markets priced in the 1 April 2013 carbon tax within a few days, and were not pricing it in beforehand
Nomura | Drax Group November 30, 2011
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Step 2: Marking to market, change in hedging The next step in our NPV reconciliation is to account for the movement in market conditions and Drax’s hedging position since 23 February. The outcome from modelling this scenario is highlighted in Figure 5. We observe that the valuation increases by around 52p to 378p.
Fig. 5: Rally in global gas prices, strong forward hedging since 23 February 2011 benefit valuation Model incorporating market conditions and hedging position from 27 November 2011, but no benefit for biomass conversion
Source: Reuters, Bloomberg, Company data, Nomura estimates
This increase in the valuation is largely driven by the rally in dark green spreads through 2011, which is visible in Figure 6. We believe that Drax has capitalised on this rally by selling forward strongly into good spreads for 2012. However, to understand the implications of the rally in dark green spreads properly it is necessary to divide the rally into three distinct components:
• The rally in the gas curve. This can be seen in Figure 7. Most of this rally, which pushed up the power price, was over by the end of April, and in any case was accompanied by an offsetting rally in the carbon price, meaning the impact on dark green spreads was neutral. In fact, in recent weeks the trend for gas prices has been downward.
• The impact of the carbon tax imposed in March. We estimate this pushes up the power curve for April 2013 onwards, and as we highlighted above was quickly reflected by the power markets. As we already discussed, this is actually a net negative for Drax as it is on the wrong side of the carbon-intensity line.
• The slump in carbon prices. This is clear from Figure 8. This, combined with the gas price rally, has provided a boost for the assessed market dark green spreads and prompted the ‘dash for cash’ among coal power stations, several of which are due to close by 2015 under the LCPD. It should benefit Drax in 2011, 2012 and 2013 (as the level of the carbon price tax for 2013 has already been set). However, the impact for 2014 onwards is of little benefit to Drax as there will be an offsetting impact from the UK carbon price support.
So, in fact, much of the apparently strong rally through 2011 in forward dark green spreads contributes little benefit to the Drax valuation.
Key inputs Unit 2010A 2011E 2012E 2013E 2014E 2015E Outputs Unit 2010A 2011E 2012E 2013E 2014E 2015E
Scenario 0 0 - No conversion Output TWh 26.49 26.49 25.56 25.56 26.49 26.491 - Biomass conversion, no boiler upgrade
DPSBenefit from balancing mechanism GBP / MWh 1.20 1.00 1.00 1.00 1.00 Nomura p / s 32.0p 25.6p 27.4p 9.5p 3.2p 18.6p
Cons p / s 32.0p 26.2p 25.6p 12.1pFuel prices - market % diff -2% 7% -21%API2 Coal - spot (ex port to plant) USD / t 117.6API2 Coal (ex port to plant) USD / t 91.3 123.4 114.6 120.5 123.5 105.0 Valuation as at 31 Dec 2012 377.7pEUA EUR / t 14.4 13.7 8.6 9.2 14.0 23.0 Share price 552.0pBiomass EUR / t 128.6 127.1 134.1 134.8 137.0 137.0 % diff -32%
Collapse in carbon prices during 2011 should help Drax for 2011, 2012 and 2013, but benefit is countered beyond then by UK carbon price floor
Gas prices rallied in the wake of Fukushima, benefitting Drax, but so did carbon. The curve was range bound from April, and has been on a downward trend since the summer
Forward dark green spreads have rallied through 2011, and the 2012/2013 spread diverged in the middle of the year
Nomura | Drax Group November 30, 2011
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Step 3: Including value creation for the biomass option Our base case includes a scenario in which Drax executes a successful biomass conversion to co-fire biomass representing up to 50% of its output. Our modelling assumptions for this scenario are highlighted in the Appendix, but we estimate in such a scenario that Drax could create value of around 143p when compared with the scenario without such a conversion, as shown in Figure 9. This pushes the valuation of Drax up to 521p.
