This article explains why I sold Aggreko PLC as part an ongoing process of “spring cleaning” the UK Value Investor model portfolio.
Summary: Increasing uncertainty was not sufficiently reflected in Aggreko’s share price
Aggreko is the world’s leading supplier of industrial and utility-scale temporary power and temperature control systems. In practice, Aggreko has two core businesses:
- Rental: Renting out shipping container-sized generators (powered by diesel, gas or oil), electrical transformers or other industrial power infrastructure, and
- Power: Building and operating temporary utility-scale power plants, using its global fleet of containerised equipment to provide short-term support for national power grids, typically in emerging markets
Aggreko joined the model portfolio in early 2016, just before the company’s 2015 annual results were announced.
In the decade up to its 2014 results, the company had grown by a very impressive compound rate of almost 18%, and had produced average returns on capital employed of more than 16%. At the time its dividend yield was 3%, so the valuation appeared attractive, given the company’s double digit growth rate.
However, over the last four years, Aggreko has failed to maintain anything like its previous growth and profitability rates. My opinion now is that its impressive growth from 2004 to 2012 was largely due to one-off factors, most of which have reversed or reduced in the last few years.
I still think Aggreko is an above average business, but if its future growth rate is close to that of its end markets (around 5%) then the current share price and 3% dividend yield are not attractive. As a result, I removed Aggreko from the model portfolio in January.
Here are the headline results:
|Purchase date||Jan 8th 2016|
|Sale date||Jan 8th 2020|
|Holding period||4 Years 0 months|
These results are of course mildly disappointing and below my 10% target rate of return, so in the rest of this article I’ll try to explain why I bought Aggreko and why the end result is not quite what I’d hoped for.
Buying a global leader with impressive growth and a reasonable share price
One thing I look for in a company is market leadership, and Aggreko certainly had that in spades. As far back as the early 2000s, its rental and power projects businesses had global market shares of more than 20%.
That’s an enormous share of the market and to support that scale Aggreko had a containerised power equipment fleet several times larger than its nearest competitor.
Another feature I look for is consistent growth, and Aggreko had that too. It was stagnant for a few years following the end of the dot-com boom and 9/11, but after 2004 Aggreko’s business just took off, setting a blistering pace of growth across capital employed, revenues, earnings and dividends.
Although its growth was broadly based across industries such as construction and oil and gas, the largest single contributor was Aggreko’s Power Projects business.
This was driven by expansion into emerging markets where power grids were unable to keep up with rapidly increasing demand. Revenues for that business alone went from £74 million in 2003 to almost £640 million in 2012.
One potential problem with rapid growth is that it can be too fast for the company to handle, in the same way that too much speed in a car can sometimes be too much to handle safely. In companies this often shows up as rapidly increasing debts, or large rights issues, which are used to accelerate investment into capital assets such as large, expensive, containerised power equipment.
This could be a concern with a company like Aggreko, which requires investment into expensive capital assets long before they generate a penny of profit, and Aggreko’s capex to profit and capex to depreciation ratios were both quite high during this this 2004-2014 period, at around 150% each.
However, despite the speed of Aggreko’s growth, the company’s 18% return on capital employed allowed it to fund that growth organically, with retained earnings during the period more than covering the increase in capital employed. In other words, Aggreko’s growth was largely self-funded (unlike Ted Baker’s externally funded growth), with relatively little capital investment paid for by increasing debts or leases.
This all paints a picture of a very successful global leader, with large scale advantages over its nearest direct competitors.
That was more or less my opinion of Aggreko in early 2016 and, as I’ve said, with a dividend yield of 3% the company seemed to be attractively priced.
Aggreko purchase review
But since then the company has put in several years of significantly weaker performance. This prompted me to review Aggreko’s history and my original purchase decision.
Thanks to that review, I now think Aggreko’s growth over the decade to 2014 was driven by a range of external one-off factors, rather than being driven primarily by the company’s intrinsic capabilities. This undermines my confidence that it can generate anything like its past growth rate in the years ahead.
