Why Vestas Is Undervalued

Every security is a sell at one price, a hold at some lower price and a buy at yet some further decremented price when value is appreciably higher than the stock quote. Before the corrosive global financial crisis and at the apex of crude oil prices, Vestas Wind Systems (VWDRY.PK) closed at about $48/share on June 16, 2008. Today, shares trade hands around $3/share. That represents a breathtaking 94% reduction in Vestas' share price.

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To be sure, Vestas was to be avoided at $48/share, but has the market punished Vestas' share price enough that it now represents a compelling buying opportunity?

Business Overview:

Vestas Wind Systems A/S engages in the manufacture and sale of wind turbines and wind power systems in Europe, Africa, the Americas, and the Asia Pacific. It also offers wind project planning, procurement, construction, and operation services; and after sale services, as well as sells spare parts. The company was founded in 1898 and is headquartered in Aarhus N, Denmark. (Source: Yahoo Finance)

It is important for investors to consider the industry in which Vestas operates. Not only does Vestas compete with other wind turbine manufacturers, but Vestas also faces competition in the broader energy market from solar, coal, hydroelectic, natural gas, oil, among others. It's similar to how Coke (KO) perceives its competition: It's not competing in a narrowly defined market for carbonated soft drinks, it's competing to satisfy its customers' thirst so its product portfolio needs to be broader than just carbonated soft drinks. While Vestas only plays in the wind energy market, there are a number of reasons why wind energy will be in vogue in the future and why Vestas is undervalued.

The Bear Case For Vestas:

Before I buy a proportional interest in a business, I always want to know why others are willing to sell to me at a price less than I estimate intrinsic value to be. After a review of Vestas, there are a number of reasons I believe sellers want to dispose of their shares. Below is a discussion of those items.

Competition from other sources of energy. The alternative energy industry has been criticized for not being cost competitive with other forms of energy including oil, natural gas, coal, solar and nuclear. I don't claim to be an expert at the macro level with respect to the energy industry, but I know that the cost of other forms of energy and Vestas' share value are positively correlated: When the cost of alternatives to wind energy increase (or conversely, wind energy cost decreases), Vestas' share price should increase as customer preferences shift. Moreover, as governments require higher percentages of consumable energy to come from renewable energy sources (the EU currently mandates that 20% of total energy must come from renewables by 2020), this will benefit the wind industry. Wind energy should also see continued benefits from the perception that nuclear power is a dangerous source of energy, considering the Fukushimi Daiichi power plant disaster after the earthquake and resultant tsunami in Japan in March 2011.

Competition within the wind energy industry. Although Vestas' wind turbines regularly outperform the competition in terms of efficacy, the wind turbine business is becoming a commodity business with low cost competition coming from producers in China and brand name outfits like General Electric (GE), Siemens (SI) and Gamesa (GCTAY.PK). Vestas is not currently the low cost producer, but is taking aggressive measures to minimize its cost structure (more on that later). Vestas does, however, possess the best intellectual property and intelligent design solutions for wind turbines. Vestas reports that its turbines only allow a miniscule 2% in Lost Production Factor (LPF) which is the share of wind not harvested but passing through its turbines. Management expects that factor to drop below 2% in 2012, and is well below the LPF of its competitors.

Reliance on tax benefits. In order for the wind industry to remain competitive in the near term, Vestas relies on tax benefits bestowed by governments. With government coffers running thin, many believe politicians' fortitude to subsidize cleantech industries is waning. Vestas cites the Production Tax Credit (PTC) in the United States, which is set to expire in 2012 unless legislation is passed to extend it as critical to its near-term business prospects. Management maintains it is willing to take necessary measures to protect the company should the PTC expire. I don't particularly like holding my investment dollars hostage to government decision-making, but I think the severe drop in Vestas' equity value more than compensates for this risk.

Management turnover. Vestas issued two profit warnings in 2011 which caused investors to question the efficacy of Vestas' leadership team and led to the recent resignation of the CFO. While the warnings were poorly received by the Street, I think the steep decline in Vestas' share price is irrational. Here's why: Management uses two different accounting concepts when recognizing revenue (1) percentage-of-completion for turnkey projects whereby revenue and income is recognized as it is earned; and (2) completed contract method where projects don't qualify for percentage-of-completion accounting treatment, and management recognizes revenue only when risk of the transaction is transferred to the buyer. As a shareholder, why should I care if a certain transaction requiring completed contract accounting treatment was delayed only to be realized in the next quarter? Equity ownership derives its value from all future earnings irrespective of which quarter they are recognized. The profit warnings scared investors into thinking that the revenue for those delayed projects won't occur. However, revenue and profit will probably be realized on those projects in Q1 2012 when completed. For my medium- to long-term investment time horizon, I don't care much about the specious quarterly timing of revenue or profit from a financial accounting perspective. Only that the project gets done profitably.