Fig. 9: In the best case, biomass conversion could create material value Model outputs in base case (successful biomass enhanced co-firing conversion at 1.0 ROC/MWh) as at 27 November 2011
Source: Reuters, Bloomberg, Company data, Nomura estimates
Conclusion – Drax pricing in successful biomass outcome So, what is in the price for Drax’s proposed biomass conversion? We believe that the market is pricing 100p-200p into the Drax share price for value creation from the proposed conversion to enhanced biomass co-firing. The following points support this contention:
- The NPV analysis above suggests the movement in the Drax share price since 23 February is consistent with implied value creation within this range.
- On 20 October 2011, the date of the announcement of the proposed ROC banding level of 1.0 ROC/MWh for enhanced biomass co-firing, the Drax share price increased by 49p from 480p to 529p, or over 10%. At the very least, this much is almost certainly in the price.
- We believe consensus has already built significant value for biomass into target prices for the conversion.
Key inputs Unit 2010A 2011E 2012E 2013E 2014E 2015E Outputs Unit 2010A 2011E 2012E 2013E 2014E 2015E
Scenario 1 0 - No conversion Output TWh 26.49 26.49 25.56 24.83 24.83 24.831 - Biomass conversion, no boiler upgrade
DPSBenefit from balancing mechanism GBP / MWh 1.20 1.00 1.00 1.00 1.00 Nomura p / s 32.0p 25.6p 26.9p 10.6p 4.2p 16.5p
Cons p / s 32.0p 26.2p 25.6p 12.1pFuel prices - market % diff -2% 5% -12%API2 Coal - spot (ex port to plant) USD / t 117.6API2 Coal (ex port to plant) USD / t 91.3 123.4 114.6 120.5 123.5 105.0 Valuation as at 31 Dec 2012 521.1pEUA EUR / t 14.4 13.7 8.6 9.2 14.0 23.0 Share price 552.0pBiomass EUR / t 128.6 127.1 134.1 134.8 137.0 137.0 % diff -6%
Positive biomass outcome is not a given In this section, we outline two reasons why a highly successful outcome for Drax from biomass might not become reality.
Reason 1: The UK government is unlikely to gift Drax such a large amount of value To help it set an appropriate final level for the ROC subsidy for biomass in Q1 2012, we expect the UK government will be considering information from a variety of sources, including reviewing research from brokers and examining the reaction of the markets to the publication of the proposed level of the banding.
Drax’s strong share price performance so far this year appears to imply that the UK government would be gifting Drax a significant amount of value, perhaps in the range GBP 350m-700m, on an investment in plant improvement that could be around GBP 350m.
We believe that the UK government could interpret the market’s reaction as evidence that at 1.0 ROC/MWh the banding level has been too high. There is a risk that the UK government will reduce the ROC banding level as a result – for example, a reduction to 0.75 ROC/MWh could imply a share price fall of up to 75p or 13%.
Reason 2: A large part of any subsidy might be absorbed by the supply chain Supply chain is tight and needs significant investment The argument for subsidizing the biomass as a generation source is that in the long run the cost of delivering the feedstock to European power stations could fall as a result of economies of scale. In this scenario, as an early mover on a subsidy, Drax could derive advantageous bark spreads in 5-10 years’ time.
However, we believe that there are currently significant constraints in the supply chain for biomass, the feedstock that Drax needs to obtain and burn to benefit from the proposed UK subsidy. The following sources back up this assertion:
• According to Drax (presentation to Nomura UK Utilities Conference June 2011), the current sources of biomass are “limited by collection, processing and transport facilities. Pricing for many fuels reflects start-up costs for these supply chain activities.” We also note that Drax does not expect full utilisation of its existing 12.5% biomass capability at the current level of ROC support (0.5 ROC/MWh) – there is not enough cheap biomass available at the moment to make it economic.
