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Trader Talk is produced by a team of active traders, analysts and various derivatives professionals from multiple organisations. Trader Talk provides comment on equities, commodities, and other financial instruments based on both technical and fundamental analysis.
Headwinds ahead for Drax
It has been another strong week for UK equities as investors react to a highly anticipated solution to the Eurozone sovereign debt crisis.
Policymakers delayed an announcement from last weekend and subsequently cancelled the mid-week meeting between EU finance ministers, known as Ecofin, as the finer details of the meeting had not been finalised.
On Wednesday however, European officials announced the outline of a plan aimed to draw a line under the spiralling debt problem that has threatened the global economy. Under the deal, private sector holders of Greek debt have agreed to voluntarily accept a 50% cut in its investments, which will reduce Greece’s debt burden by €100 billion, lowering its debt to 120% of GDP by 2020 from 160% currently.
Simultaneously, the European Financial Stability Facility, which has been used to support Ireland, Portugal and Greece, has been leveraged four to five times to around €1 trillion. This will be used to offer a credit enhancement to those that have taken a haircut on their Greek exposure and to provide on-going support to the region as a whole.
Against that backdrop came further negative news from Italy, after the country’s inability to deliver a sustainable plan for reforming its pensions system raised doubts about Prime Minister Silvio Berlusconi’s ability to tackle the crisis that threatens the economy. Italy has the largest sovereign bond market in Europe, with public debt at 120% of GDP.
Global economic data has largely been affected by the on-going uncertainty in Europe, with Eurozone PMI slipping to 47.2 in October from 49.1 in September, below forecasts of 48.8 and its lowest level since July 2009.
UK factory orders fell at their fastest pace in a year in October to -18 from -9 in September, as exports declined and firms expected to cut output as worries about the debt-crisis weighed on sentiment.
The mood amongst US consumers also deteriorated further this month, with the Conference Board’s consumer confidence index plunging to 39.8 in October from 46.4 in September. This was well below the 46.0 expected by economists and is back to levels last seen during the 2008-2009 recession.
Technical analysis captures the recent increase in risk appetite, with the FTSE 100 gaining 17% in the past few weeks. The index has catapulted through resistance from the 50 and 200 day moving averages at 5370 and 5572 respectively and moved above key historical support at 5600.
The oscillators are however, extremely overbought with the majority of metrics near all-time highs. Support is now seen at 5572, 5490 and 5400 with the next upside target at 6000.
In conclusion, it has been an incredible move for equities of late. Despite the deteriorating macro-economic backdrop, investors appear to have solely focused on a resolution in Europe and see the recent announcement as a building block for an economic recovery.
In practice however, much good news has already been priced in and I am sceptical that the risks have been removed. Aside from the Eurozone debt, global economic data has continued to deteriorate with many metrics declining to levels last seen in 2009, when the FTSE 100 was at 3600. Debt in many peripheral nations is at historically high levels, at multiple to GDP and any continued deterioration in economic conditions will take its toll.
Drax (LON:DRX), which operates the largest coal fired power station in the country, received a boost from the UK Government’s plans to increase incentives for power firms to switch to biomass to reduce carbon emissions.
Biomass is an eco-friendly renewable energy source that Drax plans to invest heavily in. The group however, was hoping to get a greater financial incentive from the Government and prompted CEO Dorothy Thompson to call for a moderate uplift in subsidy to make it viable.
A glance at the above chart of Drax highlights the relative strong performance with the shares gaining 45% year to date, considerably above the European utility sector.
First half results on 2nd August showed a healthy increase in operating profit to £169 million from £132 million last year, as it also benefited from a £198 million one-off tax credit after negotiations with HMRC. Revenue also grew to £866.3 million from £780.6 million in 2010.
The company however, faces a number of headwinds. Despite an improvement in the first half of 2011, underlying profits for the full-year 2011 are expected to be below 2010, due to escalating forward prices for electricity and coal. Drax is also facing the prospect of considerable green taxes on carbon emissions as free CO2 emission permits cease in 2013.
Drax now trades on 11x earnings, considerably more than the 7.4x it traded on earlier this year and with only 7% growth forecast into next year, it puts them on an unappealing PEG of over 1.5.
Technical analysis of the chart indicates the oscillators are overbought and showing early signs of weakness. The MACD histogram is stepping lower and the stochastic has intersected to the downside, indicating the recent momentum is deteriorating. The shares are also trading within close proximity of major resistance at 541p.
It has been a good year for Drax, but margins are now probably at their peaks. The biomass announcement was not as positive as hoped and with several headwinds ahead, I believe the shares are too high.
At the time of writing the share price is 529p and with a stop-loss marginally above resistance at 551.5p, a short trade offers an attractive risk / reward bias. Short-term targets are seen at 501p, 487.5p and 462p.
This report was written by Mark Allen – Head of Derivatives at Simple Investments Stockbrokers. The writer does not hold a position in Drax, but client accounts may. The material in this report has come from Simply Charts and Drax’s corporate website.
