Despite heading in the right direction these past 12 months, the FTSE 250 continues to offer bargains. The economic environment is improving, but investors are still punishing capital-intensive companies in the face of rising interest rates.
Caught in the crossfire of this pessimism are two renewable energy empires, Greencoat UK Wind (LSE:UKW) and Foresight Solar Fund (LSE:FSFL). And there is some justification for concern. After all, building wind and solar farms isn’t cheap, and it’s resulted in a lot of debt being racked up over the years.
However, even with the added pressure from high debt-servicing costs, neither firm appears to be in serious trouble from what I can tell. And with both stocks down by double digits despite raising dividends, this, to me, looks like an attractive entry point.
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Investing in renewable energy infrastructure
Foresight and Greencoat have very similar business models. They both use shareholder and lender capital to acquire green energy assets to generate and sell electricity to suppliers such as SSE, Centrica, and EDF Energy. And Foresight has also begun taking things a step forward by investing in industrial-grade energy storage solutions on top of its solar assets.
While the initial cost is high, both solar and wind power technologies don’t require much maintenance compared to other energy systems. As such, both groups boast high double-digit profitability. And, in turn, this has led to impressive levels of cash generation.
In fact, it’s precisely how both companies have successfully raised dividends for eight consecutive years. And this trend doesn’t look like it’s changing even with higher interest rates, considering both have hiked their interim dividends once again.
Shifting landscapes spell trouble
Despite the seemingly solid performance, investors appear to remain unimpressed. And there might be a good reason for it.
Higher interest rates may not pose a threat to the firms’ existing loan book, but to continue expanding operations and raising dividends, more debt is going to be needed. And, over time, as old cheap loans mature and new expensive ones make up the bulk of the debt portfolio, profit margins will likely get squeezed.
This threat is particularly problematic since neither Greencoat nor Foresight have any pricing power to offset this impact. Don’t forget energy prices are driven by the market, not the individual companies.
The bottom line
As global warming becomes an evermore present threat, demand for clean energy sources is on the rise. And the UK in particular appears to be at the vanguard with 36% of total electricity generation coming from renewables in the last 12 months. For reference, that’s up from 4.8% 10 years ago.
With that in mind, I think the opportunities for Greencoat and Foresight are only going to increase moving forward. The higher cost of funds will demand more capital allocation skill from the management teams. However, with a near-decade-long track record of creating value for shareholders, I remain optimistic, especially at today’s cheap valuations.
