We bought Drax in 2011 when most investors didn’t like it. They didn’t like it because the stock price had gone down during the past five years, and had missed out on the market rally of 2009-10.
Drax was cheap on almost every valuation measure, especially cashflow to enterprise value – an alternative to market capitalisation. It had some anxiety-inducing characteristics. It uses coal to make electricity – coal is not environmentally fashionable. It uses lots of derivative contracts to cover both the cost of coal and the price of electricity – post-Enron, derivatives in energy companies make investors nervous.
But Drax has managed its balance sheet very conservatively. It has generated lots of free cashflow, and paid off nearly all of its debt. So in 2011 there seemed to be a mismatch between investors’ perception of risk and the risk we could see when we looked at management behaviour.
Two years later a lot has changed. Management has embraced biomass. It is starting a complicated and costly project to convert part of its power station to use expensive, difficult-to-source, non-coal fuel. The execution risk is high and the promises by the management are laced with self-confidence and optimism. This causes us anxiety.
But investors like the environmentally-friendly shift and view management behaviour as risk reducing. Time to sell.
Jeremy Lang is co-manager of the Ardevora UK Equity fund
