Gamesa Continues To Run On Its Second Wind

| About: Siemens Gamesa (GCTAY)
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Gamesa's turnaround strategy is paying off in better margins, lower debt, and better capital efficiency.

Order growth in 2013 covers more than half of management's guidance for 2014.

A joint venture with Areva could allow the company to become a player in offshore turbines.

Spanish wind turbine manufacturer Gamesa (OTCPK:GCTAY) (GAM.MC) has continued to face quite a bit of skepticism from analysts regarding its turnaround prospects, but the company continues to execute on its turnaround plan. That plan has led to high single-digit order growth for 2013 and a return to double-digit growth in the fourth quarter, and the stock has continued to recover with the shares up about 250% over the past year and another 60% since my write-up in September ("The Street Still Doubts Gamesa Has A Business For The Long Term").

There is always a risk with turnaround stocks that investors will push their luck and hold on too long. To that end, Gamesa is not out of the woods. The company is still looking up at the global market shares held by Vestas (OTCPK:VWDRY), General Electric (NYSE:GE), and Siemens (SI), and moving into the offshore market (where Siemens and Vestas hold more than 80% share) with Areva (OTCPK:ARVCY) could prove tantamount to a bunny jumping in a wood chipper. Should Gamesa manage mid-single digit revenue growth and additional margin improvements, these shares could have another 10% or so left in them before settling in to market-par return.

What Has Changed?

It has been only about six months since I last wrote on Gamesa, so it is not too surprising that there have not been monumental changes in the interim. What has happened, though, is that the company has stuck to its plans to rationalize its product development (consolidating around a smaller number of shared designs), take costs out of the manufacturing process, and get smarter about it capital demands.

It was encouraging to see the company show improved results for the fourth quarter of 2013. Sales were lower than expected in the fourth quarter (though still up 14%), but the company did exceed its EBIT margin guidance for the full year (5.5% versus the high end of its range) and the fourth quarter. The company also lowered its working capital more than expected and the net debt position shrank more than expected.

An Emerging Markets-Heavy Mix, But Still A Lot Of Volatility

Quite a bit has changed for Gamesa over the last four years. Whereas the U.S. and China were each more than one-quarter of the company's volume, both have shrunk into the single digits. In the case of China, interest in wind turbines has remained, but local manufacturers like Goldwind and Sinovel have taken share on the basis of price and "buy local" preferences with Chinese utilities. In the case of the U.S., it would seem that some of the issues have been related to price, but also competition from Vestas and GE and a mismatch between Gamesa's offerings and the sweetspot of market demand - Gamesa doesn't have any particularly well-reviewed turbines in the 2.1MW to 3.5MW category.

Gamesa certainly owes some of its decline in overall market share to its shrinking Chinese and U.S. businesses, as the company has slipped to the sixth-largest turbine company by recent installations (though it remains third in total installed base, behind Vestas and GE). Some of the decline can also be attributed to the company no longer building and operating wind farms (Gamesa Energia), as these installations accounted for about 15% of volume from 2008 to 2012.

In the place of those declines, Gamesa has been picking up business in Latin America and India. Latin America has grown to nearly 50% of volume, and Gamesa is a share leader in Brazil due in no small part to its local manufacturing presence. The same is true in India, which has doubled as a percentage of the company's volume over the last few years.

With this migration, Gamesa finds itself dealing more with IPPs instead of public utilities. That does create some concerns for me with the stability of the business, and IPPs have seen difficulties in accessing credit/liquidity in the past. Likewise, the state of many Latin American economies has not been so wonderful of late and that slowdown is a risk factor. That said, the company just announced (March 4, 2014), a joint venture with Santander to develop 500MW of wind farms in Oaxaca, Mexico.

Going Offshore

Gamesa has been focused on onshore turbines so far, but the company and Areva are pursuing a joint venture for offshore turbines. The details are still being worked out (a more definitive announcement is expected in the summer), but it should see some incorporation of Gamesa's 5MW turbines and technologies, and will likely also extend to development of 7MW/8MW turbines.

Offshore wind is a growth opportunity in Europe (which still generates more than 30% of Gamesa's volume), but it is an area where Siemens, Vestas, and Repower have a strong business already. As mentioned above, Siemens and Vestas have more than 80% of the installed base and I think it's fair to question whether Areva improves matters enough to make this a true growth opportunity.

Progress On Many Fronts

As mentioned, Gamesa is starting to see some benefits of its turnaround efforts. Revenue was up 14% in the fourth quarter (admittedly an easier comp), with MWe sold up 12% (but down 8% for the full year). Operations and maintenance is looking like a solid growth and margin opportunity for the long term, and Gamesa made progress on its working capital usage and could clean up its balance sheet further with some wind farm sales.

Gamesa also announced orders for 1.8GW of turbines in 2013, up 9% yoy and excluding a large master supply agreement with EDP Renováveis in the U.S. for 450MW. I think it's also worth mentioning that although Gamesa didn't show up in the top ten for Wind Power Monthly's 2013 turbine awards for the 2.1MW to 3.5MW class, it did get gold in the < 2MW category and bronze in the 3.6MW-plus category.

Plenty can go wrong from here, and Gamesa certainly has foreign currency exposure to contend with in its large Latin American and Indian operations, not to mention ongoing erosion in wind turbine pricing due to competition. Even so, I believe Gamesa can grow revenue at a long-term rate of around 6%, with the company's ongoing manufacturing and cash flow efficiency efforts leading to mid-teens FCF growth.

The Bottom Line

Discounting those cash flows back, I believe Gamesa is worth around $2.40 per ADR today. There is definitely scope for the company to outperform my revenue expectations if the offshore JV is a success and/or if the company can regain more of its global market share than I presently expect. Though Gamesa isn't as cheap as it once was, it still looks priced to outperform the market by a worthwhile degree.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.