News that the National Audit Office (NAO) plans to scrutinise the government’s biomass strategy served as another reminder of the fragility of Drax’s business model and how jittery this is making investors.
When the government reaffirmed in August that burning pelletised wood to generate electricity could play a key role in reducing dirty emissions, it barely triggered a response. The big reaction came a month later when the UK’s independent public spending watchdog announced that it wanted to examine whether this expensive and controversial power generation process represented the best way to spend taxpayers’ money.
Bullish analysts played down the importance of this potential setback. They noted that the NAO routinely did this sort of thing and did not wield enough influence to force the government to stop counting on Drax’s biomass and carbon capture technologies to help it achieve its ambitious climate targets. These were reassuring words but not quite enough to make the doubt go away.
Drax’s shares are down 24 per cent this year for a reason: the way it generates power is expensive, unviable without government subsidies and attracts a lot of scrutiny. That is not the sort of stuff usually associated with capital gains.
Promising to reduce the nation’s reliance on fossil fuels and claiming that the energy it produces is carbon neutral has landed the FTSE 250 company billions of pounds in subsidies but generated much anger.
Some scientists dispute the theory that planting new trees absorbs the carbon emitted by burning pellets. Critics also point out that Drax’s fuel materials come from North America and are mainly sent over in huge diesel-powered ships.
These are not the only worries weighing on the shares. Ofgem is investigating whether Drax breached sustainability rules after a BBC Panorama programme claimed that the company chopped down trees from precious forests. Biomass must mainly be procured from unwanted waste. And, last month, it was accused of using a loophole in the government’s subsidy scheme to get out of paying up to £639 million of extra earnings to households.
Drax denies any wrongdoing. However, it is still negative PR that is turning the heads of influential figures, including Ed Miliband, the shadow climate change secretary, who said that Labour would review subsidies for biomass.
Existing subsidies are due to expire in 2027 and Drax is banking on them being renewed. Without government money it is in big trouble.
The company’s long-term success also hinges on government funding to get technology that captures and stores emissions underground fitted. Biomass using bioenergy with carbon capture and storage (BECCS) is said to have zero emissions. BECCS has been touted as the only viable way for the UK and other countries to meet their ambitious climate targets but governments have not yet fully committed themselves.
Various threats and lofty profits captured from unusually high energy prices have left the shares, trading at four times forecast earnings and an enterprise value of three times earnings before interest, taxes, depreciation and amortisation, looking deceptively cheap. Valuation multiples are less appealing when applying normalised profits and not necessarily low enough to compensate for the risks.
Drax could end up spearheading the UK’s net-zero drive, making it big in the US, where the government is doling out green tax credits, and turning into an ultra-reliable dividend play. Or maybe not. A lot can go wrong and most investors will find that Drax is cheap for a reason.
ADVICE Avoid
WHY The way Drax generates power is expensive, unviable without government subsidies and attracting a lot of scrutiny.
Warpaint London
Usually, a company reporting 46 per cent sales growth and a near doubling of profits would be rewarded with a rising share price. That wasn’t the case for Warpaint London. Its valuation has jumped so much over the past year that investors opted to take profits instead.
The Aim-listed Warpaint is behind the cosmetic brand names W7 and Technic. Its affordable make-up is sold to consumers all over the world either directly online or, more commonly, via retailers such as Tesco, Boots and New Look.
The company’s latest financials, covering the six months to June 30, tell us that business is booming. Warpaint’s product range, which is renowned for being just as good as much more expensive brand names and reflecting all of the current fashions, is flying off shelves. And, unlike many other growth stocks, these revenues are not costing an arm and a leg to achieve.
Warpaint outsources production and doesn’t rely on just one manufacturer. A variety of trusted partners can be called upon to quickly pump out quality goods at competitive prices.
That’s just one of the ways management keeps a lid on expenses. Costs are minimised wherever possible, with the company able to reel in customers without acquisitions or much spending on innovation and marketing. The upshot is healthy profit margins, zero debt and constant dividend growth.
This great business model hasn’t gone unnoticed: Warpaint’s shares have risen 71 per cent this year. That kind of momentum comes with risk. In this territory, locking in gains, as we saw after the results, is common and investors can become very demanding.
On this particular occasion, investors taking a breather has created a buy opportunity. The shares trade hands at 18 times forecast earnings, a discount to the three-year average, and more sharp growth seems likely.
Warpaint is a very well-run business, offering internationally loved products at cheap prices. It still has a small footprint in a huge market and plays to the strengths of a weakening economy. The odd pullback shouldn’t rattle investors.
ADVICE Buy
WHY This company has lots more growth potential.
