Orsted Navigates Q4 Challenges: Dividend On Hold, Equity Raise Sidestepped (DNNGY)

Last year was a tough one for Ørsted A/S (OTCPK:DNNGY), which saw massive impairments of roughly $4 billion on its Ocean Wind United States projects. This was the result of a decision to cancel them, due to several factors including high inflation, rising interest rates, and supply chain issues that made them no longer viable.

Investors had been waiting to hear how the company would update its business plan, and whether this would include a capital raise to shore up the balance sheet. This was among the least favored options by investors, considering shares are trading at a fraction of their peak price a few years ago, and currently considered significantly undervalued by many. Fortunately, the company today said they would resort to other options. This might have been influenced by the fact that the Danish government owns 50.1% of the shares, and would have lost its controlling position if it didn’t participate in the offering.

On February 7th the company presented an updated business plan based on a comprehensive portfolio review. The good news is that no equity issuance is being planned, the bad news is that the dividend will be put on pause for three years, some projects will be removed from the pipeline, and there will be cost-reduction measures. This includes reducing fixed costs by DKK 1 billion (~$144 million) by 2026 compared to 2023, on a like-for-like basis. This will include a reduction of 600-800 positions globally.

The company will also accelerate its divestments and farm-downs. These are expected to contribute with proceeds of roughly DKK 115 billion (~$16 billion) towards 2030, of which roughly DKK 70-80 billion (~$10 billion to $11.5 billion) are expected to be completed between 2024 and 2026. Additionally, the company is significantly reducing its planned CapEx from today to 2030 by roughly a third compared to the previous plan.

In some ways, the company is making some lemonade from its “lemon” projects. It has dramatically improved its risk management, even if that means not pursuing some opportunities. In fact, this has forced the company to really concentrate on its best risk-adjusted projects and put aside the ones that were expected to create less value. As one analyst noted during the event, the 2030 guided EBITDA was less impacted than expected given the reduction in CapEx. He asked if this was due to the remaining projects being more profitable on average, to which the company responded affirmatively.

Orsted expects EBITDA (excluding new partnerships) to increase to close to DKK 39-43 billion ($5.6 billion to $6.2 billion) in 2030, corresponding to an annual growth (“CAGR”) of 8% in the period 2023-2030. The previous target was DKK 50-55 billion ($7.2 billion to $7.9 billion) in 2030. On the positive side, this will require about one-third less investment, and some of the riskier projects have been removed from the pipeline. Importantly, the company is maintaining its return on capital employed (ROCE) target of approximately 14% on average during 2024-2030. It is committing to maintaining a solid investment-grade credit rating, and it is raising its funds from operations to net interest bearing debt ratio target from 25% to 30%. The company is also taking the decision to pause dividends for three years. This means investors should not expect to be paid a dividend until 2027, but management said they expect to pay a meaningful dividend once reinstated.

Lessons Learned

The company admitted during the call with analysts that it learned some hard lessons from last year’s experience. For example, they will drastically reduce investments pre-final investment decisions to something around 10%. The company admitted that with Ocean 1 they were closer to 30 to 50%, which was excessive even if they might be able to recover or reuse some of the investments.

Another lesson learned by the company was the importance of inflation-linked or adjusted contracts, especially when it can take several years from initial development, permitting, and supplier contracting, to the commercial operation date (COD).

FY23 Results

Putting aside the massive impairments the company took, underlying financial results were actually quite solid, with adjusted EBITDA slightly above the company’s previous guidance. This was in part due to higher wind speeds in 2023 compared to 2022, despite still being somewhat below what the company considers to be long-term average speeds.

New projects put in operation contributed meaningfully to growth, while traditional CHP power plants saw their contribution decline as fuel costs rose and power prices declined.

Financials and Growth

While less ambitious compared to the previous business plan, we find the targets quite decent, and they also appear more achievable. Especially with the company’s focus on quality over quantity, and in a certain sense being in the privileged position that with a massive project development pipeline, it can concentrate only on the best opportunities and still deliver meaningful growth.

2024 Outlook

In terms of EBITDA, the 2024 outlook shared by the company reflects a combination of tailwinds and headwinds. The company will benefit from the ramp-up of generation from Greater Changhua 1 and 2a, South Fork, and Gode Wind 3, but will also see a significant increase in expenses from DEVEX and Other. This is mostly driven by costs related to the Ocean Wind 1 cancellation, and accounting modifications where the company will expense a higher share of its cost base instead of capitalizing it.

With underlying results for 2024 being guided to be only modestly higher, and no dividend for three years, investors might be discouraged. However, things look more positive when looking at the medium and long-term potential.

