ReNew Energy: Potentially differentiated product, not yet investment grade (RNW)

investment presentation

As we grapple with a range of macroeconomic factors, each of which has an impact on the cost and profitability of energy supply, the time is ripe for energy suppliers to bid.Renewable energy is the wild card, offering potential differentiation Compare to traditional energy suppliers in terms of pricing and core products. Renewable new energy (NASDAQ: RNW) has become one such name and more importantly its footprint in the Indian market.

RNW is a renewable energy supplier to the Indian market. Its clean energy portfolio is one of the largest in the world. As of June this year, the current installed capacity is approximately 13.7 GW. RNW also provides storage and trading for carbon markets. The company listed on Nasdaq in 2021, and since then, its stock performance has not lived up to the hype despite hitting bottom earlier this year (see Figure 1).

This report will unpack all the moving parts in the RNW investment debate and tie it into what I believe is the reason for the current moratorium on investment. While there’s a compelling argument for the company’s competitive position, I don’t think it will impact the economics, so say this is a screamer acquisition. Net net, interest rates remain unchanged.

figure 1.

Delving deeper into the Indian renewable energy market

India’s renewable energy market has experienced significant growth and transformation over the past decade, driven by several key factors, including (i) government policies, (ii) its global climate commitments, and (iii) economic dynamics. India has set an ambitious target to achieve 450GW of installed renewable energy capacity by 2030, focusing on solar, wind and hydropower. The compound annual growth rate is expected to reach 7.3% by 2028.

Main renewable energy

1. Solar energy has become a major renewable energy source and has made a huge contribution to the country’s total renewable energy. India is a sunny place and abundant sunshine, coupled with the falling cost of solar panels, has accelerated the adoption of solar energy. Both utility-scale and rooftop PV projects are attracting investment.
2. India also has a well-established wind energy industry and the country is one of the world’s largest producers of wind energy. Technical advances and supporting policies for wind turbines have encouraged further expansion. Offshore wind projects are also being explored in coastal areas due to its potential.
3. Given India’s diverse geography, hydropower plays a vital role in the country’s renewable energy mix. The government is focusing on improving the efficiency of hydropower and is exploring pumped hydro storage.

economic and investment flows

The cost of solar and wind energy technologies is falling, making them increasingly competitive with traditional fossil fuels. In India, this resulted in record low tariffs for solar and wind energy auctions, boosting investment in the sector.

Government initiatives such as ““Made in India” and ‘Atmanibal Bharat“It also promotes domestic manufacturing. So I think its renewable energy industry has a basis for competitive growth.”

Key Insights into Investing Fact Patterns

Takeaway Q1 FY24

[Note: as a reminder, RNW reported its first quarter fiscal ’24 results. This corresponds to Q2 CY 2023. For simplicity and consistency, I’ll talk in terms of 2024 from here. As a further reminder, all figures are quoted in USD, at the cross rate at the time of RNW’s reporting].

In Q1 FY24, RNW cut total revenue by approximately $305, down from $305 last year. EBITDA is 227mm and revenue is c. $36 compared to a net loss of $1 in 1Q23.

Regarding unit economics, please note the following:

• RNW sold approximately 5.1 billion kilowatt hours of electricity this quarter, a year-on-year decrease of 1.4%.
• In terms of spin-offs, the electricity sales of wind power assets decreased by 8.8% year-on-year, while the electricity sales of solar energy assets increased by approximately 9% year-on-year.
• Electricity sales from hydropower assets fell by approximately 9% year-on-year.

figure 2.

Something to consider is that RNW’s operating portfolio has grown significantly since ’22. In the first quarter, it reached 8.4 GW, an increase of 47% from the first quarter of 2022. Installed capacity also increased by 10% over the past 12 months, from 7.6 GW to 8.4 GW. As of the end of June, RNW’s portfolio comprised 13.7 GW, of which approximately 8.4 GW was operational and the remaining 5.3 GW was firmly committed.

image 3.

Looking ahead, RNW plans to commission 1.3-1.7 GW of projects over the remainder of the fiscal year. The company’s Peak Power and RTC projects are expected to be significant contributors to growth, managing projects to deliver over 35% EBITDA growth in FY25, with the company targeting commissioning guidance of 1.75-2.25 GW by the end of FY2524.

economic performance analysis

In the utility sector, particularly in the energy sector, a lack of differentiation is a significant challenge. It is difficult for suppliers to differentiate themselves in terms of cost, product offerings, and branding, so suppliers have few clear consumer advantages. Most suppliers follow similar pricing mechanisms and are indistinguishable since they all sell energy etc. This is similar to commodity producers, there is no cost differentiation/cost leadership, so the key insulators are production and efficiency factors. Therefore, the economic characteristics of each company are critical to identifying companies with a competitive position.

Renewable energy offers a potential antidote to this dilemma. The interplay of bidding and offtake is different from that in the traditional energy industry, so after-tax margins and capital turnover are expected to improve, potentially increasing the industry’s competitive advantage.

