Siemens Energy: Awaiting Q4 Results Keenly (OTCMKTS:SMEGF)

Siemens Energy AG (OTCPK:SMEGF) at the time of writing is up 88% in the past 12 months. That makes it the top-performing Eurozone energy stock, and beats every stock in the Euro Stoxx 50 index, too. The story is a combination of energy transition excitement about Grid Technologies – rapid growth in data center power demand meaning demands on power grids – and the general investor interest in the electrification megatrend, and the turnaround happening in the Wind business.

Yet, the stock is still only up slightly since its spin-off from Siemens in 2020 and in recent weeks the momentum has stalled somewhat, so what’s the deal?

Siemens Energy AG was spun-off from German industrial conglomerate Siemens AG (OTCPK:SIEGY) in September 2020. The stock is perhaps the ultimate “picks and shovels” type stock to play the energy transition, as the company manufactures the equipment needed for a wide range of low carbon and clean energy production methods.

Since the spin-off, operational improvements have been introduced, including a new group structure, and this has been playing out across its Gas Services, Grid Technologies and Transformation of Industry segments, and it is also in a huge turnaround situation at Siemens Gamesa, which Siemens Energy formerly a majority shareholder in, took full control of in February last year, after engineering problems at the wind turbine manufacturer. This was done to be able to fully integrate the wind businesses of Siemens Energy and Siemens Gamesa.

At the Capital Markets Day at the end of 2023, management fleshed out the strategic priorities of “deliver, fix, maintain” Siemens Energy with several action points promised to deliver shareholder returns.

• Executing on a record backlog with healthy margins
• Project execution excellence driven across Siemens Energy by new Global Functions division
• Expanding capacities and competencies with efficient use of capital resources
• Progress on Onshore wind quality issues and Offshore wind ramp-up trajectory
• Action plan to get profitability back to a sustainable level
• Active portfolio management to eliminate distractions from strategic core
• Strict capital discipline, supported by stringent capital allocation principles

Challenges impacting Siemens Gamesa

At the that Capital Markets Day, management was explicit about the problems the wind business faced: lower prices, cost increases, problematic contract terms and conditions, quality issues and operational challenges all created the perfect storm for the profitability of the company’s backlog, which caused huge write-downs to be taken in the 2023 fiscal year.

Despite the significant price improvements, we achieved in recent quarters, unsustainable competition among wind turbine manufacturers in recent years has resulted in market pricing below healthy levels. Significant increase in wind turbine manufacturers’ direct cost base, mainly driven by raw materials and logistics, has deteriorated project profitability. Previous inadequate market-standard terms and conditions forced wind turbine manufacturers to assume unbalanced risks and impeded them from passing cost increases on to customers. Fast development cycles among wind turbine manufacturers in recent years affected quality levels of new platforms. Rapid growth of offshore demand has posed operational challenges in ramping up production simultaneously in multiple locations.

Source: Siemens Energy 2023 Capital Markets Day, November 21, 2023 in Hamburg.

Fast forward a year and progress has been made at Gamesa, as noted by the improving quarterly margins.

At the Q3 FY24 earnings call earlier this month, management noted that there would be an update on Gamesa operations in the Q4 earnings release in November. This, I believe, will be a crucial catalyst for the stock. In the Q3 earnings call, it was mentioned that the company was on track for the reintroduction of the 4x turbine model in 2024 and the 5x turbine model in 2025. The Q4 call in November will hopefully go into more detail on this.

We can see that over the last seven quarters, profit margins have been highly negative both for the New Units (turbine manufacturing) and the Services unit at Gamesa. The company has been reducing its order intake to focus on quality improvement and to work off its backlog in an efficient way. At the capital markets day last year, management said it aimed to break even by fiscal year 2026 at Gamesa. This is because many contracts which still need to be fulfilled had locked in losses, and profits are only recognised on completion and delivery of product to customer. I will discuss what this means for future EBIT forecasts and the company’s valuation later on.

Ultimately, the wind business has been a problem child for Siemens Energy. The company has provided fairly good data at the end of earnings presentation slides on Gamesa. In September, the company is attending several investor conferences, so there may be some more updates announced soon.

A narrowed focus on only attractive markets is likely going to mean that Europe will be the core market for Siemens Gamesa, thanks to an attractive policy framework provided by the EU Wind Power Package, launched last year.

