Siemens Energy: Not A Buy Anymore After Recent Rally (Downgrade To Hold) (OTCMKTS:SMEGF)

Notes: Amounts in the article are in EUR unless indicated otherwise. At the current exchange rate, 1 EUR is around 1.085 USD.

Investment Thesis

Siemens Energy (OTCPK:SMEGF, OTCPK:SMNEY) had a terrible year in 2023. The company lost over EUR 4bn because of the persistent troubles in its wind energy business. After a seemingly endless stream of bad news last year, Siemens Energy finally had better news for investors when it reported its Q2 FY 2024 results. (Siemens Energy has an irregular fiscal year from October to September, so Q2 FY 2024 was Q1 2024.)

I covered Siemens Energy in several articles last year. I started with a cautious warning, then a Sell recommendation, and moved to a Buy recommendation in my most recent article in August 2023. I deliberately called this Buy recommendation “contrarian” because I thought there was too much negative sentiment around the stock. Shares went down further after that because Siemens Energy’s management communication around financial guarantees from the German government for its EUR 100bn+ order book was exceptionally bad and spooked the markets. Still, shares are up more than 80% since my recommendation, outperforming the S&P 500 by a factor of more than 4.

But I am moving back now to my cautious stance. I think the rally has been overdone like the beating down of the stock last year. In my view, the stock is good for short- and medium-term trading, if you have the stomach for its volatility and the willingness to take risks, but for long-term investors Siemens Energy has been a disappointment ever since Siemens (OTCPK:SIEGY, OTCPK:SMAWF) spun off the Energy business in 2020.

I pointed out in my first article on Siemens Energy that investors would have been better off reinvesting their Siemens Energy shares back into the Siemens business after the spin-off, and this is still true now. Siemens has been consistently outperforming its Energy spin-off.

The Industrial Energy business is cyclical and suffers from low margins. The low margins have been the key reason why Siemens spun off its Energy business in the first place. While Q2 FY 2024 results were promising, Siemens Energy has still not made enough progress on the margin side, in my view.

The record order book of EUR does not guarantee that the company can translate those orders into record profits over the coming years. It can mean the opposite as we have seen with the wind turbine business where orders from years back had to be fulfilled at conditions the company had not foreseen after its costs increased. While this has plagued the whole wind turbine industry, Siemens Energy additionally ran into quality problems from its Siemens Gamesa subsidiary, resulting in a EUR 4.3bn loss in its 2023 financial year.

While the worst seems to be behind Siemens Energy now, I doubt that the wind turbine business will contribute significantly to the bottom line for years to come. Siemens Energy itself expects the wind business to be negative for the next two years and the best we can hope for is that Siemens Energy continues to downsize the business to avoid future losses. Recently, there seems to be more progress here. While we do not have a statement from Siemens Energy, there are reports that the Indian wind turbine business is up for sale for an expected price of USD 1bn, around EUR 1.07 per share. Siemens Energy is also cutting jobs in its wind turbine business, adjusting the workforce to the new reality of a smaller setup focusing on Europe and North America as its core geographical regions.

That leaves the “legacy” energy businesses as the main profit contributors, and they are doing well. However, this is now mostly priced into the stock valuation after the recent rally, in my view. The rally may continue for a while, but the risk/reward ratio starts looking unfavorable to me. Therefore, I am downgrading Siemens Energy to Hold.

Q2 FY 2024 financial results

Siemens Energy released Q2 results of the fiscal year 2024, (which ended on March 31) on May 8. Both top-line, but mostly bottom-line numbers came in above consensus. While there was not much tangible positive news from the wind turbine business, at least the company broke the pattern of negative surprises. Siemens Energy emphasized that there were no new technical findings and no material changes to cost assumptions related to Siemens Gamesa. Given the constant stream of bad news last year, this counts as good news.

There was more good news regarding the bottom line. Net income was EUR 108mn compared to a net loss of 189mn in Q2 FY 2023. Free cash flow (pre-tax) was also positive at EUR 483mn, significantly improving from negative 294mn in the previous year.

Revenue grew 3.7% (on a comparable basis) to EUR 8.3bn. The revenue growth was higher in the legacy energy business – Gas Services, Grid Technologies, and Transformation of Industry grew between 7% and 26% YoY. However, reduced new business in the renewables division meant that revenue declined there by 7%.

Based on the strong performance in the first half of the fiscal year, Siemens Energy raised its revenue and profit guidance. For the full fiscal year, the company now expects a (comparable) revenue growth between 10% and 12% (from previously between 3% and 7%). The profit margin (before special items) should be between negative 1% and positive 1% (previously between negative 2% and positive 1%). The guidance for free cash flow (pre-tax) was significantly raised to up to positive EUR 1.0bn (from previously around negative 1.0bn).

However, the operational business is not the main reason for this significant improvement. Siemens Energy expects around EUR 3bn from disposals, the greater part of which will be the sales of its stake in Siemens India Ltd to Siemens. The outlook for Siemens Energy’s net profit was kept unchanged at up to €1bn, including the one-time proceeds from disposals.

