Description

[Above figures in Euros]

Thesis: Long Vestas Wind Systems (VWS GY). VWS is the world's #1 wind turbine manufacturer. Renewable energy companies were historically economic boondoggles and creatures of subsidy - that attitude has persisted such that growing concern about the economics of wind turbines at the end of a subsidy period starting now through 2020 has caused the Western publicly traded turbine companies to trade down as much as 40% - 60% off of their highs. In fact, we believe that wind turbine manufacturing today is a much better, more orderly capital goods market than the bears give it credit for and VWS is competitively advantaged in this post-subsidy world. Furthermore, we believe that VWS’ service business is an underappreciated gem that will swiftly grow both its proportion of VWS’ total EBIT as well as its EBIT in absolute terms and ultimately prompt a rerate given the profitability and stickiness. At 10x - 12x consensus forward earnings including net cash or 7x - 8x EV/Fwd EBIT, we don't think our more optimistic view is even close to being priced into the stock and the stock looks to have a high-teens IRR just on these factors. However, we are also structurally optimistic about renewable energy (wind in particular) and, in our bull case, believe that this could become a coveted business as its strategic importance and future business prospects become clear.

Instead of being an economic boondoggle, VWS is an excellent business with a pristine balance sheet, strong returns and FCF generation and the leading position in an emerging oligopoly. VWS is even a buyer of its own shares and we can’t think of many renewables companies that are in a position to do that, much less do it repeatedly!

Some Background: 5 to 10 years ago, this author focused a material amount of his workday on the energy sector. At the time, renewables were seen - at best - as a nice gesture towards the environment and - at worst - as cynical greenwashing and an uncommercial waste of money fueled by political fancies. This author fell somewhere in the middle of that spectrum but, whatever, at the time renewables were viewed within almost all quarters as economically nonviable and, at the time, that view was correct.

However - 8-12 months ago - this author STILL held the belief that renewables were nonviable on an economic basis. That view had been overtaken by human progress and had become incorrect.

In fact today, on an UNSUBSIDIZED basis, the cheapest incremental MW of power generation is provided by wind:

This is Lazard’s most-recent version of this analysis but it has been corroborated by other research efforts as well as the fact that energy companies are continuing to bid for renewable projects on an unsubsidized basis. You don’t have to believe research projections, market participants are speaking for themselves. Some companies like NextEra even believe that new renewables plus storage already make sense as a replacement to baseload power”

We aren’t willing to go that far yet, but consider it food for thought as we wouldn’t find it shocking if many VIC participants had similarly skeptical attitudes to this author’s from not that long ago. It’s an important tipping point that we have just recently reached:

[Note: LCOE stands for ‘Levelized Cost of Energy’, a measure of the cost of building and producing a MWh of energy]

Hopefully this inclines otherwise-skeptical readers to be less skeptical. And the LCOE of wind looks to keep dropping further for many years. The world has changed.

Company Background: VWS is a Danish company. Founded in 1945, VWS began making turbines in 1979. As the market matured has matured, VWS has emerged as the #1 OEM in the world and now has over 85 GW of installed capacity globally. As with many other capital goods companies, VWS has a servicing business that has grown in importance and now does a significant amount of 3rd-party turbine servicing after acquiring the largest independents in Europe and the US in 2016. In total, VWS services ~75GW globally today and has by far the largest turbine servicing business.

Key Thesis Points

Excess pessimism around the extent to which turbine prices could go down:  We think this is likely to be an orderly market and the recent large price declines are more of a reset to a post-subsidy world than representative of a new price decline cadence.

Confidence in future wind turbine prices has been roiled in recent months as the US Production Tax Credit (PTC) which incentivized the construction of renewable energy moves towards expiry in 2020 (and was threatened by the recent US tax bill along the way) and many other markets, especially in Europe, move towards an auction model. The concern is that wind turbine manufacturers, unaccustomed to this new commercial reality, will get involved in a messy price war. To wit, all the major Western turbine OEMs have disclosed HSD to low-DD px/MWh declines in the most recent quarter.