• The European Climate Foundation’s 2010 report Biomass for heat and power – Opportunity and economics reported that there are a number of barriers throughout the biomass value chain and that companies will need to think about biomass as “building a business and a value chain for the long term – and with long-term payback – as opposed to a fuel shift with immediate payback.”
• In section 9.17 of DECC’s ROC banding review consultation document, DECC highlights that part of the reason for the subsidy for enhanced co-firing is that it is potentially a cheaper way to help “build the global biomass supply chain which still represents a barrier to investment in large-scale biomass electricity”.
We think it is important to note that the proposed subsidy is not a subsidy for biomass generation. It is a subsidy for the entire biomass supply chain, from grower to storer, to pellitiser to transporter, to generator. It is intended to help establish and remunerate all the infrastructure along the biomass supply chain.
Therefore, while it is tempting to imagine that the benefit of any additional subsidy for biomass generation would be kept by Drax, in reality a significant part of it would most likely be claimed by the various other members of the supply chain.
Biomass does not grow on trees
Subsidies for biomass are intended to fund investment in the whole value chain
We think Drax’s share price implies the UK government will allow Drax GBP 350m-700m value creation on a GBP 350m investment
European subsidies likely to attract strong demand for feedstock If the UK subsidy for enhanced co-firing biomass remains attractive, then we think it is likely that other power stations will look at converting and buying up biomass. For example, International Power’s 1GW Rugely plant (14 September 2011 investor day), and more recently SSE’s 2GW Fiddler’s Ferry and 0.4GW Uskmouth plants (SSE H1 results announcement 9 November 2011) have been mentioned as potential future biomass facilities. RWE’s 1GW Tilbury plant (www.rwe.com) has also been testing its recently-completed biomass burning capabilities.
From our discussions with biomass suppliers and distributors, we also understand that companies in the supply chain are expecting a step-up in demand from elsewhere in Europe, as well as the UK.
Drax is buying in a seller’s market We have argued above that there is tightness in biomass supply and that attractive subsidies could drive strong demand.
As a UK-based coal plant, Drax’s negotiating position is also weakened by the impending UK carbon tax, due to come into effect from 1 April 2013. The carbon tax will depress the unit margin on coal generation (the so called ‘dark green spread’) – Drax’s alternative to burning biomass.
We conclude that in the early years, much of any subsidy for biomass in the UK will probably be passed through to the supply chain, resulting in disappointing bark spreads for Drax.
Generation subsidies should drive demand for feedstock; supply tightness leaves pricing power with the seller
Valuation, catalysts and rating Valuation In our view, there are two key scenarios to consider in valuing Drax. In the base case, we assume Drax executes a biomass conversion project and then has the option to burn biomass up to around 50% of its total output with a UK government subsidy - the assumptions we make in this base case are outlined in more detail in the Appendix.
In the downside scenario, Drax does not execute the biomass conversion project and remains a coal plant, which burns only a limited quantity of biomass with a lower government subsidy.
In each case, we value the operating activities using a DCF approach, adopting an estimate for Drax’s WACC based on market data and a CAPM model for the cost of equity. Non-operational assets and non-equity claims are valued using book values. The valuations for Drax in the base case and downside scenario are outlined in Figures 10 and 11, respectively.
The replacement cost for a new CCGT (around GBP 600/kw) should provide a ceiling for the Drax valuation, in our view, as we think a newly-built CCGT is the most valuable type of large scale thermal generation asset (notwithstanding tough conditions at the moment), and even these are not being initiated in the UK right now. It makes sense that Drax without the biomass conversion should be valued well below this level given that the UK policy environment is hostile to coal power plants.
In our view, the most likely scenario is that Drax converts successfully to an enhanced co-firing biomass plant. However, we think there is a significant likelihood the conversion does not go ahead and Drax remains in its present state. Therefore, in order to derive our target price for Drax, we take a 75% weighting of our valuation in the base case, and a 25% weighting of our valuation in the downside case. This results in a target price for Drax of 485p.
