The latest Investing Matters Podcast episode featuring financial educator and author Jared Dillian has been released. Listen here.
It is indeed worrying. I think Kerley is hoping that a recovery in Asian markets will come to the rescue and mask the capital erosion from his dividend-washing tactics. In any event, this Trust will be a low-growth vehicle compared with others in the sector.
I've had another look at the annual report. I don't think "interest income" is going to offset higher borrowing costs. These are mostly loans to subsidiaries that don't earn interest for the group. The critical paragraph is on p58:
"Apart from any drawings under two revolving credit facilities for an aggregate
of £145m that expire in 2022 and 2024, there are no borrowings by the Company or any of the HoldCos or SPVs that are expected to be refinanced."
Let's assume borrowing costs increase by 3% per annum on £145m. That's £4.35m per annum, which has a present value of £69m at 6.3% interest. This about 10% of the current net assets of NESF, which would justifiy a 10% reduction in the share price.
They might well reduce borrowing, but that won't improve earnings per share. Even borrowing at 6% p.a. improves shareholder earnings if UKW achieves its projected return of 7.7% p.a. on its wind farms. The benefits of cheap credit are coming to an end. Maybe it will knock off 1% per annum from the return on UKW shares. But still a very good investment at the current price.
I think I see what the problem is. Although the interest rates on UKW's debts are effectively fixed by hedging, the average term of the debts is only 4-5 years. As the average interest rate on these debts is only 3% per annum, it's likely they will be refinanced at much higher rates. If we assume future borrowing costs double to 6% per annum, that will be an additional £25 million interest paid every year. By my calculation, this knocks about 8% off the value of the business, justifiying an 8% reduction in the share price.
There are two possible explanations for the price fall:
1) Anticipation of higher discount rates (as a result of higher gilt yields) that will reduce calculated net asset values. This is not something that will affect future profits and dividends.
2) Higher borrowing costs for new loans (not existing loans which are hedged).
3) Higher interest earned on new debt investments.
(2) and (3) WILL affect future profits and dividends, but as the annual report indicates borrowing and debt investments are roughly equal, the net effect may be small. It will depend on how much the Trust earns from this debt arbitrage, which isn't clear from the accounts.
Logically, higher borrowing costs should only affect how the revenue stream is split between interest and dividends. It should not affect the revenues generated by renewable energy.
It's because of the sudden increase in gilt yields. The discount rate used to value projected UKW cash flows is the gilt yield plus a risk premium. If the discount rate goes up, the net asset value goes down. The projected cash flows have not changed, so anyone brave enough to buy now should achieve a higher return in the long run.
The most credible explanation for the recent price falls in this sector is the expectation that the discount rates will increase because they are calculated as gilt yields plus a risk premium. Higher discount rates will lead to lower net asset values. Another possible explanation is anticipated higher borrowing costs, but this is not identified as a risk in the annual reports, which suggests that future borrowing costs have been hedged with swaps. I don't think anything has happened to change future revenue projections.