Figure 4 depicts RNW’s cash conversion cycle (“CCC”) and days receivables outstanding (“DSO”) on a rolling TTM basis since ’21. The company went public that year, but we have data going back to FY20. Crucially, lagging CCC tightened by about 150 days from 2022-23, with DSO at 102 days during the 51-day period in RNW Q1. At this conversion rate, taking into account the average of the past 2 quarters (assuming a 365-day year), its NWC can achieve 6.3x annual turnover.

What interests me most is the rate of return generated by RNW’s capital investment. In Figure 5, you can see that through the first quarter, the business had $8.2 billion, or $22.30 per share, at risk. This produced trailing after-tax earnings of $509, or about $1.40/share, and a return on investment of just 6.2%, in line with historical averages. Returns on new capital deployment are no savior here, with TTM down 6% and just 3% in December.

But here’s a key takeaway that relates to what I mean by differentiation and so on:

1. RNW’s after-tax margins are very high, with a TTM of 54%. Meanwhile, capital turnover has remained statistically low, consistently sitting at 0.11 times sales.
2. To me, this is consistent with the economics of the business. For one, renewable energy has not yet been widely adopted. Therefore, capital is unlikely to operate efficiently. Relatedly, replacement of existing critical mass locations has not yet been required.
3. But what is intriguing is the marginal difference between renewable energy supply and conventional energy supply. For example, compare this to the ONE Gas (OGS) name, which I recently covered. Its after-tax profit margin is about 12%, its capital turnover rate is about 0.4 times, and its return on capital is about 4-5%. The marginal difference here is staggering, which begs the question: Does RNW’s product enjoy a consumer advantage? More likely, in my view, is a cost differential factor, as renewable energy is currently more expensive than conventional energy supplies, further reducing RNW’s P&L. Still, if the company improves its capital efficiency numbers, these are very compelling economic benefits.

As mentioned, I’m tasked with benchmarking the company’s propensity to compound capital at above-market returns. We believe this represents 12% of our holdings and reflects the long-term market average. So RNW took advantage of this practice and caused a series of economic losses. Figure 6 outlines this in detail. With an investment of $8.2 billion, TTM would need to generate an after-tax income of $991.4 at a 12% tax rate, compared with an after-tax income of $509 in the first quarter. The resulting economic loss per share was $1.30. Economic profit is undoubtedly preferable.

Expectations for Steady State Operation

RNW’s operational drivers since 2020 are plotted in Figure 7. As mentioned above, we have data for the company going back to 2020. The operating profit margin is very attractive, and the revenue compound growth rate is 3.8%. Of course, most of the capital allocation went to fixed capital, while NWC requirements were narrowed. For every $1 of additional sales, RNW invests $8.30 in its fixed asset base.

Advancing these hypotheses is very compelling. Management expects capital expenditures of approximately $2 billion in FY24. If it holds steady as shown above, it will be about $500 behind. Reaching this level of investment either requires:

(I).Increase revenue growth and maintain the same rate of fixed capital investment, or

(2). No matter what, we must increase capital allocation to fixed assets.

Figure 8 shows capital requirements if revenue growth stabilizes at 4.5%, not far from consensus expectations. Here, it would need to invest ~$2 billion per year into its capex program, ~$350-$420 per quarter, which equates to ~60% of trailing NOPAT per rolling period, or >100% of expected FCF per period.

Valuation and conclusion

The stock sells for 15 times forward EBIT, creating only $1.80 in market value per $1 of NAV to date. As you can see in Figure 9, it’s trading at a discount to invested capital. In other words, the market simply doesn’t value RNW’s assets high in terms of their future profitability. In fact, given capital productivity, the market is likely already pricing RNW at current levels.

Compounding the company’s equity value according to the numbers shown in Figure 8 as a function of its return on investment and reinvestment rate, I get an implied equity value for the company of $7.28 per share. This level is also supported by technical research, as shown in the P&F study in Figure 11. In percentage terms, that’s a potential value gap of 28%. But in reality, capital appreciation per share is $1.60, so I think a larger position size would be needed to achieve that, but I’m not committing to that given the risk profile.

Figure 11.

In short, there are compelling arguments in the RNW investment debate. Chief among them is the core product of renewable energy. Second is the high after-tax profits generated by its roughly $8.5 billion in venture capital, unlike traditional energy suppliers. It will also invest heavily to fuel future growth. But the flip side is that RNW has lower capital productivity. This is a high-margin, low-capital-turnover business that requires extremely high levels of reinvestment to maintain its competitive position. I estimate that at a revenue growth rate of 4.5%, it would need to invest $8 for every $1 of new sales to remain competitive and meet its internal capex targets. The problem is that the resulting subsequent returns are unattractive, with returns of 6-7% on a rolling TTM basis. At this point, funds can be compounded elsewhere at more attractive rates and, in my opinion, with much less risk. Net net, interest rates remain unchanged.