It does seem however that the stock price rally has priced in some recovery in profitability at Gamesa, as I will discuss.

A note on accounting

When you first look at Siemens Energy’s financial reporting, you notice a focus on “Profit before Special Items”. This is essentially what we often see as “adjusted profits”. Profit after special items is then before “Amortization of intangible assets acquired in business combinations and goodwill impairment”. Only after both these adjustments do we get to the IFRS Earnings Before Interest and Tax, also seen as operating income (loss). Adding up the segments to get to group numbers, you also have to include “Reconciliation to Consolidated Financial Statements”.

I’m often sceptical of adjustments, but it’s all there at the segment level and the group level, and the adjustments, in the grand scheme of things, are not that big, typically in the tens of millions in segments on sales of multiple billions.

In Q1 FY24, a chunky special item was reported, but that was explained as driven by a pre-tax gain related to the sale of an 18 percent stake in Siemens Limited, India, of €1,729 million.

Gas Services

Five underlying trends driving the gas market until 2030

At last year’s Capital Market’s Day, Siemens Energy modelled the gas market and predicted the following:

In conventional gas, China will add about 200 Gigawatts, and Saudi Arabia will add about 40 Gigawatts. The Coal-/Oil-to-Gas Shift will create about 35 Gigawatts of new capacity in the European Union and 15 Gigawatts in South Korea. Hydrogen and Green Fuels Turbines will create 15-20 Gigawatts of hydrogen ready gas-fired power plants to support coal and nuclear exit in Germany’s “Energiewende” and in the UK the “Decarbonization Readiness Program” requiring 100% hydrogen ready turbines will support flexible power generation. Renewables Integration will drive demand for gas peaker plants. In the US, rising demand for peakers to ensure grid stability and security of supply will demand about 25 gas turbines per annum and in Europe, gas peakers will be demanded to provide dedicated grid services and cover “dark doldrums” (e.g., in the UK, Germany, Ireland). Finally, all these trends will create an increasing backlog for Siemens Energy and mean its Service business will have a longer reach.

Siemens Energy also appears to be quite cautious on gas, as they have flat revenue guidance for the Gas Services segment out to FY 2026, and guidance for revenue growth of about negative 1% for FY 2024. I feel, however, that with the importance of electricity for data centres, electric vehicles, renewables can’t support this alone. Hence, gas will take a larger market share of electricity production, as we have been seeing in the US in recent years, so gas turbines and gas services should have tailwinds in the coming years.

Gas Services has a profit margin before special items on track for 10% in 2024, with management guiding to 11% by 2026.

Grid Technologies – the profitable growth engine for the global energy transition

This segment is likely the segment the market is bullish about. It’s on track for 33% revenue growth this year and through 2026 “mid-double digit” compound annual growth. Profit margin before special interests is on track to reach 9% this year, up from 7.5% in 2023. Going forward, management is guiding towards about 10% margin. While Gas Services is driven by orders in services, more than new units, Grid Technologies is driven by revenues and orders in new units over services. New units today, will lead to service business in the future.

Management’s double-digit market growth is being supported by global policy packages:

• In Europe the EU Green Deal/Fit for 55, Net Zero Industry Act and REPower EU
• In the US, the Inflation Reduction Act substantiating market growth
• In Asia, China is committed to be carbon-neutral by 2060 and India by 2070

The business is all about connecting renewable power to the grid, enabling power grid resilience, and managing increasing grid complexity. Products include Transformers, Switchgears, Converter towers and battery energy storage.

Transformation of Industry

The business aims to decarbonize industrial processes by three main levers: Energy Efficiency (increasing the efficiency of existing assets), Electrification (converting industrial processes from fossil fuels to electricity) and Hydrogen (producing and transporting green hydrogen and clean fuels). The segment has four businesses: Industrial Steam Turbines and Generators (providing process steam and converting heat to electricity), Electrification, Automation and Digitalization (electrifying industrial processes) Compression (compressing, transporting and storing fuels across all decarbonization offerings, including carbon capture) and Sustainable Energy Systems (manufacturing electrolyzer systems for hydrogen production). In short, this is the “clean tech” division.

In the longer term, the Electrification, Automation and Digitalization business which helps customers in converting industrial processes from fossil fuels to electricity, is in prime position to capture the electrification megatrend, as 50% of world primary energy will come from electricity in 2050 vs. 22% in 2020.

