As this column has discussed in the past, there are a number of reasons for the wind sector's out-performance, including the manufacturer-friendly turbine supply and demand (im)balance, strong underlying sector growth, significant advance "framework agreements" for wind turbine orders, positive investor sentiment about green power, and the seemingly successful restructuring and industrial performance plans at a number of the companies. That is a long list of ingredients for share price out-performance even before the appearance in the last quarter of the most potent additive to the mix: a good dose of merger and acquisition activity (M&A).
The takeover battle for Repower -- in its third round in late March -- has dominated the headlines and the share prices of the listed wind companies over the past quarter. Areva and Suzlon have been slugging it out since January when Areva tabled its first offer (page 36). Repower has long been the subject of M&A talk, specifically because of the presence of Areva on its share register; there ought to have been no real surprise on announcement. Nonetheless, actual activity focuses investors' minds like nothing else, especially when they think there is another, higher offer potentially out there. Repower's share price, which had risen sharply before the initial Areva announcement, rose above the Areva offer price on this expectation. Suzlon's counter offer drove Repower's share price even higher before Areva weighed back in with a second, improved offer. The latest Areva offer represents a 95.9% premium over the average share price for the three months prior to the initial offer -- and still the share price is above Areva's latest offer. That level of premium, which is essentially saying that Repower has doubled in value, is extraordinary for any sector.
The M&A effect echoed throughout the rest of the European wind stocks, most noticeably with Nordex, whose shares rose 87% over the last quarter. Vestas, Clipper and Gamesa also all outperformed, posting 18.0%, 16.8% and 15.5% gains over the quarter, compared with a 3.2% increase in the broader market. The recent price surge in wind stocks, centred on the M&A activity, raises a number of questions for longer term investors, the main one being: are the valuation levels sustainable and what will the M&A activity do to those companies that stepped into the ring to slug it out?
The "dare to be great situation" is a term of common currency on Wall Street, also echoed in the occasional Hollywood movie. The same phrase has been used in the M&A market for years to describe situations where a potential buyer is looking to transform or expand their business with a large, daring acquisition. Suzlon has dared to be great with admirable approach and resolve, even aside from the final outcome with Repower. As with its purchase of Hansen, a major gearbox supplier to the wind turbine industry, Suzlon has demonstrated an ability to move quickly and decisively. Public companies are often captives to short term earnings and analyst expectations. It genuinely takes bravery to present a transaction that is going to reduce, let alone not increase, short term earnings. Predictably, Suzlon's analysts did not like this about the Repower offer and some raised questions over valuations. It is a tension to be expected around a company looking to play a leading role in a fast changing, dynamic industry. Suzlon's share price fell 23.5% over the last quarter, primarily on the back of reaction to the Repower situation, disappointing quarterly earnings, and a general market correction which sent the broader Indian market down 6.4% for the period.
It is premature to jump to conclusions about the impact of the Repower battle on its participants. Auction winners can sometimes end up being the losers if they overpay -- and auction losers can move on to win the next battle. To date, investors have been the real winners. The question of whether current valuation levels can be sustained, whether the underlying business prospects justify the prices or whether it is just takeover speculation fumes, is also unresolved. Investors would do well to keep one eye on the past.
An eye to cyclical ups and downs
The other eye might be usefully employed in keeping a watch on the cyclical nature of manufacturing businesses in general: they go through up periods of profitability and down periods of reduced profitability. Typically, the cycles are tied to overall market conditions, demand for products, commodity prices and whether there is too much or too little production capacity at any given time. For wind, another industry-specific trigger has been wavering energy policies. A common response to a shortage in production capacity is a rush to build more, which eventually results in an excess, causing prices and profitability to fall. The wind sector these days is trying to manage the challenges of cyclicality. Framework agreements with customers is an important tool, as are attempts to better balance sales among different markets. The industry is clearly enjoying a period of upswing and enhanced profitability. But unless the sector is different from any other manufacturing business, the upswing will be followed by a downdraft.
The current M&A frenzy has momentarily distracted most of the market from these thoughts. The release of 2006 results is a timely reminder to analyse the listed wind companies based on their fundamentals. Gamesa was the first to release its headline numbers, which analysts viewed as being broadly in line with consensus, though some were disappointed. The view of Gamesa, though, continues to lie in the shadow of whether and when its majority owner, Iberdrola, will reshape the company. One analyst comments that the sole reason for its "buy" recommendation on Gamesa is the expectation of such M&A activity in the next year or two. Vestas, Repower and Nordex followed with their preliminary results, each showing increased profitability, increased revenues -- particularly pronounced in the case of Nordex and Repower -- and strong order books. The challenge is to spend the time looking past the headline numbers, past the M&A froth, and into the depths of what happens next from a fundamental perspective.