Tag Archives: Macro

The Debacle of Wind Turbine Manufacturers

Energy, Global Economy, On the cover, Sin categoría,

(This article was published in Cotizalia.com on August 19th 2010)

I said it three weeks ago. Sell turbine manufacturers and buy wind developers. Turbine prices are plummeting, margins fall inexorably and the demand bubble, artificially created by the debt and subsidies of the OECD countries, has burst. And the only beneficiaries of this are the wind developers that centre on returns and not empire-building growth. They buy more turbines, cheaper and of better quality.

The turbine manufacturing industry is a great industry with great professionals and great engineers. But as an investment it is a disaster. It committed the sin of greed and the industry has been bloated with excess capacity for some time. Since 2006, the market has not seen anything but cuts to their own estimates for orders and margins. The industry positioned itself for excessive growth, undifferentiated returns and the hope that competition would never appear and are now paying the excess.

And it’s not a cheap sector in any shape or form. My readers who have access to Bloomberg can see that the stock market debacle has been entirely justified by falling estimates. And the sector is trading at 20x 2011 PER and average EV/EBITDA 7.5x. Not cheap at all for a sector that has proven to be more mature and cyclical than its managements and analysts would like to admit.

On Wednesday, Vestas, the largest turbine manufacturer in the world, fell 22% after they announced a downward revision of revenue estimates (for 2010!!) from €7bn to €6bn. The analyst consensus, who claimed that their average estimates were “conservative” (€6.7 bn), again had to slash estimates. This has happened six times in three years. The EBIT margin has been reduced by 50%, no less. Let us not forget that Vestas, like all turbine manufacturers, had given estimates for 2010 only a few months ago. And now they cut their estimates for this year … 50%. Then they say that it’s a temporary issue and that 2011 is fine. Again, something they said in 2007, 2008 and 2009. And some say that the market is speculative and short-term. Come on.

When a global leader is unable to estimate properly a year, THE CURRENT YEAR, how can they demand from us to make long-term valuations and investments? Come on. But what’s more important is that we are also seeing the cash flow fall and what is worse, a deterioration of the ratio of working capital/sales, which is what indicates the strength of the sector. Many firms take 20% WC/sales, which it is too risky,and shows that the industry is so desperate that they could be financing their own clients, in a downward spiral of financial weakness.

Gamesa, only a few weeks ago, further reduced, as it is almost a recurrent episode, its estimate of 2,700-3,000 MW of installations to 2,400-2,500, and their expectations for EBIT margin to 4.5-5.5%, compared with 6 -7% in January’s previous estimate. A very difficult process of adjustment to reality after the aggressive expansion plans and ludicrous expectations to compensate the falling Spanish business with Chinese and US growth.

As I told the CEO of one of these companies, who was asking what to do to mak the shares go up: “for once, please beat your own estimates. Simple.”

The turbine manufacturing sector faces three problems:

– The drop in demand, obviously. As I mentioned three weeks ago, the American green dream has faded. Expectations are for about 4 Gigawatt installed in the U.S. in 2010, less than half that of 2009. The European Union has very high electricity reserve margins. And the growth in renewables in other countries of the world is poor at best, and not enough to justify the “high growth sector” multiples. The bubble has burst.

– Production capacity is excessive. Turbine manufacturers themselves confirm that its plants operate at 50-55% capacity. This makes the need to reduce average prices to their remaining customers (10-12% decline in 2010, after a 12% in 2009) and compete aggressively with low margins. And what is worse, not only there have been no cuts in capacity, but it continues to increase both in European and America as well as Asia.

– Competition in the target market of China, which had been ignored with almost xenophobic arguments. “Not enough quality”, “customers do not trust them”, “European turbine prices can not fall and the Chinese have to accept it.” Well, Goldwind and Sinovel continue grabbing the Chinese market with prices 20% lower than European manufacturers, and what’s more improtant, better margins (12%).

The solution for the sector exists. “Shrink to greatness.” ROCE and margins. Easy. Reduce capacity, focus on margins, be less “engineers”, less empire-builders and more managers… And provide the market with realistic expectations. If we return to the bull market for renewable installations, and believe me, do not expect it, they will generate higher margins, better cash and have sustainable and profitable businesses. If the bull market does not come back, and it isn’t, they will be able to generate solid returns and correct the gradual and painful decline that we have seen since 2007. And do not cling to offshore as a salvation, as it’s more costly, less efficient and riskier… But, what’s most important, as replicable and technologically undifferentiated as onshore.