Management has guided low-single digit revenue growth through 2026, and is on track for a 6% profit margin before special items in 2024 growing to about 7% by 2026.

Valuation

Earnings are distorted by the losses in Gamesa and the ongoing improvements across the business. Management has guided for Gamesa breakeven in 2026, so I have forecast a range of segment EBITs for 2027. For Gas Services, Grid Technologies and Transformation of Industry I am using profit margins of 11%, 10% and 7% respectively to get to 2027 EBITs. For Gamesa I have a range of margins depending on the case. I use the sector medium EV / EBIT multiple of 17x as a base case. Reconciliation to Consolidated Financial Statements stay constant at negative EUR 200m in each case.

Base case:

From 2024 levels, Gas Services revenues stay flat, Grid Technologies grow cumulatively by 45%, Transformation of Industry grow cumulatively by 24%, and Gamesa revenues grow cumulatively by 9%. Gamesa achieves a 4% profit margin before special items. Taken together, this produces a group EBIT of EUR 3.2 billion. At 17x multiple, that gives us an enterprise value of EUR 54.4 billion. Subtract net debt of EUR 35 billion (assuming no cash from sales of non-core assets), gives us a market capitalisation of EUR 19.4 billion, slightly below today’s market capitalisation of just over EUR 20 billion. In other words, my base case suggests Siemens Energy is roughly fairly valued now. This has priced in rapid growth in Grid Tech, a slow recovery in Gamesa, and flat Gas Services, with margins only about 1% point above where they are today, excluding Gamesa.

Bull case:

From 2024 levels, Gas Services revenues grow cumulatively by 15%, Grid Technologies grow cumulatively by 50%, Transformation of Industry grow cumulatively by 27%, and Gamesa revenues grow cumulatively by 12%. Gamesa achieves a 5% profit margin before special items. Taken together, this produces a group EBIT of EUR 3.7 billion. At a slightly better 18x multiple, that gives us an enterprise value of EUR 66.6 billion. Subtract net debt of EUR 33 billion (assuming two billion Euros cash raised from sales of non-core assets), gives us a market capitalisation of EUR 33.6 billion, which is about 68% above today’s market capitalisation. This bull case assumes a stronger recovery in Gamesa by 2027, and stronger revenue growth in the other three segments.

Bear case:

From 2024 levels, Gas Services revenues drop cumulatively by 5%, Grid Technologies grow cumulatively by 36%, Transformation of Industry grow cumulatively by 20%, and Gamesa revenues stay flat to 2024 levels. Gamesa achieves a zero profit margin before special items, i.e. breakeven a year later than management forecasts. Taken together, this produces a group EBIT of EUR 2.6 billion. At a slightly worse 16x multiple, that gives us an enterprise value of EUR 41.1 billion. Subtract net debt of EUR 35 billion (assuming no cash from sales of non-core assets), gives us a market capitalisation of just EUR 6.6 billion, which is about 67% below today’s market capitalisation. This bear case assumes continued problems with Gamesa, and slower or declining revenue growth in the other three segments.

My base case is the one that is most realistic to me. But the bull and bear cases are also somewhat realistic, and the risk reward to bear and bull case is about 1:1. However, I have not factored in any conglomerate discount, and it is also possible that Siemens Energy could warrant a higher multiple as its group of businesses are likely to be in a faster growing market than the medium industrial stock. A discounted cash flow valuation also would reduce the risk around the forecasts for 2027 earnings and multiples.

An alternative valuation approach would be to compare against direct competitor GE Vernova (GEV) as the businesses are very similar and figure out which one is cheaper, or which one is likely to fix its struggling wind business faster and/or better. It’s also important to note that Siemens Energy gets around 20% of its business from the United States alone, making it a strong competitor to GEV.

Conclusion

I have made a number of assumptions after carefully reviewing each segment’s quarterly performance over the last two years. The stock seems fairly priced, with likely optimism priced in to the gas and power businesses, and likely pessimism or at least less enthusiasm for the new/clean energies segments Transformation of Industry and Gamesa Wind. With an Altman Z Score of just 0.57 means the company’s financial strength isn’t great, which is a concern, although management is aware of this and is looking to sell non-core assets. The stock’s momentum is also fading now. If you think my bull case is scenario is more likely, then the stock is a buy, but otherwise the stock is a hold for now. The key catalyst comes at the Q4 earnings release on 13th November, when we should get a better picture of the Gamesa turnaround.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.