Simple But Powerful

Increasingly I try and benchmark my new investment ideas against what I would call Buffett Investment Principles. Usually I subsequently find out that each certainly wasn't a Buffett like investment but this process does at least help shape my overall thinking about what makes a good investment.

The inspiration I had today followed the Drax presentation to report on 2007 results. Drax is a very simple business with a single coal fired power station, by far the largest in the UK and which produces 7% of our electricity. These shares have been pushed down by investors spooked by the increased cost of coal (blame bulk shipping rates) and uncertainty about the future cost of carbon under the EU Emissions Trading Scheme. Simple it might be but Drax is affected by the cost of coal, electricity and carbon with oil and gas prices a part of the equation. These are very volatile factors and so there are just too many variables to make an accurate forecast of earnings over the next year, although Drax do hedge many exposures and this reduces the volatility. My interest is driven by some much simpler and more strategic factors:

• Coal has a strong future - management put global proven reserves at 900bnt which, assuming 6.5bnt pa production, suggests a reserve life of 140 years.
  


• In coal fired generation Drax is the low cost producer with the cleanest and most efficient UK plant.



• By being able to burn biomass Drax helps meet our Renewable power objectives



• Long term the UK energy supply market is tightening due to increased demand coupled with plant closures.



• Management put the cost of coal fired new build at £1,000 to £1,100 per kW. Thus the 4,000 mW of Drax would cost over £4bn to replace. This compares to a current EV of around £2.3bn.



• This is a focused business and management are committed to enhancing shareholder value through return of excess cash.

The message therefore is don't try and forecast all the variables but focus on the overall profitability driven by Drax as a highly important and strategic asset with capacity in a market increasingly becoming supply constrained. In the meantime the P/E is under 6.