Not in My Back Yard (aka "Nimby-ism"). While there is an overwhelming consensus regarding the need to create and use renewable energy, one of the headwinds lies in the transmission of that energy. People want renewables, but they don't want a wind turbine in their neighborhood, or power lines above ground sullying the views of the landscape around them. Living in Massachusetts for a few years, Nimby-ism reared its pejorative head for a proposed wind turbine project in the gusty Nantucket Sound off the coast of Cape Cod and Martha's Vineyard. Likewise, the NY Times reported on a similar topic with respect to the recently nixed Keystone XL pipeline that was supposed to transport oil from remote parts of Canada to the Gulf of Mexico. The deal ran into trouble with environmentalists and the Obama Administration when it was discovered the planned route for the pipeline would run underneath the Ogallala Aquifer in Nebraska. While Nimby-ism is of concern to me as a shareholder, I again believe the share price more than reflects such concerns and ignores the positive catalysts on the horizon for Vestas.

What is it exactly I'm buying? Another thing that is of concern to investors is understanding exactly how much of the business they are purchasing when they acquire a share of Vestas. Because Vestas is listed on a number of stock exchanges, including the Copenhagen exchange, numerous German exchanges including Frankfurt, Berlin, Munich and Hamburg, and the over-the-counter (i.e., pink sheets) market in the United States, it is disconcerting for investors trying to figure out what exactly their ownership stake is of the company. Paying more or the same for less is a recipe for investment disaster. In the 2011 annual report, Vestas reported 202.4 million shares outstanding, up from 185.2 million in 2007, which represents about a 9% dilution of equity owners' proportional interest in the company. That dilution is only a sliver of the 94% loss in Vestas' share price since the summer of 2008.

The Bull Case For Vestas:

Now that I have a pretty good idea about the bear thesis, what are the catalysts that can align price more closely with the higher value I ascribe to Vestas' equity?

Changing business model. Vestas' management now realizes that wind turbines have become a commoditized product, where the lowest cost producer has competitive advantage. That is evident from the recent earnings call where management indicated that they chose not to participate in the bidding process for certain turbine projects because prices were too low, and the admission that its operating costs are too high to compete effectively. Vestas reported a EUR 258 million operating loss in 2011 for its wind turbines, spread across all its geographic segments including: Europe and Africa; the Americas; and Asia Pacific. However, those losses mask the prospering business performance in Vestas' services segment where the company recorded a EUR 110 million operating profit in 2011. (Full disclosure: That figure is before an allocation of group overhead costs which management footnoted in the annual report.) That represents an operating margin of about 16% on EUR 705 million in service sales. Management expects EUR 850 million in service sales in 2012 with an operating margin of 14%, equating to a pro forma operating profit of EUR 119 million. With 202.4 million shares outstanding, 2012's expected operating profit in the service business represents about EUR 0.59/share, or about 20% of the current share price. When the wind turbine business stabilizes and the balance of Vestas' restructuring activities are put in place, investors will realize Vestas is a bargain after the strength in its service business is exposed.

To further cement the thesis that the wind turbine servicing business will only become more robust, look to the rapid growth in the installed base of wind turbines. According to the World Wind Energy Association (WWEA), the total installed capacity for wind reached 239 gigawatts in 2011, up from 2.4 gigawatts in 2001. As more wind turbines are installed, this will represent a catalyst for Vestas as the company is called on to administer and repair existing wind turbines. Management indicated in its annual report that it will begin to strategically render service on non-Vestas turbines.

New market identified: wind turbine blades offshore. In 2015, Vestas will begin delivering its new V164-7.0 megawatt (MW) wind turbine, which is the first dedicated offshore turbine in Vestas' product portfolio and it represents the largest R&D spend in its history. Vestas estimates that given the wind production and size of the North Sea, that 27,500 of these offshore turbines over a 141x141 kilometer area could generate enough power to satisfy all European households. Similarly, 44,500 of these turbines over a 171x171 kilometer area could power all households in the United States. Of course, power transmission and other headwinds will likely need to be overcome. For starters, though, Vestas has the option to acquire 70 hectares of land in the Port of Sheerness in Kent, United Kingdom through 2013. Lofty goals indeed, but I don't plan on taking the wind out of Vestas' turbines, especially when these offshore turbines in particular likely won't fall prey to Nimby-ism.

