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May 2010

Drax Group (DRX) – 367.3p

SECTOR - ELECTRICITY 

The top end of the UK market has recovered very strongly over the last year or so, defying concerns over the fragile global economy. In our opinion, this has left many constituents of the FTSE 350 looking fully valued. However, there are still some companies with scope for upside and whilst it may have paid to concentrate on momentum plays in recent months, we have identified a share which should now be poised for recovery.

Drax Group has been out of fashion for some time and the company has seen its share price considerably underperform the broader market. The reasons for this are fears about the company’s credit rating, with a downgrade potentially on the cards, whilst some analysts are downbeat about the prospects for the sector, believing that tough times lie ahead. Although we agree that there will be challenges going forward, it appears to us that these fears have caused an overreaction in terms of the share price fall, especially when the stock market has been so buoyant.

The company owns Drax Power Station, the largest coal-fired power station in the UK. The plant currently generates around 7% of the UK’s electricity needs. A £2bn dedicated biomass project, which would be a joint venture with Siemens, is currently under consideration and this would require a significant contribution from Drax Group.

Given the exceptionally low UK base rate, it seems logical to us that income seekers should look to quality equities and there are few companies in the FTSE 350 with a higher prospective dividend yield than Drax Group. Although the payout was cut in 2009, consensus forecasts are for total dividends of just over 30p per share in the current year and that translates into a very healthy income return of over 8%. Analyst opinion is divided as to the likely level of dividends in the medium term and much will depend on the profitability the company is able to deliver. However, it seems that fears the payout will be slashed again have driven the share price down and should this mood change then there could well be a surge of buying interest. Equally, it is not beyond the realms of possibility that there could be potential buyers running their rule over the company given its current valuation. Borrowings have fallen to historic lows and the value of the equity is such that a sensible deal to buy Drax Group could be completed way above the current share price. Whether shareholders would be interested in selling is another matter, but both historic and projected free cash flow is chunky. As the business stands it would certainly provide an excellent initial rate of payback to anyone able to put together a successful bid.

Although there is a broad range of opinion amongst analysts as to how the company will perform, even the most pessimistic projections would see the shares trading on a single digit multiple for 2011. At the higher end, some forecasts suggest earnings per share of over 60p for both 2010 and 2011 and, if this performance was achieved, then the share price will surely move substantially higher on a 12 to 18 month view. Bears of the stock suggest that the UK generation market could be oversupplied for several years and this will see profits plunge, making the current level of dividends unsustainable. This is a valid point, but it appears that such fears have dragged the share price down too far. Although gearing is currently low by historic levels, commitment to the biomass project would require significant investment and that fact is no doubt unnerving some potential investors.

An interim management statement is scheduled for 18 May and given recent performance it would be no surprise if the share price was to drift further ahead of the announcement. The shares went ex-dividend on 28 April (dividend of 9.6p payable on 14 May) and it is possible that some investors who held on for the dividend may sell in the short-term. We would suggest that the shares look cheap at around the 350p level. BUY. (CJB)

there are few companies in the FTSE 350 with a higher prospective dividend yield than Drax Group.