Government CfD And Renewables Will Drive Growth Amid Pellet Risks

Key Takeaways

• Secured government support and strategic investments in flexible, low-carbon energy fortify Drax's long-term revenue stability and position in a rapidly transitioning energy market.
  
• Early leadership in carbon removals and disciplined capital management enable Drax to capitalize on emerging markets and deliver consistent shareholder returns.
  
• Oversupply and regulatory uncertainty threaten pellet margins and earnings growth, while reliance on new markets and shifting business models heighten risks to Drax's long-term revenue stability.

Catalysts

Engages in renewable power generation in the United Kingdom.

• The recent agreement on a government-backed low-carbon dispatchable CfD for Drax Power Station (covering all units through 2031) significantly increases long-term revenue visibility and reduces earnings volatility, supporting stable EBITDA and predictable cash flows well into the next decade.
  
• The accelerating energy transition-marked by ongoing global decarbonization mandates, retirement of coal/nuclear baseload plants, and rising electricity demand-directly expands the market need for reliable, flexible renewable generators like Drax; this positions the company to capture outsized market share and drive top-line growth.
  
• Continued operational focus on expanding value from flexibility and grid support (e.g., FlexGen, pumped storage, battery/storage investments) and system services is enabling Drax to access new high-margin revenue streams as grid volatility and system balancing needs rise, improving long-term net margins and earnings.
  
• Drax's leadership and development in BECCS and carbon removals (e.g., Elimini joint ventures, participation in emerging carbon markets, expansion into negative emissions credits) positions the company to benefit from increasing adoption of carbon pricing mechanisms globally, providing significant upside to future revenue and cash flow as these markets mature.
  
• Strong capital allocation discipline-evidenced by a robust balance sheet, regular dividend growth, and a substantial new share buyback program-signals management's confidence in sustainable cash generation and underscores potential undervaluation, as capital is increasingly returned to shareholders amidst ongoing operational growth.

Drax Group Future Earnings and Revenue Growth

Assumptions

• Analysts are assuming Drax Group's revenue will decrease by 5.7% annually over the next 3 years.
• Analysts assume that profit margins will shrink from 7.2% today to 4.3% in 3 years time.
• Analysts expect earnings to reach £205.6 million (and earnings per share of £0.63) by about August 2028, down from £407.7 million today. However, there is some disagreement amongst the analysts with the more bearish ones expecting earnings as low as £166 million.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 17.9x on those 2028 earnings, up from 5.9x today. This future PE is greater than the current PE for the GB Renewable Energy industry at 6.7x.
• Analysts expect the number of shares outstanding to decline by 1.04% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 8.36%, as per the Simply Wall St company report.

Drax Group Future Earnings Per Share Growth

Risks

• Drax is anticipating a significant reduction in internal pellet demand post-2027, from around 8 million tonnes to 3 million tonnes, while the broader market is forecast to be "long pellets" as other European generators also step down usage; this oversupply could compress third-party pellet margins and depress revenue, impacting the ability of the pellet business to contribute toward group EBITDA targets.
  
• Management acknowledges that delivering growth in pellet production is unlikely unless new markets (e.g., sustainable aviation fuel) materialize and that the 5 million ton production target is now less certain, indicating heightened risk that the pellet segment will face underutilization and margin pressure, challenging overall earnings growth.
  
• The long-term viability of Drax's biomass generation model remains exposed to changing environmental scrutiny, regulation, and carbon accounting standards; any tightening of "green" definitions or subsidy eligibility for biomass (including in key CfD/government support) would erode future revenue streams and investor confidence.
  
• The group's CAPEX discipline means larger capital deployment (other than maintenance/growth in FlexGen) is likely delayed or highly selective, particularly for data centers and battery/storage opportunities, many of which require complex external partnerships and long lead times; this delays or dilutes new high-margin revenue opportunities and raises execution risk for future earnings growth.
  
• As FlexGen and system support services expand, Drax's power station will operate "significantly fewer hours," altering the EBITDA mix to rely more on flexibility and capacity payments, which-despite long-term contracts-may carry greater market and regulatory risk, threatening the stability of projected net margins and cash flows beyond 2031.

Valuation

• The analysts have a consensus price target of £8.577 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 £10.63, and the most bearish reporting a price target of just £6.89.
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2028, revenues will be £4.7 billion, earnings will come to £205.6 million, and it would be trading on a PE ratio of 17.9x, assuming you use a discount rate of 8.4%.
• Given the current share price of £6.96, the analyst price target of £8.58 is 18.8% 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.