Investors have capitulated. Seasoned investors know that when there is blood on the Street, it's time to put capital to work. If investors believe Vestas will remain solvent, then $3/share appears to provide a wide margin of safety. The market may remain irrational for some time, so it is advisable to open with a third or half of the intended position in case the share price should fall further, so more shares can be purchased at a lower price if the fundamentals remain unchanged. The company expects positive free cash flow in 2012 and its EUR 600 million bonds at 4.625% come due in March 2015, plenty of time to right the ship and make scheduled interest and principal payments from increasing cash flows from operations. My main point is that if investors have a concern about bankruptcy, I think it is rather unlikely (see next point below).

Share buybacks. Believe it or not, management retired 700,000 shares in 2011. The board of directors authorized management to acquire up to 10% of outstanding shares up until the next general annual meeting on March 29, 2012. While Vestas won't fill the treasury with 10% of outstanding shares in its remaining authorized time, it could still put a dent in the share count at current depressed share prices. Not only does this insight provide an indication of near term demand and a price floor for Vestas' equity, but it also indicates insiders' bullishness on the future prospects of the business. For a company to authorize such a large equity stake for its treasury, I surmise there is rosy piece to the Vestas story that investors aren't detecting.

Subsequent events. In January 2012, Vestas announced two orders totaling 79 MW of capacity in China and Finland. Management only announces orders that have a value in excess of EUR 66 million. While these were relatively small orders representing about 0.8% of the backlog (see below), it shows positive momentum for Vestas and illustrates that this company isn't going away anytime soon.

Increasing backlog. As of December 31, 2011, Vestas announced a record backlog of 9,552 MW and EUR 9.6 billion in sales value, both up substantially from 2010, the previous record backlog year. The backlog is split 60% in Europe and Africa; 25% in the Americas; and 15% in Asia Pacific. Part of that backlog was probably due to those projects that were supposed to be recognized in 2011, but the transfer of risk was delayed until 2012. Again, as an equity shareholder, the short delay in the timing of revenue and profit recognition is not of great concern (except for slight present value adjustments, perhaps). Artificially allocating revenue into quarterly buckets is done for accounting purposes, and slight adjustments to expected sales volumes in each bucket should be ignored. True economic value is not confined to financial accounting matching principals.

Restructuring the business. Management indicated that it plans to reduce the workforce in Europe, wringing out about EUR 150 million in annual fixed operating costs (or about 2% of the EUR 7.25 billion midpoint of 2012 expected sales). In addition, Vestas announced as part of its 'New Vestas' initiative that it will employ new lean manufacturing techniques by outsourcing many of the components for its turbines to its manufacturers that itself once made. This should free up additional working capital and reduce inventories. Other manufacturing activities will be consolidated and management will make the requisite investments to grow the service business.

Little to no defined benefit pension liability. Vestas estimates that 99% of its pension expense is related to its defined contribution pension plan. As a shareholder, I like that statistic because it removes uncertainty regarding the future cash payments needed to satisfy any defined benefit promised. Once Vestas provides the matching contribution under the rules of the defined contribution plan, its pension liability is eliminated.

Shareholder friendly jurisdiction. For what it's worth, I prefer to have my investment dollars allocated to companies and countries where effective shareholder regulations exist and where principled corporate governance takes high priority. Management was even implored by large shareholders to be less transparent, only reporting and forecasting a few investable metrics such as free cash flow, operating margins and revenues in order to reduce static around the measurable operating results of Vestas.

Conclusion:

In any stock transaction, sellers believe value is deteriorating while buyers maintain conviction that value is appreciably higher than the transaction price. It's a tug of war and future business performance will ultimately determine the winner. I'm in the camp that believes Vestas is undervalued at current price levels and that it deserves at least a small portion of an investment portfolio. If the stock price goes even lower, Vestas will only become a better buy should the investment thesis remain materially intact. Vestas' management likes to point out that wind energy is as green as it gets. I think my brokerage account will agree as catalysts play out.

Disclosure: I am long VWDRY.PK.