Drax may slice its payout but it still offers a good income.
Popularised by the experiments of Benjamin Franklin, used to great effect by the X-Men's Storm and sometimes a cause for the wailing and gnashing of teeth when the bill arrives, electricity is arguably the most essential component of modern industrial civilisation. It's also an interesting sector for investors to consider for the long term because, barring a complete rewrite of the laws of physics, the electricity business is going to be with us until the end of civilisation.
One way to invest in electricity generation is via Drax Group (LSE: DRX), the owner-operator of the Drax coal-fired power station in North Yorkshire which produces up to 4,000 megawatts of electricity, some 7% of Britain's electricity needs.
Drax's shares offer an eye-watering historical dividend yield of 12.8% which makes them an extremely attractive target for income-seeking investors. Clearly you don't find an investment paying that level of income without there being some sort of catch and Drax is no exception; its shareholders should be prepared for a dividend cut when Drax announces its 2009 annual results on 23 February. That said forewarned is forearmed and whilst Drax's shareholders have had a rough 2009, with the shares falling by about 26%, investors who are looking for companies that pay big dividends should find Drax to be of some interest.
The Business
Drax was floated on the Stock Exchange in December 2005 at 500p and, having risen to almost £11 in 2006, the shares have drifted back to today's price of around 415p.
Drax is a simple business to understand. It uses coal-powered steam turbines to generate electricity which it sells to its customers via National Grid (LSE: NG). Electricity generation is a regulated business with the state-appointed regulator having some powers to impose restrictions on Drax's pricing and capital investment programmes, so Drax's business is affected by four main factors; the demand for electricity, the price of coal, the actions of its regulator and increasingly by political meddling (more on this later).
The Numbers
The recession has hit Drax's profitability quite hard with diluted earnings per share for the first half of 2009 falling by 80% thanks largely to falling sales and from losses incurred on derivative contracts (Drax sells a lot of electricity in the futures market).
In the light of the first half's figures Drax's recent trading update was good news for shareholders, saying that 2009 profits would be "modestly ahead of market expectations." Market forecasts for 2009 were in the region of £320-330 million compared with actual profits of £333 million in 2008.
Drax's profit and dividend history for the four years since flotation is shown below.
| | 2008 | 2007 | 2006 | 2005 |
|---|
| Diluted eps | 98p | 99p | 126p | 108p |
| Standard Dividend | 43.3p | 14.6p | 13.1p | n/a |
| Special Dividend | 9.7p | 40.7p | 80.0p | n/a |
| Total Dividend | 53.0p | 55.3p | 93.1p | n/a |
| Post-tax profit (£ millions) | 332.9 | 353.0 | 463.5 | 282.4 |
By separating its dividend into two types, Drax is indicating that its shareholders cannot assume that a special dividend will be paid in every year. Since Drax did not declare an interim special dividend for 2009 and also cut its interim dividend by 18%, it is possible that 2009 may be the first year where a special dividend is not paid. If we assume that Drax also cuts its final dividend by 18% and does not pay a special dividend then the yield falls to a respectable 8.5%.
The Politics Of Carbon (Dioxide)
As one way of reducing its dependency upon a single asset, and the prospect that coal will targeted by so-called "carbon taxes", Drax has diversified into generating power from biomass. By the middle of 2010 Drax's biomass power plants should be producing up to 500 megawatts, one-ninth of its maximum output.
Investors in coal-powered power stations must keep a wary eye on the global warming debate. Unfortunately many people on either side of the global warming debate are far more interested in scoring political points and securing their incomes than in finding the truth. Furthermore some politicians, a class not known for having any scientific expertise, are using global warming as an excuse to impose additional taxes, bash capitalism and expand their personal fiefs.
Consequently the political momentum is such that Drax's shareholders should assume that some form of carbon tax and/or rationing will be imposed, raising Drax's costs, and it is possible that only some of this can be passed onto consumers. Of course, there is a good chance that Drax will get some form of subsidy from the state to encourage investment in "clean coal" and alternative energies, so it wouldn't come as a complete surprise for Drax to eventually make some money out of any new regulations!
The Future
Whilst alternative sources of electricity generation, such as solar and wind power, are likely to appear as serious competitors in the near future given the wild abandon with which they are currently subsidised, society's increasing demand for electrical power, and the relative cheapness of coal, should provide Drax with some protection.
Drax offers investors a high income, albeit one which is likely to be cut, by providing an essential product which is increasingly being exposed to political interference.
More from Tony Luckett:
> Tony owns shares in National Grid.
