Turkey of the week: a vulnerable power generator

Aggreko is the world leader in the rental of temporary power generators and air conditioners. Indeed, its entire capacity (5,500 megawatts) could deliver 9% of Britain’s electricity needs. In Europe and North America it hires out equipment for short-term assignments. These include music festivals, sporting events (such as the Winter Olympics) and even emergency situations, such as the aftermath of Hurricane Katrina or the Haitian earthquake.

However, it is in the emerging markets that Aggreko really makes its money. Its bread-and-butter product is the diesel generator, which can be housed inside a 20ft shipping container. These cost about £130,000 to build and can generate 1MW of power. Connect dozens together, and you have a medium-sized power station that can be built as quickly as the containers can be transported. In fact, its equipment now supplies about half of Uganda’s, and 15% of Kenya’s, generation needs.

With the world’s energy supplies still unstable, and the added boost of a football World Cup in South Africa this June, the sector has so far stayed relatively immune from the wider economic malaise. Furthermore, during the downturn, the board has cleverly shifted capacity from one-off projects in rich countries to long-term supply agreements in the developing world. That’s because many fledgling countries regularly suffer from blackouts, damaging their hopes of establishing local high-tech industries (say in semiconductors and electronics assembly). Even call centres require resilient power sources. The big advantage of using Aggreko is that its power stations can be established in a matter of months. A permanent one, on the other hand, takes more than five years to build.

Aggreko (LSE: AGK) rated a BUY by Altrium Capital

As for the numbers, the group has not only stabilised sales, but also boosted operating profit (Ebita) margins to a staggering 26%. That compares to a historical average of 17%. The City has duly bid up the shares to a near all-time high. But don’t be fooled by the hype. Investors should remember that renting equipment is a ‘feast or famine’ industry with very high fixed costs and dangerous levels of operational gearing.

For example, during 2001-2004, after the fallout from the dotcom crash, Aggreko’s earnings tanked with lower utilisation rates. And since the purchase of new kit is often funded by debt, utilisation rates need to be high enough to cover interest payments before any profits are generated. While its debt burden only falls when money is paid back to lenders, the value of its rental assets can plummet if demand falls.

Aggreko is also exposed to the volatile mining, oil and gas, and shipping markets. So when China eventually does decide to pull in its horns on commodities spending, this part of the group is going to get whacked. Lastly, with such rich returns on offer, aggressive new competitors are bound to emerge to trim profitability.

So what is the stock worth? I would value Aggreko on ten-times through-cycle Ebita, assuming sustainable margins of 20% on revenues of £1bn. After adjusting for the £180m in net debt, that delivers an intrinsic value of 675p per share. Sure, Aggreko has been making hay while the sun shines, but it’s now time for a reality check. Final results are due on 4 March.

Recommendation: TAKE PROFITS at 917p

Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments

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