Fig. 10: Share price reflects successful biomass scenario Drax - summary valuation in base case (successful biomass enhanced co-firing conversion at 1.0 ROC/MWh) - market price at 27 November 2011
Value of operations DCF Justified 2011E EV/EBITDA 5.4x, EV GBP 472/ kw 1,782 488
Current financial assets BV 95 26Cash and cash equivalents BV 106 29Non-operating assets BV 201 55
Enterprise value Various 1,984 544
Long term loans BV -11 -3Short term loans BV -28 -8Employee benefits (including pensions) BV -37 -10Provisions for contingencies and charges BV -6 -2Nonequity claims BV -82 -23
Equity value at 31 December 2012 Various 1,901 521
Latest market price 552
Implied equity upside -5.6%
In most scenarios, Drax is probably worth less per kw than a newly-built CCGT, and even these are not being initiated right now (at cost GBP 600/kw)
Nomura | Drax Group November 30, 2011
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Fig. 11: Drax would be worth significantly less if biomass outcome were not ideal Drax - summary valuation in downside case (Drax as coal plant with limited biomass co-firing) - market price at 27 November 2011
Source: Company data, Nomura estimates
Catalysts We believe the following factors could have a material impact on the Drax share price in the coming months:
• Further news on the UK Electricity Market Reform due by the end of 2011, which could affect the outlook for UK power markets and how Drax is remunerated.
• Announcement on the UK government’s Bio-Energy Strategy due around the turn of the year.
• The ROC banding review is scheduled to be legislated on during 2012, following consideration of responses to the consultation due to be received by 12 January 2012. This will include confirmation of the ROC allowance for Drax’s proposed enhanced co-firing biomass project.
• Developments in the power and fuel (including biomass) markets could have an impact on Drax’s share price performance.
Recommendation We believe that Drax is pricing in a successful biomass outcome, but argue that such a scenario is not a given. Our probability-weighted valuation of 485p (from 380p) is significantly below Drax’s share price, and we therefore adopt a Reduce rating (from Neutral).
Value of operations DCF Justified 2011E EV/EBITDA 3.5x, EV GBP 303/ kw 1,146 313.97
Current financial assets BV 95 26.03Cash and cash equivalents BV 220 60.24Non-operating assets BV 315 86.28
Enterprise value Various 1,460 400.25
Long term loans BV -11 -2.90Short term loans BV -28 -7.65Employee benefits (including pensions) BV -37 -10.22Provisions for contingencies and charges BV -6 -1.75Nonequity claims BV -82 -22.53
Equity value at 31 December 2012 Various 1,378 377.72
Latest market price 552.00
Implied equity upside -31.6%
Nomura | Drax Group November 30, 2011
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Review of base-case financials Our base-case financial forecasts for Drax are set out in Figure 13. We highlight the following points regarding the forecasts:
• We expect EBITDA to step down in 2011 versus 2010, as the benefits from forward sales into strong dark green spreads in prior periods roll off. In 2012, we expect a flat EBITDA versus 2011.
• However, in 2013, we forecast a significant step-down in EBITDA owing to the loss of Drax’s annual 9.5mt free carbon allocation as we enter Phase III of the EU Emissions Trading Scheme, which we estimate will contribute additional costs of around GBP 93m per annum. We also expect the UK carbon price support scheme, which is due to come into force from 1 April 2013, to have a negative impact on Drax’s EBITDA in 2013 – our power market model suggests that the GBP 5/t tax will be passed through to the power price at a carbon intensity of 0.6 t/MWh, meaning that Drax, which operates at a carbon intensity of around 0.8 t/MWh, would be a net loser to the tune of around GBP 19m in EBITDA in 2013. While we expect some benefit from the assumed step-up in ROC allowance for enhanced co-firing to 1.0 ROC/MWh and the rising proportion of biomass in the mix for Drax in 2013, there is also some offsetting negative pressure from the roll-off of Drax’s 600 MW contract with Centrica, which we estimate would otherwise be contributing a beneficial spread.
