The wind energy market has been built up over the years by government subsidies, but now these are being phased out, where does that leave investors?
It's no surprise then that the share price of Denmark's Vestas (VWS), one of the largest wind turbine suppliers in the world, has been under pressure.
But Morningstar analysts think that the dominant players in the industy will prove resilient as the industry consolidates.
Vestas is one of the largest wind turbine suppliers in the world and this scale should mean it is well positioned to cope as the industry changes. While government subsidies have previously helped build the market and encourage new entrants, as subsidies are phased out price competition is likely to intensify along with consolidation of the number of players.
Morningstar analyst Andreea Matysiak says smaller players are likely to exit the market in the years ahead, but larger firms should last the course. Currently the top three players – Vestas, Siemens Gamesa (SGRE) and General Electric (GE) – hold around 45% of the market between them.
Vestas is mainly present in developed markets, with around 80% of its installed base of wind turbines and turnover coming from mature markets in Europe and the US.
Reduction of Government Subsidies
The phasing out of government subsidies is a crucial development for the wind industry. So far, such grants have played an important role in project tendering and the finances of the wind companies, turbine suppliers and their operators. But governments are in the process of reducing these subsidies, weaning the sector off them as the industry dynamics now support more market driven pricing. That puts great pressure on turbine suppliers, because they face lower margins on future projects, says Matysiak.
This is clear from recent company results. Vestas’s operating margins on turbine construction in the second quarter almost halved from 11.5% to 6% amid a double-whammy of lower subsidies and price pressure from both energy companies and end customers. Also putting pressure on margins are rising trade tariffs, transport costs and raw material prices. It’s not just Vestas suffering either, the trend was echoed in the results of its competitors Siemens-Gamesa and General Electric, notes Matysiak.
To counteract this pressure on margins, Vestas has in the past few years been mainly concerned with cutting costs: between 2013 and 2017, the cost per megawatt of power supplied fell by 30-40%. The firm is also reducing the cost per wind turbine produced. Of course, this strategy is not without risk; a continued focus on costs and a lack of product development could erode the firm’s offerings, leading to a loss of market share.
Matysiak sees the trend continuing for the time being: costs must fall faster than electricity prices fall. Thanks to its scale and efficiency, Vestas can reduce costs more quickly than its smaller rivals. This efficiency is reflected in, among other things, the modular design of wind turbines, which means that production can be standardised, reducing production costs. Manufacturing footprint adjustments also carry cost savings and recently, Vestas cut 590 jobs at factories in Germany and Denmark. Matysiak expects the company to increase manufacturing capacity in lower cost locations instead.
The Morningstar View
Vestas has a "no moat" rating from Morningstar analysts, because turbine suppliers lack product differentiation that would give a firm a marked lead over its competitors. While scale differences exist among competitors, the products themselves are not necessarily different or better. Without differentiation, suppliers also lack brand pricing powering that could lead to higher margins, although Vestas is one of the more well-known names in this industry.
But Vestas’s revenue mix could boost its margins compared to its competitors. After the construction of wind turbines, maintenance is required during their active life. The buyers of the turbines, the energy companies, sign multi-year service contracts with the turbine suppliers. This is a healthy business for Vestas, which saw 15% revenue growth in the second quarter of the year.
These service activities also offer the possibility to collect data on the use and performance of the wind turbines. For example, data can look at performance in different weather conditions or trends in power production over time with turbine supplier algorithms providing insight into the turbines’ long-term performance. The turbine supplier can adjust maintenance accordingly and keep costs as low as possible.
Wind energy is expected to maintain its status as the most competitive among renewable and conventional sources of energy and Vestas is well-placed to benefit as governments across the world put climate change high on their agendas and build clear plans for adopting renewable energy.
Over the long term, the analyst expects worldwide wind energy growth of 3-4% for the next five years, although Vestas is set to grow slightly faster than the market thanks to the service division. IT should also be able to improve margins through cost cutting and higher productivity, from 8.1% today to an estimated 10% by 2025.
While a phase-out of US subsidies and a lack of clarity over the EU’s energy plan post-2020 are likely to weigh on sales growth in the short-term, Matysiak expects longer-term growth to be more robust.
Morningstar has a fair value estimate of 606 Danish kroner on the stock, putting the shares at a 15% discount based on their current level.