The bears seem to be inclined to assume these price declines are the new normal but we think that’s not correct. While price declines will be a part of this business as incremental efficiencies are realized, this is not the feisty, diffuse industry of a decade ago when wind power really took off globally:

China has been a big part of those capacity additions but, as you’ll see in the following exhibits, it tends to be separate:

Globally, there are clear leaders but VWS is the only truly global player:

[Note that Siemens recently acquired Gamesa]

In the US, a number of entrants flooded the market as installs took off before becoming consolidated. In CY16, VWS and GE made up >80% of the entire US wind turbine market:

While we were not able to find excellent global market share data for every year, we see a similar pattern in Europe:

Note that Siemens recently acquired Gamesa to create the publicly traded entity SGRE. A wave of industry exits and M&A created the more consolidated industry we see today. Excluding China (where local champions like Goldwind rule but struggle to succeed outside of China), the top 3 OEMs (VWS, GE, SGRE) represent almost 70% of the global wind market and the top 5 represent 85%. That is a pretty consolidated market.

In addition to the general argument that consolidated capital goods industries tend not to have price wars, some specific context might be helpful.

 1. VWS can better endure price declines than its competitors. Because of its greater scale and efforts to reduce its cost structure, VWS has notably superior margins to its competitors:

 2.  Both of VWS’ key competitors (SGRE & GE Renewables) are going through painful restructurings and have given guidance around both growth and EBIT margins.

Everyone here is likely familiar with at least the headlines around GE’s struggles. GE has indicated that onshore wind will be a key source of growth whose pricing headwinds can and will be offset through pricing efficiencies:

Meanwhile, SGRE is going through a messy integration of Gamesa into Siemens and has watched its stock get cut roughly in half over the past year as a result.

Their guidance for FY18 is quite explicit: a moderate decline in revenues and EBIT margins (albeit heavily adjusted ones) right at the low-end of GE’s own guidance.

Meanwhile, the smaller players barely have positive operating margins at all and have no balance sheet capacity to endure sustained losses. There are two explanations for the recent, dramatic pricing pressures: that they are one-off responses to changed economic regimes or they are the new normal of intensified competition. Who is incentivized to act as a spoiler in this market in any kind of sustained way?

To wit, while GE gave limited pricing commentary on its call (it is more diversified, admittedly) SGRE gave the indication that this pressure was abating on its Jan 30, 2018 call:

On the related question of turbine demand, while we are totally prepared to believe that volumes will drop for some time post-2020 - but we believe that has far more to do with demand pulled forward by subsidy than a structural decline in demand. Wind is the cheapest source of incremental power in the world and getting cheaper. We believe that economics will win out.

Underappreciated service business - as it grows, the stock will likely rerate:

This point is easier to explain than the competitive dynamics above. As important pieces of capital equipment, turbines require periodic servicing. Beyond parts & repair, modern turbines have significant amounts of telemetry and operating data that allow for preventative maintenance and regular software updates. This only became a focus for the major OEMs in recent years as they developed significant install bases. For VWS (as well as GE Renewables and SGRE), service is becoming an increasingly crucial part of their business and VWS has begun the process of building out third-party servicing operations so that it can steal share from competitors and OEMs that have left the market.

As it happens, VWS has the leading onshore wind servicing franchise:

This is crucial because economically attractive servicing operations require network density just like any other ‘[wo]man in a van’ service business. As a result of its larger installed base of serviced turbines (75-80 GW globally), VWS’ service costs lead the way:

The company also claims better uptime than the industry average - so it can charge lower prices for better outcomes. Some amount of this has to do with the sheer amount of data it is receiving from its installed base of turbines. Our industry work suggests that VWS is far and away the leader in data collection and optimization, which is crucial for renewables generation.

