The UK has one of the most mature solar markets in the world with around 16GW currently deployed across the country. The government has a target to quadruple this to 70GW by 2035, illustrating strong support for solar as a source of low-carbon power and energy security. The latter has become a priority following Russia’s invasion of Ukraine.
What challenges are facing the solar industry?
Although solar power is a cheap source of energy when the sun is shining, the price that generators receive is often tied to the natural gas price. This means that renewable-energy companies benefited when the price of gas more than doubled from the start of 2022 to August of that year, following the invasion of Ukraine. However, since then the gas price has returned to close to its long-term average, and shares in the renewables firms have slumped.
NextEnergy Solar Fund (LSE: NESF) is one of the hardest hit, down by 40%. It trades on a forecast dividend yield of 12% and a 30% discount to its latest net asset value (NAV). Presumably, due to that yield, NESF has become the most-bought investment trust on platforms such as Hargreaves Lansdown, AJ Bell and Interactive Investor.
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A yield this high signals that there are risks. One reason for NESF’s low valuation could be its debt burden: this stood at £533 million as of September 2024, which is around 1.3 times its market capitalisation.
Management says that its weighted average cost of debt is 4.9%. Around 70% of the debt is fixed rate, including £200 million of preference shares issued in November 2018 and August 2019. These pay a fixed dividend of 4.75% and there’s no requirement to redeem them (instead they can convert into equity from 1 April 2036). The remaining £333 million debt consists of long-term interest rate hedged debt of £156 million and £153 million revolving credit facility (RCF) on a floating rate. This £333 million of debt will need to be repaid, either from cash flow generated by the solar panels or by selling off assets.
Management chooses not to show the entire £26 million interest costs from this debt running through a consolidated income statement. Similarly, it reports £1.14 billion of invested capital, yet total assets on the balance sheet are well below that level, at £771 million. The reason for the divergence is that management report as an investment entity on a non-consolidated basis. The company then makes investments in solar panels through holding companies and special purpose vehicles, which are off the balance sheet.
So we have fair-value accounting, a share price at a discount to book value, a reliance on short-term funding (the RCF), the use of alternative performance measures, and worries over the sustainability of dividends. This will sound familiar to anyone who followed banks before the financial crisis.
Slow progress on sales
In April 2023, management announced a capital-recycling programme, intending to sell five subsidy-free UK solar assets with 246MW of capacity. The proceeds would go to paying down debt, buying back shares and investing in battery-storage facilities.
NESF completed phase I of the divestment in November 2023, selling the ready-to-build Hatherden solar project with 60MW of capacity for just £15 million. In phase II and phase III, it sold the operational Whitecross (35.22MW) and Staughton (50MW) solar farms for £27 million and £30.3 million respectively.
NESF has invested £1.14 billion of capital to own 983MW of installed capacity. It is difficult with the information available to understand how much the value of a project should increase as it goes from ready-to-build to operational, but if one were to use the sale of 60MW of ready-to-build capacity for £15 million as a lowest bound, it would imply that the mark-to-market fair value of the group’s entire invested capital is closer to £300 million! To pay down the £333 million of debt at the valuation achieved for phase I, NESF would need to sell more than its installed capacity.
Fortunately, the subsequent deals have been better, even if both look to be surprisingly low valuations when we note by way of comparison that NESF paid €132 million (£110 million) for 35MW of installed capacity (the Solis portfolio) in Italy in December 2018.
Management is now more than halfway through the disposals, having sold 145MW of the 246MW target. Yet, based on the first-half figures, the debt burden remains stubbornly high.
Why is NESF trading at a steep discount to NAV?
Stockbroker Cavendish and renewable-energy specialists Longspur Capital have both published “sponsored research” (ie, the company pays for it) on NESF. Yet it’s not obvious from reading this material – which obviously aims to give the subject a chance to present its investment case clearly – why NESF is trading at a 30% discount to NAV, or what has caused the shares to fall 20% since the summer, when the gas price has risen sharply.
Still, there are a couple of helpful tailwinds. First, interest rates seem to have peaked with the Bank of England making two cuts. Secondly, gas for delivery next summer is being priced at a record premium to winter 2025/2026. Around half of NESF’s revenues come from inflation-linked government-backed subsidies, but it also locks in prices with a rolling three-year hedging programme. So rising prices should help support medium-term cash flows to maintain the dividend, and could also mean better prices on the remaining phases of the asset disposals.
Management said a few weeks ago that investors have sufficient information to calculate if the dividend is sustainable. That claim seems tenuous. The board has set a target dividend of 8.43p for the year ending in March, but cover is expected to decline to 1.1, down from 1.4 two years ago. The lack of consolidated reporting means it is hard to compare fair value accounting assumptions with the reality of cash flow. I hold the stock while feeling that a yield above 12% suggests a dividend cut is probable, but not inevitable.
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