In an industry where the cost of replacement is reduced in absolute and relative terms every year as the technology is affordable and easy to replicate, basing a business on volume growth is crazy.

Turbine manufacturers should learn from the oil services sector, who suffered the lesson in the 80s when the same “GROWTH FOR GROWTH” and overcapacity issues occurred. Acciona, for instance, has seen this happening for some time. Its turbine manufacturing division is now a mere chain in their renewable business, which allows it to be integrated and manage the total cost in the projects it builds. Indeed, it does not provide the company any higher valuation, but at least they manage the business based on real internal demand, not on unachievable global growth expectations. Gamesa and Vestas have a tough road ahead. But a fascinating one nonetheless. As stocks, still a space to avoid except for very (VERY) short term beta trades. And to me, beta is better found elsewhere.

Unemployment inflection

Energy, Global Economy, On the cover, Sin categoría,

From one of my colleagues:

As of today, looks like the unemployment rate peak is behind us, and this long disastrous road of job losses that started December 2007 has ended. Job creation and job attrition look about flat. Unemployment would be able to fall naturally in the future without adding jobs because unemployment benefits run out and long-time unemployed people stop filing or reporting data–this is a data quirk, not necessarily a big positive per se.. Further, in the next 3 months, we get the once-a-decade US census hiring, which can be several hundred thousand jobs (though lined out by economists). All eyes are pointing now to expectations in June-Aug employment.

Combined with ISM’s running >50 for 7 months, global GDP coming in strong, and leading indicators running well above average (though maybe already having peaked on the recovery), seems we are in for slightly better economic picture than expected a few months ago.

Gotta be bullish for oil prices, as well as many globalized commodities. Goldman reporting US power demand running slightly above expectation in the US already, that may continue now, but admitedly its rather a shallow recovery (
Interest rates not really reacting to this data, except modestly on the front end. Further risks remain: the double dip on housing activity appears a growing risk, and end of March marks the completion of the Fed MBS purchasing program (read: mortgage rates will move higher). The sheer magnitude of bank write-downs coming on home mortgages is really just getting warmed up (the Fed kicked that can down the road, and we’re near the cul-de-sac). No idea how Fannie/Freddie even function post Fed purchasing program, they can’t warehouse all these mortgages and the banks aren’t holding new ones at all (85% securitization to Fannie/Freddie last year!)

So + industrial activity, slowly moving inflection on employment (but loads of slack to keep wages low for a while), and – on banking sector, lending. Seems that is a net/net positive environment for commodities and equities, neutral for bonds.

Can Spain afford to be "green"?

Energy, Global Economy, On the cover, Sin categoría,

(This article was published in Spain’s Cotizalia on February 11th 2010)

What timing. After months preparing for a trip to Madrid, I arrived on Thursday 4th, amid the market and debt debacle. A day after the market crash and four days before the presentation of the Spanish Secretary of State for Economic Affairs here in London. The macroeconomic forecasts “from -0.3% GDP growth in 2010 to +3% in 2012 by doubling the exports” worry me. What country will Spain double its exports to in two years with the Euro at all time highs and competitiveness at historical lows?

I have the luck or misfortune of following the economy of 58 countries. What country in the world is forecasting to increase its imports from Europe between 2010 and 2011? No idea. And above all, how can Spain take away market share from other exporting countries in an environment of aggressive competition?

Amid all this, people wonder why the markets fell and different articles comment on the role of “short speculators”. Too bad no one called us “long speculators” or “saviors of enterprises requiring capital increases” in 2009.

Going back to the Spanish Government presentation… Imagine the CEO of any publicly traded company which had breached the consensus estimates for three years in a row submitted such bullish growth plan and think how much his companies shares would drop. Obvious.

Fortunately, my meetings on Friday left me much calmer. The companies are doing their homework and, as always, it will be the private sector which will rescue the economy. I hear no one expects a quick economic recovery and corporates, which are close to the customer and the export industry are preparing themselves for several years of less than modest growth. I hear excellent plans to cut costs by 30-40%, diversification efforts and, above all, restraint in capex and debt control.

And in this day an issue did pop up constantly. In Spain there is little more that can be done in infrastructure and renewable spending for a few years. The drastic cut of the civil works and infrastructure spending is imminent. Spain has invested in infrastructure like an emerging country, but with the demand of a mature market, and now it has an enormous excess capacity while it needs to digest, and pay, the national debt increased through a stimulus plan that brought debt to GDP to 11% devoted to infrastructure and civil work with no returns, ie spending that generates debt but does not generate GDP.

