A paradox of capitalism is that a product can be wildly successful but never make any money. Rising demand attracts new suppliers, which compete on price so aggressively that, while customers are happy, the makers struggle to survive on paper-thin profit margins.
The example Questor has in mind today is solar cells: the shiny rectangles are seen everywhere but profits for their makers are a much rarer sight. They are relatively easy to make, so hundreds of suppliers exist and collectively they make themselves unprofitable.
It’s a very different story, however, in that other staple of green energy, wind turbines.
Ben Preston, who owns a couple of turbine makers in his Orbis Global Equity fund, explained why the dynamics were different. “It may be true that solar cells have got too cheap to be profitable but wind turbines are getting bigger and more complex,” he said.
“The power companies will buy some land for a wind farm and then want as much out of that land as possible. This means that they want big turbines that are reliable and durable. Every hour they are not spinning they are costing you money.”
He named some of the engineering challenges: “Some offshore ones are bigger than the London Eye. When you get to a diameter of 200m, the tips of the blades can be travelling at close to the speed of sound. But the blades have to be made in one piece as joints would be a weak spot and the turbine has to last for 25 years.”
The expertise needed to overcome such challenges is not found everywhere, so there is not the proliferation of competing suppliers that you find in the solar industry. In fact, the sector resembles more an oligopoly.
“Two companies, Denmark’s Vestas Wind Systems and Siemens Gamesa, have 40pc of the onshore turbine market and 90pc of the offshore,” Mr Preston said.
It’s a hard market for newcomers to break into because turbine owners have every reason to stick with suppliers they trust. Not only do they need to have faith that the turbines are well engineered in the first place, but they need to know that the equipment can be properly maintained throughout its life.
“You want someone to be able to support you if a turbine goes wrong, so you want a trusted name,” Mr Preston said.
There are some industries where servicing machinery can be more profitable than supplying it in the first place – aircraft engines and lifts spring to mind – and it’s a similar story with turbines.
Here, too, the relative scarcity of turbine companies works to their advantage.
“There are only a few turbine firms but many turbine owners that need maintenance, so the dynamics of supply and demand are in the makers’ favour,” Mr Preston said.
He said the average service contract ran for 18 years and profit margins on servicing were four times those on the original sale, although sales made more revenue.
“Demand for new turbines may ebb and flow but every time you sell one you increase your installed base for servicing,” he added. “So service revenues grow in a nice steady way.”
Although competition in the offshore turbine market is even more limited than onshore, margins are currently lower because the market is at an earlier stage of development.
Of the two main suppliers, Mr Preston has therefore put more of his money in Vestas. “Vestas has made the better call – it is the market leader in terms of profitability,” he said.
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Margins recently have been 5pc on sales and 25pc on servicing, while returns on invested capital were 30pc in the year to March. Over the past nine years sales have grown by 7pc a year on average and profits by 20pc, “although there is earnings cyclicality”, Mr Preston said.
Although the company had not been turning all its profits into cash, partly because of its need for working capital, Mr Preston said “it does pay a dividend and does produce free cash”.
When it comes to valuation he said: “It is on the high side of what we would normally want to pay but is compensated for by demonstrated market leadership – it has won the competitive battle and you are backing a high-quality company in an area that’s bound to grow.”
Questor says: buy
Ticker: CPH: VWS
Share price at close: 948.8 Danish kroner