At a dynamic moment for the global energy sector, Drax (LSE:DRX) could be an interesting opportunity. This FTSE 250 constituent’s undergone a remarkable transformation in recent years, pivoting from coal-fired power generation to become a leader in renewable energy.
And with a share buyback programme now in full swing, management looks to be signalling confidence. Let’s take a closer look.
A notable transition
The firm’s transition from coal to biomass and hydroelectric power generation aligns well with the UK’s ambitious net-zero carbon emissions targets. This strategic repositioning not only addresses environmental concerns, but also positions the company for long-term growth in the renewable energy sector.
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The commitment to sustainability extends beyond its core operations. In a dramatic overhaul from 50 years of operating the North Yorkshire coal-fired power station, the business is now actively exploring carbon capture and storage technologies. This emerging area potentially opens up new revenue streams and further enhancing its green credentials.
From a valuation perspective, the shares look pretty appealing. The company trades at a price-to-earnings (P/E) ratio of just 3.8 times, significantly below the FTSE 250 index average of about 14 times. It’s possible this discrepancy’s due to uncertainty in the sector, but with the shares up 21% in 2024 to date, it’s also possible that the market may be undervaluing future growth prospects.
Moreover, the company offers a respectable dividend yield of 3.56%. With a conservative payout ratio of 14%, there’s ample room for dividend growth, assuming the company’s earnings trajectory remains positive.
Share buybacks
The firm’s ongoing share buyback programme adds another layer of appeal to the investment case. The company recently purchased 145,000 shares at an average price of 647.34p per share, part of a larger £300m buyback initiative announced earlier this year.
This move serves multiple purposes. It demonstrates management’s confidence in the company’s value and future prospects. By reducing the number of outstanding shares, it can potentially boost earnings per share and shareholder value. Investors often view buyback programmes as a positive signal, indicating the company believes shares are undervalued at current levels.
A discounted cash flow (DCF) calculation backs this up, with an estimate of fair value about 57% higher than the current share price.
Risks remain
While the investment case is fairly compelling, it’s crucial to consider the associated risks. This is true for any company in transition, but especially in such a cyclical and uncertain sector.
The firm carries a significant debt burden of £1.56bn. While not uncommon in the capital-intensive energy sector, this level of debt requires careful monitoring. Analyst estimates suggest an average earnings decline of 21.5% a year for the next three years. This projected downturn could be attributed to various factors, including potential regulatory changes or fluctuations in energy prices.
As a key player in the UK’s energy transition, the business is also subject to changing government policies and regulations, which could impact operations and profitability.
To me, the company’s low valuation, solid dividend yield, and ongoing share buybacks offer multiple avenues for potential returns. Management’s bold transition to renewable energy, coupled with its shareholder-focused initiatives, makes it a noteworthy contender for investors looking to capitalise on the shift towards sustainable power generation.
I’ll be buying some shares at the next opportunity.