Due to the disposals, investors do not need to worry that Siemens Energy will run out of money. With a net debt of EUR 1.8bn euros, liquidity of EUR 6.7bn, and equity of EUR 10.2bn, the company is again well financed.

The large order book has opportunities and risk

Siemens Energy ended Q2 FY 2024 again with a record order book. Over the last quarters, the company has consistently achieved a book-to-bill ratio above one.

While new orders declined 21.8% on a comparable basis to EUR 9.5bn in Q2, the book-to-bill ratio was still 1.14 and the total order book grew to a record 119bn, more than 3.5 times the annual revenue. New orders exceeded revenues in three of the four Siemens Energy business segments – Gas Services, Grid Technologies, and Transformation of Industry. Only Siemens Gamesa saw reduced orders, which was expected as sales activity in the troubled renewables business was reduced.

Siemens Energy also said that the margin profile in the order book supports the mid-term margin targets. Siemens Energy targets a profit margin between 5% and 7% for FY 2026 (which will end in September 2026). And here lies the problem, in my view. Not only does Siemens Energy need to successfully execute and deliver its record order book, which it has struggled to do in the past due to the problems in Siemens Gamesa. Also, the profit margins it wants to achieve do not seem overly ambitious to me. I am back at my opinion about the spin-off from Siemens. While the industrial energy business is core to the energy transformation and our future, the business itself is cyclical and has low margins.

Comparing Siemens Energy and GE Vernova

General Electric (NYSE:GE) recently spun off GE Vernova (NYSE:GEV), its Energy business, as Siemens did a few years ago with Siemens Energy. The similarities go beyond that and comments from GE management and analysts look very similar to what we have been reading about Siemens Energy. There is talk about being central to the energy transformation, the unique positioning of the company, the future potential, and the narrative of the approaching energy investment super cycle, etc.

The two companies have a very similar business model and product portfolio, although with a different geographical footprint. They also have almost the same size. In its Q1 2024 earnings report, GE Vernova guides for USD 34-35bn of revenue in 2024. Siemens Energy’s guidance for FY 2024 revenue is between EUR 34.2bn and 34.8bn.

Not only are sales quite the same, but both have a large order book greater than 100bn.

The similarities go beyond that, and not always in a good way. Siemens Energy has not been profitable in a single year since the spin-off. GE Vernova is not (yet) profitable either. In Q1 2024 GE Vernova had a loss of USD -106mn.

S&P assigned a preliminary BBB- credit rating (the lowest investment grade rating) to GE Vernova, citing the low profitability compared to other manufacturers and the track record of weak earnings. The rating agency gave GE Vernova a stable outlook but mentioned operational risk in growing the renewables business as a possible reason for a potential future downgrade. This will sound familiar to long-term Siemens Energy investors. Siemens Energy has the same BBB- rating from S&P now but had started a notch higher at the time of the spin-off. S&P subsequently downgraded Siemens Energy due to the significant losses in its Siemens Gamesa wind turbine subsidiary.

However, GE Vernova enjoys a substantially higher valuation than Siemens Energy, with an EV/Sales ratio almost 2x that of Siemens Energy.

So, does this mean that there is a further upward potential for Siemens Energy? It could be, but I think, not. My view here is that this is rather a warning sign for GE Vernova investors to look closely at what happened to Siemens Energy after the spin-off when they assess the risk in their investment.

Valuation

As Siemens Energy has been unprofitable and in transformation (or turmoil if we want to put it negatively) since the spin-off in 2020, it was hard to put a target valuation on the stock. Stock price targets from analysts range from EUR 13 to 37, and the average is around 25 – about where the stock is currently. Maybe this makes sense, as the broad range of price targets reflects the uncertainty and execution risk.

The company targets for its FY 2026 are a profit margin between 5-7%, net income between EUR 1-1.5bn, and revenue of around EUR 38bn. This should come to earnings per share of between EUR 1.2 and EUR 1.9, and a P/E ratio between 13 at the lower end and 20 at the upper end, based on the current share price of around EUR 25.

In my view, the current share already adequately reflects the expected profitability improvements –and there is also a considerable execution risk to consider as Siemens Energy has not been profitable so far as a stand-alone entity.

Investors also need to consider that Siemens Energy has received government guarantees for its large order book. The company will not be able to pay out dividends or buy back stock for some time, so share price appreciation is the only value they get back.

Conclusion

Siemens Energy remains well-positioned to benefit from the energy transformation for years to come. The record order book of more than EUR 100bn shows that there is significant demand for Siemens Energy’s products and services. However, there remains uncertainty as to whether the company can translate this into sustainable, high-profit margins. I think a Buy recommendation is no longer warranted after shares have appreciated significantly since my Buy recommendation last year. Therefore, I am changing my recommendation to Hold.

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.