This is a classic ‘virtuous cycle’ kind of business and it has shown in the incremental EBIT margins:

We exclude 2016 because it includes the results of the two newly-purchased 3rd-party installers but the incremental service EBIT margins in CY17 have continued the trend for VWS:

Meanwhile, the typical turbine is sold with a 2yr guarantee and the development timeline of a new wind farm means that we have upwards of 3+ years of visibility on incremental installations:

Given the above plus the 70% retention rates for the life of a turbine according to IR (the typical turbine is supposed to last 20-30yrs) and the fact that the company services <90% of all the generating capacity it has ever installed, we have very high visibility on service growth over at least the next 5yrs. Revenue growth of >50% appears to be highly probable with a lot of evidence that this should lead to very attractive (30%+) incremental margins given prior form.

This assumes no material share gains on its 3rd-Party business, but VWS appears to be enjoying some real success there, e.g.: https://www.windpowerengineering.com/slider/siemens-gamesa-vestas-win-service-tenders-iberdrola-wind-fleet/

It is also worth mentioning that a significant piece of VWS service revenue appears to come from software updates and not physical service. These periodic tweaks to the control systems of turbines can lead to real performance gains relative to often highly localized climactic conditions. We think this represents a significant percentage of service profitability and likely represents pricing power over time which should further flatter incremental margins if we are right.

Longer-term - this could become a coveted business again if positive sentiment returns to wind:

This one is more about ‘dreaming the dream’ but we think there is a structural bull case for wind as it has just begun to enjoy its time as the cheapest source of generation around and still represents a small portion of world energy consumption:

And for those who really want to dream the dream, historically generation sources have had gradual marches up over time once they have reached a certain saturation point:

Note that this set of graphs includes solar within ‘modern renewables’ but only wind is economic without subsidy today in most instances.

And, historically, the IEA among others have habitually whiffed in a big way on how much wind would be built out:

While this is now entirely pie-in-the-sky, there is more than enough ‘good wind’ in the US to theoretically meet most of our power needs (although this would likely not be practical for several reasons):

Because wind (as with solar) is an intermittent power source, there is only so much power generation it can provide without economically viable storage. But even given that constraint, load factors have continued to improve despite being in less high quality wind sites:

But without storage solutions, how much market share can wind take? As parts of Europe show, the answer is ‘a lot’:

And because wind tends to work best at night while solar tends to work best during the day (obviously), the combination of the two serve as complements in increasing the penetration of renewables:

There is also some cause for optimism around batteries coming down in price, which would significantly increase wind’s ability to take share:

But even small amounts of storage allow for significant incremental renewables within the grid and we had a number of instances (such as in California) where storage is getting built out for experiments and grid enhancement because the other benefits seemed worth it and utilities could validly add it to the rate base. We are guardedly optimistic in our bull case that widespread grid-scale storage will happen much faster than consensus.

If any of this happens, the leading pure-play wind turbine manufacturer and servicer will become a coveted asset as wind will grow rapidly.

Valuation:

On our base case numbers (11%/yr service revenue growth, 24% incremental EBIT mgns) and 20x EV/Service EBIT we are only paying for the service business and the company’s heavily discounted cash in 2020 on a PV0 basis, meaning we would struggle to lose principal even if de minimis value was attached to the turbine business whose economics is being questioned by the bears. On our base case expectations for 2020 (and using an 18x multiple for the service business), we think the stock is worth ~E75/shr which means we are paying 11.7x EV/EBIT for the blended business net of the cash - well in line with other capital goods businesses with service components. That assumes the turbine EBIT margin gets cut almost in half from today, which would suggest that VWS’ competitors are making no EBIT on their turbine sales at all! On somewhat more bullish assumptions, we can readily see this being worth >E100/shr.

Catalyst

Clarity around pricing dynamic

Further growth in the service business that makes it a larger part of the overall profitability picture

Longer-term and more speculatively: growth in awareness around the prospective transformative economics of economically viable grid-scale storage