Is It Time To Sell Drax Group Plc And Buy National Grid plc?

Shares in Drax (LSE: DRX) slumped by 28% yesterday after George Osborne announced that he was making some key changes to the UK’s  Climate Change Levy. 

As part of these changes, renewable energy companies will no longer be exempt from the levy. Currently, tax is not paid on renewable electricity generated under renewable source contracts, regardless of whether it is generated in the UK or abroad.

Drax is in the process of converting the UK’s largest coal power station into a plant designed to burn wood pellets, which are considered a renewable fuel.

So, the company stands to lose a sizable amount of income following this change. 

Latest setback

Unfortunately, this is just the latest in a string of setbacks for Drax. Indeed, during the past few years, the company has issued a series of profit warnings, net profit has fallen by 31% since 2010 and the group’s long-term debt has tripled. 

But what’s more concerning is the fact that Drax’s return on assets has collapsed during the past five years. 

Falling returns 

Return on invested capital is a key metric for measuring business efficiency. The figure gives a great indication of how well a company is using its money to generate returns. And the most efficient businesses, with the highest ROIC figures, are usually the best long-term investments. 

For example, National Grid’s (LSE: NG) ROIC has remained steady at around 7% per year since 2011. Over the same period, shareholder equity has expanded by 33%, and book value per share has grown at a compound annual growth rate of 13.5% per annum since 2010.

In other words, National Grid has been creating a significant amount of value for investors. It’s little wonder that the company’s shares have produced a total return of 15.8% per annum since 2010. 

Over the same period, Drax’s ROIC has slumped from a high of 29.4% to a low of 3.9%. Book value per share has increased at a compound annual growth rate of around 2% per annum since 2011.

So, it should come as no surprise that Drax’s shares have produced a total return of -0.6% per annum for the past five years. 

Unlikely to improve

Drax’s fortunes are unlikely to improve anytime soon. Estimates vary, but figures suggest that due to the tax changes announced yesterday, Drax’s earnings before interest, tax, amortization and depreciation could be lower by £30m this year, and £60m during 2016.

Analysts were expecting the company to report EBITDA of £193m for 2015. After factoring in the reduction of £30m, Drax’s EBITDA is now set to fall to £163m this year, 29% below last year’s reported figure. On the other hand, National Grid’s EBITDA is set to march steadily higher by around 3.5% per annum for the next three years. 

National Grid currently supports a dividend yield of 5.3%, and the payout is covered one-and-a-half times by earnings per share. City analysts expect Drax to cut its dividend payout by 40% this year, which will leave the company supporting a yield of 2%. 

Foolish summary 

Overall, National Grid looks to be a better investment than Drax.