Drax's income appeal

Drax provides energy through a combination of biomass and coal generation. Through these, it accounts for 6 per cent of the UK’s electricity and 15 per cent of its renewable energy. It also has a large energy supply division, serving business customers in the UK, which generated revenues of £2bn last year, representing around 10 per cent of the business-to-business power market. High bills have led to increased political pressure in the domestic power market in recent years, but business supply has remained robust. Drax also runs a pellet production business, which makes wood pellets that can be used in low-carbon energy generation.

The group was once heavily reliant on coal generation, but in recent years has been shifting towards low-carbon methods. It has converted three of its plants to use biomass to generate electricity and is in the process of commissioning a fourth. Once completed, only two of its six power plants will use coal. In its most recent update profits were impacted by two unplanned outages affecting biomass facilities, but no lasting impact on profitability is expected. The group also has two open-cycle gas turbines applying for subsidy in an upcoming capacity market auction, with planning applications for two further turbines and a coal-to-gas repowering under review. As governments increase the pressure to manage carbon emissions and climate change, renewable energy is expected to become a more crucial part of the overall energy mix.

The shift to clean energy is a long-term trend which underpins Drax's target to sharply increase cash profits from £229m in 2017 to £425m by 2025. However, Drax has also generated immediate benefits through its shift away from coal. Government renewable energy subsidies, in the form of a contract for difference lasting until 2027, provide more certainty about cash flows from the group's biomass operations. This, combined with high UK power prices, has strengthened cash generation and in turn has provided more certainty about dividend payouts – especially after a restatement of the payout policy in June following a refinancing of debt in the previous month. As well as having set the 2017 dividend at a level management deems "sustainable and growing", the company has pledged to return built-up excess capital. To this end, Drax announced a £50m share buyback with its full-year results (equal to the amount paid as dividends for the year). Brokers expect more buybacks to follow, adding substantially to overall shareholder returns.

The upside allowed by government subsidy has also been growing. This month, the Department for Business, Energy and Industrial Strategy (BEIS) released a document outlining how many Renewables Obligation Certificates (ROCs) biomass units would be able to generate in 2018-19. ROCs are tradeable certificates that reflect a unit’s energy generation performance against its clean energy targets. Consensus estimates were that Drax would be able to generate around 9m in the financial year, but the BEIS document put the level at closer to 10.3m. In response, analyst RBC Capital Markets estimated the increase could add £30m to annual cash profits and upped its free cash flow forecasts.

Payments from ROCs come a few months after they are earned, typically, and the group uses sales agreements to manage the timing of payments. Use of the agreement, combined with capital expenditure on the conversion of the fourth biomass unit and other investments in future generation and pellet production have weighed on free cash flow expectations for the full year. However, both cash flows and earnings are expected to grow rapidly from next year, as biomass generation and rising power prices take effect. The length of the subsidies allows for some clarity on the future strength of cash flows. Broker Credit Suisse forecasts the group will generate around £2.4bn in free cash flow in the years to March 2027, allowing for continued dividend growth while maintaining capital expenditure.