Dividend opportunity at Drax

It's fallen out of favour following half-year results, but this Woodford stock could be a great pick for income investors, writes Graeme Evans.

A setback for Drax Group shares after a dip in half-year earnings exposed a potential opportunity for income investors today, with the power generation company sticking by its pledge for a "sustainable and growing dividend".

The FTSE 250 company, whose shareholders include Woodford Investment Management, suffered the 27% drop in half-year earnings per share (EPS) following two unplanned outages impacting its biomass operations earlier in the year. 

But crucially, the North Yorkshire-based firm is not changing full-year earnings expectations and has revealed that it intends to recommend a dividend for 2018 trading worth £56 million, a 12% increase on a year earlier.

Some 40% of this will be paid as a result of today's interim dividend of 5.6p a share. Alongside the £50 million share buy-back programme announced in February, Drax said this demonstrated its confidence in future earnings and "underlines our commitment to returns to shareholders".

Source: interactive investor      Past performance is not a guide to future performance

Drax's projected dividend yield is now in the region of 4%, which reflects the turnaround seen since 2017 after several years of declining pay-outs.

The company is now much less vulnerable to fossil fuel volatility, having diversified its generation mix towards biomass and developed into new areas such as B2B energy supply and pellet production. It announced today that conversion of a fourth of its six units to biomass firing is well under way.

And despite today’s earnings dip, chief executive Will Gardiner pointed out that operational performance remained good, with the prospect of improved generation margins in the second half.

This has drawn Drax and its dividend into the view of more investors, with shares up 60% between mid-February and last week. In April, for example, Bank of America Merrill Lynch placed a 425p price target on the stock and highlighted the potential for a big upside from reducing biomass fuel costs.

The shares, which had been trading as high as 800p in 2014, fell back 5% today.

Despite the projected full-year dividend coming in below their estimate for £75 million or 19.2p a share, analysts at RBC highlighted the scope for further big increases in shareholder returns through enhanced dividends and buybacks in the next few years — subject to capex plans.

They said:

"We continue to forecast Drax maintains significant balance sheet headroom, with the potential for dividends to double to 2020."

And if Drax can continue recent progress on lowering the generation costs of biomass, RBC said it may be possible to run biomass without subsidy post 2027.

They added:

"We continue to see robust free cash flow generation and the potential for Drax, via a combination of dividends and buybacks, to return 100% of the current market cap (of £1.4 billion) back to shareholders by the time coal units are likely to close in 2025, as the key attractions in the investment case."

Gardiner took the helm at the start of 2018 after Dorothy Thompson, one of the City’s longest-serving chief executives, stepped down after 12 years.

Under her leadership, the site dramatically cut its carbon footprint and now accounts for around 15% of the UK’s renewable electricity. It is currently working towards a coal-free future through plans to switch its remaining coal-fired units to gas.