Drax Group (LSE: DRX) and Gulf Keystone Petroleum (LSE: GKP) have been two of this year’s most disappointing investments, falling by 52% and 76% respectively.
Will things start to improve in 2016? I’ve been taking a fresh look at each company to find out more.
Drax Group
The biggest single reason for the fall was the government’s surprise decision in July to remove renewable power generators’ exemption from the Climate Change Levy (CCL).
Two of Drax’s six power-generating units have already been converted from coal to biomass, with a third in the pipeline. The loss off the CCL example was bad news for Drax. The group expects its earnings before interest, tax, depreciation and amortisation (EBITDA) to fall by £30m this year and by £60m in 2016 as a result of this change.
For investors, it’s difficult to know how to value Drax. Earnings are expected to fall by 60% to just 5p per share in 2016. The firm’s dividend has already been halved and is expected to fall again in 2016. I’m not sure how profitable Drax’s biomass-fired power will be over the medium term.
On the other hand, Drax has a strong balance sheet with minimal debt and a reasonable amount of cash. Despite this year’s setbacks, Drax is expected to remain profitable.
My view is that Drax shares are cheap if the firm can return to anything like its historic levels of profitability. However, if proves to be impossible, Drax stock may still be too expensive.
Ultimately, the government’s inconsistent approach to energy policy means that Drax remains too risky for me.
Gulf Keystone Petroleum
Gulf Keystone shares currently trade at around 16p, valuing Gulf at £157m. However, even this could be too much if the firm ends up defaulting on its bonds. This is a real possibility.
Based on Gulf’s interim results, the firm’s operational costs are running at about $8.2m per month, or $98m per year. In addition to this, Gulf has to make interest payments of about $26m, twice a year. In total, these costs add up to about $150m per year.
Yet Gulf’s revenue, based on the current $12m monthly payments from the Kurdistan Regional Government, will only be $144m per year. The shortfall between revenue and costs will be made up from Gulf’s cash balance, which was $54.6m as of 2 December.
This means that unless revenues increase sharply, Gulf’s cash balance will fall steadily. There is almost no chance of the group being able to repay the capital amounts on its bonds when they become due in April 2017 ($250m) and October 2017 ($325m).
Gulf’s eroding cash pile could also cause it to default on its bonds before they become due. The terms of the firm’s debt apparently require it to maintain a cash balance of at least $32.5m.
If Gulf defaults on its bonds, the firm’s bondholders might well choose to take control of the firm and wipe out shareholders completely. This is what happened with Afren earlier this year.
I can’t see any reason to buy Gulf Keystone stock. If I wanted exposure to Kurdistan oil and the chance to profit from rising oil prices, I would invest in Genel Energy instead.