Medium-term Outlook

Something we appreciate with Orsted is that for the most part, they are self-funding growth, with most of the required capital sourced from a combination of retained operating cash flows, asset recycling, and modest increases in debt and hybrid securities (similar to preferred shares). According to management, adjusted net debt should be roughly the same in 2026 compared to the end of 2023. Still, with such massive capacity under construction and some additional awarded and pipeline projects, the expectation is that installed capacity should be about 50% higher in 2026 compared to 2023.

Long-term Outlook

Compared to the previous plan, in the new 2030 plan the percentage of capital the company is counting for expansion from its own operational cash flow has increased to ~50%, with partnerships, divestments, and tax equity taking care of most of the remaining capital needs. It expects to source only about 5% from debt and/or hybrid securities.

Most of this capital is expected to fund investments, with only about 15% budgeted for paying the coupons on the hybrid securities and for dividends, which the company expects to start paying again in 2027.

What is very reassuring is that just with under construction, awarded and contracted projects, the company has a line of sight to an increase in gross renewable capacity of 27.7 GW, from 15.7 GW currently.

Balance Sheet

Net interest bearing debt of roughly DKK 47 billion does not appear excessive compared to the adjusted underlying EBITDA of DKK ~24 billion. This would imply leverage of ~2x based on the adjusted numbers. Still, for Orsted it appears the company and the credit agencies mostly focus on funds from operations to net interest bearing debt (FFO/NIBD). The company used to target an above 25% ratio, but it is now changing the target to the stricter 30% FFO/NIBD target going forward. When looking at free cash flow for 2023, we can understand why rating agencies would start to worry.

Credit Metrics

At the end of last year the company still retained very strong credit metrics from the main rating agencies, including S&P Global Inc. (SPGI) and Moody’s Corporation (MCO), but they have the company either with a negative outlook or on credit watch. This is an important reason why the company had to come up with a revised business plan, which hopefully now avoids a rating downgrade.

Orsted believes it will be significantly below its 30% FFO/NIBD target in 2024, but should be close to the target next year, and comfortably above it in 2026. The main drivers for this are expected increased earnings from projects commencing operations, with adjusted net interest bearing debt remaining stable.

Valuation

While we acknowledge that Orsted will continue facing some headwinds in the short to medium term, we believe that shares have been overly punished. While the new business plan targets lower growth compared to the previous one, it is still a rapidly growing company in a sector with a lot of potential. Shares are currently trading with valuation metrics that are significantly below their historical averages. For example, the price/book ratio is around 2.1X, compared to a ten-year average closer to 3.5x.

The EV/EBITDA is also significantly below the historical average, and just a fraction of the peak value at which the company’s shares traded a few years ago. Admittedly, the valuation likely got excessive in 2021 and early 2022, but now it seems investors have become unreasonably pessimistic.

Orsted is trading with a market cap of around $23 billion, and an enterprise value of close to $29 billion. If Orsted meets its 2030 EBITDA target, this would represent an estimated EV/EBITDA of only about 5x. While there is no guarantee the company will meet its target, we believe this is too low for a leading company with unique capabilities in an industry that is likely to grow for at least several decades.

Risks

While the company’s operational projects are usually considered low risk, given that most of their produced energy is sold under long-term contracts to investment-grade customers or counterparties, there are significant risks with the development pipeline. This became evident last year with the massive write-downs the company had to take to cancel projects that became no longer attractive.

There is also a risk that offshore energy could be adversely affected if the United States decides to modify the Inflation Reduction Act. Orsted shared that they do not believe it would have much impact on projects already under construction, and for future projects they could redeploy capital to European or Asian opportunities.

Another risk includes a potential credit downgrade from one or more credit agencies, although we believe it is less likely now given the dividend pause, the strong adjusted underlying results, and the reduced CapEx plan. Still, the company said they believe they can operate with a slightly lower rating without that much impact.

Other risks we see are lower average wind speeds, a forward electricity price curve that has been declining, and potential future impairments if they cannot secure attractive prices for some of their development projects. One example is the Sunrise Wind project, where the company estimates a 75% chance it will secure an attractive contract and would mean reverting some of the impairment already taken, and a 25% chance that they fail to secure an attractive contract, which would mean increasing the booked impairment.

Conclusion

While it is painful for investors to suffer a dividend pause and reduced growth targets, we find the new business plan presented by Orsted as quite rational and achievable. The company appears to have learned from its mistakes, and is now being more cautious. There is even a silver lining in the fact that now the company will concentrate only in its most promising and value-creating projects. While there remain headwinds, including declining forward power prices, and a few projects that still have impairment risk, we believe shares are currently very attractively priced.

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