The AES Corporation: A Hold Until The Balance Sheet Improves

Investment Summary

The AES Corporation (NYSE:AES) is a renowned global energy company that operates in the power generation and utility sector. AES offers a diverse portfolio of power generation technologies, including thermal, hydro, and wind, along with energy storage and distribution systems.

This solid exposure to different end markets has helped the company immensely in growing in the last few years. Just in the first quarter of 2023, AES saw a 31% increase YoY in EPS, and this has helped the company affirm its outlook for 2023 which now sits at a $1.65 - $1.75 EPS. The reason this is important is that it helps play into the long-term target the company has of a 7 - 9% CAGR between 2020 - 2025, something they seem to be well on track to achieving. But for me, I am looking at the balance sheet and this is weighing down the buy case here quite a lot, enough to make AES a hold in my opinion. With more debt than the entire market cap of the company and not impressive margins, I think they offer too much risk to be a buy right now, honestly.

Market Outlook

The benefits are greatly from the shift to renewables and away from traditional energy sources. As a company that runs power plants and sells energy to customers, they are making strong moves to divert their business and fit into the mold that is renewable energy.

Looking at the last report from the company, they are still generating the vast majority of revenues from their Energy Infrastructure segment, but the Renewables are growing at a solid 17% YoY rate. I think the investments the company is making in this space will prove well worth it over the long run.

Looking ahead, the global utilities market is expected to grow at a solid rate of 7.9% annually until 2026. Fueling this growth is the vast investments that are going into renewables right now, placing a lot of demand on companies like AES to expand their business and satisfy the market. In a presentation by the company, they also see the installed capacity nearly doubling until 2027, going from 32 GW in 2022 to 57 - 62 GW in 2027, with renewables making up around 79% of the installed capacity. This I think highlights the importance of looking at the renewables segment of the company right now. This is where a lot of the growth could be had. Like the New Energy Technologies SBU segment which generated $74 million in the first quarter. Besides looking at the segments just mentioned one vital part is the backlog the company has. Where I notice a bad trend is the decrease in the backlog in Q1 compared to the end of 2022. It decreased by 2% which isn't a shocking amount, but it is certainly worth taking note of because if this continues then the 2027 targets the company has might need to be adjusted downwards. What I think could cause this would be a lack of incentives from governments for companies to seek renewable energy adoptions. For the moment, however, the trend seems to suggest that demand is still high and growing the capacity to generate renewable energy is still there.

Risks

Looking at the risks facing the company, or investors interested in getting into the company is first and foremost the extremely high amount of debt they have. I mentioned in the first part this is actually the reason. This I think is also one of the main reasons for the company trading at a low multiple it does, as the debt places a lot of risk for investors.

Especially when the levered FCF is a negative $3.1 billion in TTM. Fortunately, this hasn't turned into any significant share dilution over the years, but the question certainly arises if AES can't grow and generate positive FCF. Eventually, the payments for debts will have to come from somewhere and I find it likely it could be from share dilution if worst comes to worst.

Financials

Moving over to the balance sheet of the company, this is the main part of why I have a hold rating for the company right now. There are plenty of improvements I'd like to see before ever entertaining the idea of raising the hold rating to a buy.

On a QoQ basis, the company has made a solid move in increasing the cash position they have from $1.374 billion to $1.441 billion in the last report. This is a great move to see and helps them be more financially flexible and make strategic investments when necessary. Unfortunately, this cash position does little to affect the long-term debts of $22 billion. In fact, the cash position is not even enough to cover the current debts the company has which is around $2.2 billion. I think in the coming few quarters it will be necessary to watch the dilution of shares, if there is any to get an idea about how the coming few years might turn out. Without an improvement in the FCF, a trend like that might very well continue.

Where I do see some good stuff is the construction the company has in progress is rapidly increasing on a QoQ basis, going from $4.6 billion to $5.5 billion. This is a sign that AES still faces a lot of demand and is more left with the challenge of raising margins rather the raising the order backlog.

Right now the net debt/EBITDA ratio sits around 6.4 which is too high for me to ever suggest a buy case. I think there are several improvements that could be made to the balance sheet to put the company in a better position. Dedicating more capital to reducing long-term debts is a first step. But for that to happen AES needs to start generating positive FCF which I think could be a few years out as they need to scale their business and streamline the process of establishing renewables projects and constructions more. Hopefully, then they can generate positive FCF as they did in 2020.

Valuation & Wrap Up

Looking at the valuation of the company right now they are really not that expensive when comparing it to the sectors FWD p/e of 17, where AES is only valued at 11. But I think the risks I have mentioned regarding the company are the reason for this lower multiple. With a high amount of debt and a lack of positive FCF, this places a lot of risk at the feet of investors as they might be exposed to share dilution by the company, diminishing the value of their position.

The company seems to be on its way to growing earnings as they see more and more demand for renewables, and I think those segments of the company will be the most important to watch. Going into the next quarter, I would like to see an increase in the order backlog and an uptick in the margins too. I am rating the company a hold right now, but I think it could turn into a sell if there is a significantly higher risk than right now of share dilution or the company cutting the dividend. But I like the outlook and believe in that they will see strong demand as they see installed capacity nearly doubling until 2027.