Aggreko benefited from very large tailwinds which may never recur
One explanation for Aggreko’s incredible 2004-2014 results is that it was the work of CEO Rupert Soames. Soames joined Aggreko in 2003 after the previous CEO, Philip Harrower, was killed in a car accident. Soames set about developing a new five-year strategy and in very short order Aggreko started to grow at breakneck pace. This seems like a clear case of cause and effect, so perhaps Soames does deserve most of the credit.
Another way to think about this period is to say that yes, Aggreko is a good business and yes, the new strategy positioned the company to take advantage of macroeconomic factors, but most of Aggreko’s results were due to those external factors becoming more pronounced than almost anyone expected.
There were three primary tailwinds:
Tailwind 1: The 2004-2007 global economic boom
From 2004 to 2007, the global economy grew by more than 5% per year. This led to more oil and gas exploration, more construction projects and more economic activity in general, much of which requires the sort of temporary power or temperature control solutions that Aggreko is more than happy to provide.
Tailwind 2: Rapid emerging market growth from 2000-2012
From about 2000 onwards, a significant gap in growth rates appeared between developed and emerging markets, with emerging market growth exceeding 7% every year from 2003 to 2010 (obviously excluding the financial crisis years of 2008 and 2009).
Thanks to this increased growth, countries in South America, Africa and Asia found themselves with booming construction industries and rapidly increasing demands on their power grids. This fitted perfectly with Aggreko’s capabilities, and the company was able to generate growth from these countries far above their high GDP (Gross Domestic Product) growth rates.
For a while, Aggreko was the only company in the world with the ability to transport large amounts of containerised power infrastructure from one country to another, at short notice. This gave it the unique ability to rapidly build and operate temporary power stations in many of these relatively undeveloped but fast growing countries. These temporary power stations filled the power gap perfectly while governments got on with the multi-year task of building permanent solutions to their power shortages.
With little in the way of competition, Aggreko took on very large emerging market power projects with very high margins.
This side of the business eventually generated more than 40% of Aggreko’s total revenues, with high margins helping to drive returns on capital employed to more than 20%. Eventually, Aggreko’s global share of the temporary power station market reached almost 50%.
Tailwind 3: The 2004-2014 US shale oil and gas boom
This may surprise you but the US is currently the world’s #1 producer of oil, ahead of Saudia Arabia and Russia. This is a dramatic reversal of the country’s oil production, which reached “peak oil” in the 1970s and had been in decline ever since.
The oil and gas boom was driven by technological innovation. These innovations allowed gas and oil to be extracted, at reasonable cost, by drilling into and then fracturing underground rocks, a process known as hydraulic fracturing or “fracking”.
From 2004 to 2014, this fracking boom increased the number of oil wells in the US from about 200 to more than 1,600. These sites are often in the middle of nowhere, and they require exactly the sort of rapidly deployable temporary power solutions supplied by Aggreko. During this period, Aggreko’s oil and gas-related revenues grew from about £30 million to almost £350 million.
Diamonds may be forever, but tailwinds are not
Although some tailwinds can last for decades, most do not. In Aggreko’s case, all of the large tailwinds which drove it to near-20% annualised growth leading up to 2012 have either weakened significantly or turned into headwinds.
Headwind 1: Weaker global growth after the financial crisis
After global growth of more than 5% per year during the pre-crisis credit boom, the world has settled into a more sedate growth rate closer to 3% over the last few years. This means fewer new construction projects, less expansion of manufacturing facilities and a market for temporary power systems where supply can more easily keep up with demand.
This has reduced overall revenue growth for Aggreko, but the smaller gap between supply and demand has also reduced margins. This margin contraction is the main reason why Aggreko’s profits have declined even though revenues have stayed broadly flat.
