AES’ Risk-Managed Route to Renewables

By Juri von Randow | March 15, 2024 | Financial Analysis by MacroDozer

Risk Managed Investment Summary

• Target Price: $16.00 2024E
• Recommendation: Hold on a covered call or a ‘covered straddle’ basis.
• Risk Score: 7 out of 10 (high risk)

Introduction

AES Corporation stands at the forefront of the renewable energy transition, aiming for net-zero emissions amidst significant financial and operational challenges. This article examines AES's journey, highlighting the strategic shift towards renewables, utilities, energy infrastructure, and new technologies. Through the lens of risk-managed investing, we explore AES's valuation and the role of options strategies in navigating its complex investment landscape, aligning with DeshCap's risk-managed investment advisory expertise.

Company Overview and Financials

Founded in 1981, AES Corporation has evolved into a diversified power generation and utility company with a strategic focus on renewable energy sources such as solar, wind, energy storage, and hydro technologies.

See below the company in pie charts, segmented by business unit and geography.

Although the company's revenue did not grow much from 2015 to 2023, brokers estimate an annual growth rate of 5.3% from 2023 to 2027.

Shareholders also have not experienced significant capital gains over the last decade, with a total capital gain of only 23% and a revenue per share decline of 22%. This is illustrated in the share price graph below, where quarterly revenue development is rebased to share price.

The next chart shows a high-level cash flow overview to quickly gain insights into the company’s cash activities across operations, investing, and financing. Over the last years, the company has heavily invested in renewables projects and was compelled to incur substantial debt to finance those investments. The dotted green lines represent brokers’ estimates.

AES Peer Analysis

AES's ambition to lead the renewable energy transition is evident in its strategic business units and key initiatives to expand its renewable portfolio and transform its energy infrastructure. However, when benchmarked against industry peers, AES's financial health presents a nuanced picture.

Due to the sharp increase in external financing, AES's debt-to-equity ratio has risen to 3.8x, more than double the average of its peer group. Consequently, the interest coverage ratio, which indicates how often interest costs are covered by operating income, is the lowest among its peers at only 1.8x, illustrated in the chart below.

Fast-forward to 2025, and we observe an efficient AES with an asset turnover (revenues over assets) of 30%, leading the competitive field. With regard to profitability, AES ranks at the lower end of the spectrum, at only 22% operating margin, indicating room for improvement, as illustrated in the scatter chart below.

The last important metric we want to cover is growth. The annual growth rates for EBITDA and revenue from 2024 to 2027 are healthy, at 9.7% and 6.7%, respectively, even though AES revenue growth estimates only really start to kick in from 2027 onwards, and EBITDA forecasts indicate a more bumpy road with fluctuating annual growth rates.

In the current climate of tokens and digital currencies, one might assume that assets no longer need to be productive, much less generate cash. However, this distinction is significant in the long run, so knowing your dividends is always wise.

AES ranks well in most dividend metrics, with a 4.5% dividend yield, an 84th US market percentile, and an expected growth rate of 4.9% from 2024 to 2026. Given its high debt levels and growth ambitions, a low 35% payout ratio can also be considered positive.

AES Valuation

Shifting our focus to valuation, the chart below illustrates the market value multiples, price-to-earnings (P/E), and price-to-sales (P/S) ratios for AES and its industry peers. The grey dots denote each company's current trading positions, while the orange and green dots represent the 90th (high) and 10th (low) percentiles over the last ten years (L10Y).

Most companies are currently trading near their 10-year lows. AES also trades at a discount, below its earnings low, at 7.9x, and below its average sales multiple, at 0.8x. Compared to its peers, AES trades similarly undervalued.

The subsequent valuation chart displays the enterprise value multiples, including EV/EBITDA and EV/Sales. It shows that most companies are trading around their average values. Specifically, AES trades at a premium, with its EV/EBITDA above its historical high at 12.1x and its EV/Sales near its peak at 3.4x. The impact of AES's net debt is evident, as this is added to the market capitalization to get to the enterprise value. Compared to its peers, AES's valuation positions it in the middle of the range.