• In 2014, we expect Drax’s subsidised biomass output to step up further, with a positive impact on EBITDA, but a continuing weak power market means that spreads are yet to improve and this, together with a continuing rise in the rate of the UK carbon tax, means that EBITDA growth is negative.
• But in 2015, we expect a tightening in the UK power markets as outlined in our report, UK power – gas set to reign, 20 July 2011, and for the consequent expansion in spreads to drive significant growth in EBITDA in this year.
• We expect growth at the EBIT line from 2011-15E to run a little behind the growth at the EBITDA line over the same period, owing to additional depreciation on the significant investment in new biomass plant.
• Similarly, growth at the PBT line from 2011-15E is slightly behind the growth in EBIT over the same period as a borrowing facility is assumed to be drawn down to help finance investment in biomass plant. We expect underlying EPS to grow more quickly than PBT over this period owing to the step down in the rate of UK corporation tax during the period.
• We also highlight that we expect Drax to move from a net cash position of GBP 204m at 2010A to a net debt position of GBP 439m in 2015E, owing largely to the financing requirements of its proposed biomass conversion.
Fig. 12: Earnings trough in 2013E, 2014E on CO2 impact, but recover from 2015E on biomass benefit, tightening power market Summary financials - Drax base case (successful biomass conversion at 1.0 ROC/MWh)
Appendix – modelling assumptions We highlight below some of the key assumptions made in our modelling for the biomass enhanced co-firing project base case.
• Enhanced biomass co-firing is remunerated at 1.0 ROC/MWh from 1 April 2013.
• Cost of converting Drax for co-firing is GBP 350m, implemented unit by unit during scheduled outages.
• Biomass output as a % of total output rises from 8% in 2010 to 50% by 2016.
• Bark spreads – from 2013-17E these are above dark green spreads (GBP 20-25/MWh on average versus around GBP 10-20/MWh for dark green spreads), and from 2018 onwards biomass spreads are assumed to be GBP 22.5/Mwh on average versus GBP 15-20/MWh on coal.
• Plant life – Drax closes in 2040 rather than 2030.
• Load factor drops initially from 80% to 75%, but is higher than in the downside scenario at 2020 and beyond (70% rather than 60% in downside scenario).
• Plant efficiency is reduced from 40% to 38%.
Nomura | Drax Group November 30, 2011
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Appendix A-1 Analyst Certification I, Jonathan Constable, hereby certify (1) that the views expressed in this Research report accurately reflect my personal views about any or all of the subject securities or issuers referred to in this Research report, (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this Research report and (3) no part of my compensation is tied to any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group company.
Issuer Specific Regulatory Disclosures Mentioned companies Issuer name Ticker Price Price date Stock rating Sector rating Disclosures Drax Group DRX LN 568p 18-Nov-2011 Reduce Bearish
Previous Rating Issuer name Previous Rating Date of change Drax Group Neutral 30-Nov-2011
Drax Group (DRX LN) 568p (18-Nov-2011) Rating and target price chart (three year history)
For explanation of ratings refer to the stock rating keys located after chart(s)
Valuation Methodology The valuation methodology behind our 485p target price is a probabilty-weighted DCF from two scenarios. We use December year-end 2012 as the starting point for our valuation. Non-operating assets and liabilities are valued at book values. The WACC underlying our target price is 10% (post-tax nominal). The benchmark index for this stock is the Dow Jones STOXX® 600 Utilities. Risks that may impede the achievement of the target price The valuation and earnings of Drax are subject to a range of risks including: a variety of volatile commodity prices (oil, gas, power, coal and carbon); the government's decision on free carbon allowances post 2012, which could have a major effect on value; and the reliance of a proportion of our valuation on successful implementation of a number of unproven 'business enhancements'.
Nomura | Drax Group November 30, 2011
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Nomura | Drax Group November 30, 2011
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