Investments In FlexGen And BECCS Will Impact Future Earnings, But Policy Risks Persist

Key Takeaways

• Strategic investments in flexible generation and energy solutions are set to enhance post-2027 earnings and revenue through expanded capacity and efficiency.
  
• Increased pellet production and diversification into markets like sustainable aviation fuel aim to drive margin expansion and boost long-term earnings growth.
  
• Macroeconomic uncertainty, operational delays, policy shifts, and supply-demand imbalances pose risks to Drax Group's future investments, revenue, and profitability.

Catalysts

Engages in renewable power generation in the United Kingdom.

• The signing of a CfD bridge agreement for the Drax Power Station reflects significant confidence in Drax's long-term business and provides a framework for delivering £100 million to £200 million of EBITDA during the bridging period, enhancing earnings visibility post-2027. This is likely to impact future earnings positively.
  
• The development of FlexGen and Energy Solutions is on track, with a target of recurring £600 million to £700 million of adjusted EBITDA post-2027. This is driven by investments in flexible generation, energy solutions, and pellet production, which should lead to enhanced revenue and earnings.
  
• The potential for grid-connected batteries and expansion of services like Cruachan 2 can provide additional capacity and flexibility, addressing long-term storage and system support needs. These opportunities are expected to drive revenue and margin growth in the FlexGen business.
  
• The pellet production segment has seen increased volumes and margins, with a focus on maximizing efficiency and market opportunities, including sustainable aviation fuel (SAF) contracts. This diversification and efficiency improvement are projected to sustain margin expansion and boost earnings.
  
• Drax's substantial share buyback program and dividend increase demonstrate management's commitment to returning value to shareholders, which, along with potential strategic investments in data centers and BECCS, is anticipated to improve EPS through both capital efficiency and growth in profit-generating assets.

Drax Group Future Earnings and Revenue Growth

Assumptions

• Analysts are assuming Drax Group's revenue will decrease by 7.6% annually over the next 3 years.
• Analysts assume that profit margins will shrink from 8.5% today to 4.3% in 3 years time.
• Analysts expect earnings to reach £208.0 million (and earnings per share of £0.57) by about March 2028, down from £526.6 million today. However, there is a considerable amount of disagreement amongst the analysts with the most bullish expecting £264 million in earnings, and the most bearish expecting £167 million.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 17.5x on those 2028 earnings, up from 4.2x today. This future PE is greater than the current PE for the GB Renewable Energy industry at 5.3x.
• Analysts expect the number of shares outstanding to decline by 1.56% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 7.18%, as per the Simply Wall St company report.

Drax Group Future Earnings Per Share Growth

Risks

• Increased uncertainty in the macro environment, including policy shifts and economic volatility, could impact Drax's ability to make confident long-term investments, potentially affecting future earnings and investment returns.
  
• Delays in commissioning Open Cycle Gas Turbines (OCGTs) due to grid connection issues create uncertainty about capacity expansion, impacting short-term operational performance and revenues.
  
• The potential shift to zonal power pricing under REMA may influence investment decisions and profitability of existing assets, adding risk to future revenue streams.
  
• Supply-demand imbalances in biomass pellets post-2027 could result in lower margins for third-party sales or increased costs to secure long-term contracts, impacting revenue and profitability.
  
• Uncertainty in government support for carbon removal technologies (such as BECCS) in the U.K. and potential policy changes in the U.S. create risks for long-term revenue growth and investment stability.

Valuation

• The analysts have a consensus price target of £8.509 for Drax Group based on their expectations of its future earnings growth, profit margins and other risk factors. However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of £12.2, and the most bearish reporting a price target of just £5.29.
  
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2028, revenues will be £4.9 billion, earnings will come to £208.0 million, and it would be trading on a PE ratio of 17.5x, assuming you use a discount rate of 7.2%.
  
• Given the current share price of £6.1, the analyst price target of £8.51 is 28.3% higher. Despite analysts expecting the underlying buisness to decline, they seem to believe it's more valuable than what the market thinks.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.