In this environment, power prices are at historic lows due to overcapacity and lack of demand, and yet the fact that renewables account for 40% of the electricity generated in some days make the premiums for these technologies (especially solar) to generate a tariff deficit of between €1bn and €1.2bn, a bill that is transferred to future generations.

This deficit is generated by the monstrous deception that is to have a government that raises electricity tariffs by a maximum 3-4% annually in one of the countries that pays less for electricity in Europe, while the real energy costs, including renewable premiums, is much higher. And this then becomes debt, owed to the power companies, that must be placed in the market to be securitised… And we have spent many months waiting for the tariff deficit securitization while the figure of debt rises month after month, which is unacceptable and introduces even more uncertainty in the power stocks. This is the national problem of Spain: to fix it all with debt, and now the bubble of debt is almost unbearable. The government has to refinance €60bn, saving banks and autonomous regions €150bn, etc … Let’s see just what kind of spreads will be required to place this paper.

Spain’s GDP is approximately €1.06 trillion, premiums for renewables account for 6 billion euros, 0.6% of GDP, and the accumulated tariff deficit is 11 billion, or about 1% of GDP. Additionally, the tariff deficit expected for the next two years is an additional €4 billion. Spain, at the same time, wants to install about 5,000 additional megawatts of wind generation and other 2,300 megawatts of solar by 2012.

Well, friends, do numbers. Either the government passes the real tariff to the consumer, which is unlikely given there is a 20% unemployment, or the bubble and its financing becomes unsustainable and with it the green economy model. Green energy costs. Let’s face it. Now it’s time to face whether the green energy model is sustainable in a weak economic and high debt environment.

Three recommendations for utilities

Energy, Global Economy, On the cover, Sin categoría

(This article, like most in this blog, was published in Cotizalia in Spanish)

The utility sector faces this year the need to renew their strategic plans and give the market an attractive message for shareholders. It is not easy, as most companies have clear that the next five years will not see the electricity demand growth the industry enjoyed between 1990 and 2008. So the biggest risk facing the sector is to give overly optimistic messages or growth targets that are difficult to digest by the market, which would negatively impact their shares. And remember what a dreadful market performance we have seen in the past two years among large integrated utilities like Enel, Gaz de France-Suez and E. On even when they have published acceptable results.

Transmission companies are fully regulated, so they have it relatively easy, because their investment plans are guaranteed by the government with a minimum return. The complex part is to justify the multiples at which they trade (the highest since 2000) without giving the market an assessment of their minimum growth in regulated assets (RAB). Added to the equation the fact that the regulators have a nasty habit of delaying the simplest decisions for months, and the risk increases. It is therefore absolutely necessary to clarify the regulatory environment, and confirm the growth expectations. If not, we return to the regulatory risk discount that affected National Grid and the Spanish companies for years.

Large integrated groups have a harder task ahead. They face an environment without significant growth in demand, with some excess capacity in generation, and the industry no longer has the strong balance sheets that facilitated large corporate mergers. With a sector in Europe committed to divest more than €15 billion, it is difficult to see asset price inflation to levels of 2004-2006, as it’s a buyer’s market. Therefore, the challenge is to clarify how to create shareholder value when the macroeconomic environment is complex.

From my point of view, the Spanish companies can boast of having managed the 2009 crisis better than their European competitors. And they should exploit three key areas:

– The first is to clearly show their competitive advantage in costs. For example, compared with European companies, the Spanish, on average, have reduced their costs in 2009 by 7%. This ability to manage complex environments is essential to create value.

– The second is to focus on Return on Capital Employed and managing the investment process. Being bigger is not better or more profitable. Spanish companies have shown to be capable of generating superior returns to its peers (9.8% compared with those of Europe, 8%) while reducing unnecessary investments in over €8 billion despite the fall in demand for electricity and gas in Spain, which has been above the European average.

– The third is to commit to a policy of Total Shareholder Return. Once the process of reducing corporate debt has been completed, and so far it has been done remarkably well, with more than €13 billion average reduction in debt in the sector, the message should focus on profitability for shareholders. The key is to reduce exposure to low-return assets, crystallising value in the most attractive ones, as they did floating the renewables divisions, and could do again with the distribution or nuclear generation, while ensuring a minimum absolute dividend and the improvement in book equity.

This is a year in which companies will have to compare themselves with others, and show that they do better than average. Focusing on returns generated at the bottom of the cycle, ensuring shareholder remuneration and managing the balance sheet will be what differentiates the winners from the losers in the market. The empire-building strategies of European multinationals have driven the sector to a six-year relative minimum PE to the market. Now it’s time to differentiate strategies.