Verdict

Based on our analysis, which includes standalone performance, peer comparisons, and multiple expansions and contractions, we have applied the ranges shown in the chart below to today's share price to arrive at a fair price target for 2024. We have set a target of $16.00, representing a 7% upside, resulting in a Hold recommendation.

AES Risk Analysis

The transition to renewable energy introduces AES to various risks across operational, regulatory, and political landscapes. We've identified and ranked the five most important risks by severity alongside any mitigation strategies (MS) utilized by the company and any corresponding post-hedge quantitative impacts (QI).

1. Energy Transition Risks: Shifting from coal to renewable energy sources presents substantial challenges, such as technological advancements, regulatory compliance, and market demand fluctuations. This transition is pivotal yet fraught with complexities.
2. Supply Chain Disruptions: Renewable energy projects face critical operational risks due to supply chain vulnerabilities, particularly underscored by investigations into solar panel imports and the effects of legislation like the Uyghur Forced Labor Prevention Act.

(MS) We currently do not have any insights into the company’s business interruption insurance and how it is worded to act as a strong hedge to various supply chain disruptions.

(QI) To Be Determined: current lack of information around AES’s commercial insurance.

3. Regulatory and Political Shifts in Key Markets: Changes in the regulatory and political environments in essential operational regions, including Argentina's energy sector reform under President Javier Milei and legal challenges in Mexico, pose significant risks to AES's operations and strategic direction.
4. Financial and Economic Instability: The volatile mix of interest rate fluctuations, inflation, and uncertainties around the Inflation Reduction Act presents a notable financial risk that could impact AES's cost structures and project feasibility. 

(MS) AES employs financial derivatives for hedging against interest rate and inflation risks. A significant proportion of its debt, $6.6 billion in hedges, is managed to minimize exposure to variable interest rates, aiming to keep at least 70% of long-term obligations at fixed rates.

(QI) To Be Determined

5. Environmental Vulnerability: AES's dependence on hydroelectric power generation makes it particularly sensitive to hydrological conditions, highlighting an environmental risk that can significantly affect power generation capabilities and efficiency.

Considering the risks mentioned above, we have illustrated our worst-case scenario for AES’s share price below, indicating a potential 43% decline to $8.60. This is based on conservative multiples from historical lows during challenging periods.

Strategies for Risk Mitigation

Risk management is complex and requires a sophisticated understanding to identify the most important risks and to implement effective solutions, which include both commercial insurance products as well as financial insurance (derivatives). The insurance market offers various products for various risks, but structuring suitable coverage requires detailed knowledge of the specific threats. This process often depends on the expertise of senior management to mitigate risks effectively.

Since we lack sufficient insights and cannot adequately measure AES’s risks at this point, we are discussing two risk-managed equity strategies with option constructs: the covered call strategy and the covered straddle with downside protection.

Below is the payoff chart for a covered call on AES, which illustrates the potential profit and loss from owning 100 stocks and selling a call option on them. The call premium will be collected, which serves as an additional yield, and the capital gains are capped at the call option's strike price. Losses can extend to the stock reaching zero value.

A more sophisticated technique, the covered straddle with downside protection, offers a higher probability of profit without requiring upward movement in the underlying stock. It also allows more room for a downside move, as more premium is collected, resulting in a lower 'break-even' point. This customized option structure also provides crisis protection, as losses are capped at the strike price of the put hedge purchased. See the payoff chart below.

Conclusion

AES Corporation's journey towards a sustainable, net-zero future encapsulates the challenges and opportunities inherent in the renewable energy sector. While strategic initiatives and a focus on innovation position AES for future growth, investors must navigate financial challenges and operational risks cautiously. The balanced approach of maintaining a 'Hold' position, complemented by strategic options strategies for risk mitigation, reflects a prudent investment stance, especially if we are nearing the end of the rate hiking cycle. Investors are encouraged to consult DeshCap for tailored advice.