Yorkshire-based coal-fired power station, FTSE 250 operator Drax (LSE: DRX), looks like a high yield and/or contrarian recovery candidate to me.
It’s contrarian in the sense that no-one really seems to like it. Environmentalists aren’t fond of the UK’s biggest producer of CO2’s ugly cooling towers that belch out steam round the clock — though personally, I think it has a certain industrial majesty, particularly since I bought a few shares early last week!
In fact, Drax is the largest coal-fired power station in western Europe. It’s the kind of place modern art aficionados will no doubt be gushing over in 50 years’ time, but until then, its future as a provider of 7% of the UK’s electricity looks assured. It’s also billed as the cleanest and most efficient coal-fired plant in the UK.
Investors, meanwhile, seem to have lost hope as the share price has lost over 60% of its value in under four years. This is all music to the ears of the value hunting contrarian investors amongst us.
Value criteria
And Drax is beginning to look like a value investing opportunity.
The company’s overall value is covered around three-quarters by net tangible assets, it’s trading at less than six times predicted earnings per share for the current year, with net gearing of 10.7%.
Perhaps more importantly, at the current price of 357p (the shares went ex-dividend by 9.5p last Wednesday), Drax is on a forecast yield of over 8%. When yields go this high, it usually implies that the market believes a dividend cut is on the way. Indeed, the company has cut its dividends in the past.
Nevertheless, these basic factors tend to suggest Drax is too cheap and most other factors are simply noise to confuse us otherwise gullible investors.
Problems
But if investing was this easy, it would be, well… easy. And we know that it isn’t.
There are fundamental problems with Drax. First of all, it’s something of a one-trick pony. Investing in Drax the company is mainly an investment in the coal-fired power station. And it is under continuing pressure to reduce CO2 emissions, which is a costly process.
Also, the company is dependent on factors which are outside its control in the long term anyway; the future prices of coal, gas and electricity. Recent reports of weak global demand and strong supply for gas for the foreseeable haven’t helped Drax’s share price one bit. This has, understandably, been the main driver for the recent fall.
Whether this presents an opportunity or a threat is a matter of individual opinion. Personally, I think it’s been overdone. If continued weak gas prices continue, Drax should still be able to continue to operate profitably, albeit at a marginal level.
And if I’m wrong, I take comfort in the downside protection offered by the strength in the balance sheet of net tangible assets of around 278p per share.
Take courage
If you’re the kind of investor who prefers to view the overall picture when looking at big companies like Drax, without sweating too much over the short-term detail, then it may well may be a suitable investment as part of a balanced portfolio. There will always be short-term factors to depress or uplift the price.
But it may also be necessary to take courage and average down your buy price if Drax falls further still. This isn’t something that sits comfortably with many investors, but is sometimes necessary for the contrarian value hunters amongst us.
Continued subdued gas prices will make life difficult for Drax, and will keep the share price equally subdued. And these situations have a habit of travelling further than you thought possible in the same direction.
• This article was first published by The Motley Fool on 28 April 2010. Whether you’re a seasoned investor or new to trading,
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