This weaker global growth is likely to be a temporary headwind, but without another extreme economic boom I don’t expect Aggreko’s returns on sales and capital employed to get anywhere near their pre-2012 peak of almost 20%.
Headwind 2: Weaker emerging market growth and greater competition for power projects
A decade ago, emerging markets were growing up to 8% per year, creating huge demand for temporary power systems. Today, these economies have growth rates of less than 4%, and that decline has had a significant impact on their demand for temporary power and Aggreko’s revenue growth rate.
More importantly, a decade ago Aggreko was the only company in the world with the ability to move around enough power systems to rapidly build and operate temporary power stations in relatively underdeveloped economies. This enabled it to produce abnormally high returns on sales and capital, and if there’s one thing that’s going to attract competition then abnormally high returns on capital is it.
Building up the necessary resources and skills to carry out this sort of work rapidly, effectively and profitably takes years of hard work. But hard is not impossible, and companies like APR Energy are now able to compete with Aggreko for these large contracts. This reduces Aggreko’s win rate, and the increased price competition has massively reduced the prices Aggreko can charge and the associated profitability of these contracts.
Headwind 3: A lower oil price and the end of explosive growth for US shale oil and gas
The most predictable part of the US shale revolution was that it would have a massively negative impact on oil and gas prices.
From 2005 to 2014, the price of oil almost never dipped below $80 and for several years it was consistently above $100. The supply shock from US shale put an end to that, and since 2014 the oil price has struggled to exceed $60, which is below the cost of production for many of these shale wells.
Unsurprisingly then, this had a huge impact on the number of active US oil wells, with almost 1,000 ceasing operations in 2014 alone. This has had a significant knock-on effect on Aggreko’s oil and gas-related profits, which have only increased by 30% since 2014.
A 30% increase is impressive given this headwind, but it’s a long way short of the near-1,000% increase from 2004 to 2013.
Selling Aggreko because its uncertain future is not sufficiently reflected in the price
Overall, I still like Aggreko. It’s a leader in many of its markets and has an unrivalled global fleet of containerised power infrastructure at its disposal. It’s also focused on niche markets with global geographic reach, which is often an attractive combination.
It is somewhat capital intensive and must invest heavily in expanding and upgrading its fleet long in advance of profits. This isn’t a problem if returns on those capital investments are sufficient, and for the past two decades they usually have been.
In recent years though, returns have been significantly weaker thanks in part to the headwinds mentioned previously. Weaker returns have reduced retained earnings so the company has taken on debt to fund acquisitions and capital investment. This is not sustainable over the long-term, so returns on capital will have to increase from their current level of around 6% if the company is to organically grow at a sufficient rate.
By sufficient rate I mean something in the region of 7% per year. I say 7% because when I sold Aggreko its dividend yield was only 3.2%, so that dividend had to grow by 7% per year if its long-term return was to exceed my 10% annualised target.
For me, this is where the problems begin. Yes, Aggreko is a high quality business, but can it grow quickly enough over the next decade to justify its current valuation? Can it get returns on capital back up to 10% or more? That’s the level required to fund a growth rate of 7% organically, rather than by taking the easy (risky) route of increasing debts and leases.
Aggreko has a lot of exposure to emerging markets and oil and gas, but these are volatile markets with many potential headwinds and tailwinds. How will this affect the company’s progress?
If we ignore unexpected headwinds and tailwinds then we’re left with the long-term tailwind of overall market growth, which Aggreko assumes to be around 5% annually. So if Aggreko’s core business is to grow faster than 5% it must take market share, but its market share is already extremely high.
My point here is not that Aggreko can’t grow by 7% per year or more, because it may well be able to. My point is that there’s a lot of uncertainty, more than the already high uncertainty faced by most companies, and in my opinion that isn’t sufficiently reflected in the price.
So that’s why I sold Aggreko in January.
The proceeds have been reinvested into a new holding this month, which will hopefully do a better job of getting the model portfolio to its £1 million target than Aggreko.