Siemens Energy: Winds of Change - [Business Breakdowns, EP.177]

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1:05This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. And we are here to bring them to you. To find more episodes of Breakdowns, check out JoinColossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. hosts, podcast guests, their employers, or affiliates may maintain positions in the securities discussed in this podcast.

1:48This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. I'm Zach Fuss, and today we are breaking down Siemens Energy, a spinoff from industrial giant Siemens completed in 2020. Siemens Energy operates across the entire energy value chain with a significant presence in both conventional and renewable power. They're a major player in gas turbines and power generation, while also more recently taking full control of Siemens Gamesa Renewable Energy. What makes this company particularly interesting is its position at the forefront of the energy transition.

2:25As the world moves towards more sustainable energy systems, Siemens is uniquely placed to bridge the gap between traditional energy sources and renewables. However, the company faces real challenges, particularly in its renewables division. Siemens Gamesa has been dealing with a litany of issues including supply chain disruptions, project delays, and technical issues with their turbines. It presents a complex situation for Siemens Energy as they navigate the shift to green energy. The company's ability to leverage its expertise in conventional power to address these renewable energy challenges will prove to be crucial.

3:04As the global economy balances the demands of incremental energy along with a mandate of decarbonization, Siemens Energy will play a vital role. To break down Siemens Energy, I'm joined by Mark Hiley, the founder and managing partner of The Analyst, a London -based independent equity research firm. We hope you enjoy this breakdown of Siemens Energy. Mark, thanks for joining us to break down Siemens Energy. It's a business that as early as 2019, Siemens, the larger conglomerate, started to discuss its intention to kind of separate. And now with it being an independent public company, I thought maybe we just kick things off with talking about the impetus for the demerger and kind of what the business represents to you today.

3:51It's an interesting business. Siemens, as most people will know, is a very old company. It's over 150 years old, founded in the mid -19th century by Werner von Siemens. It's been a sprawling engineering business. They were pioneers in many of the electrical innovations in the 19th century, and then it became a much bigger industrial conglomerate through most of the 20th century. In 2019, 2020, they started to discuss the spin -off of Siemens Energy, which is the business in gas and power and wind, which we'll be discussing today. But prior to that, they'd already spun off Siemens Healthineers, which was their healthcare business.

4:29Healthineers then went and acquired Varian, the large radiotherapy business. And Siemens AG retained their core industrial businesses, which were digital industries is the main division inside Siemens AG today. And that has a lot of software and industrial applications. So the idea with Siemens Energy was that in 2020, the business needed separate focus, given the megatrends which were on the horizon around renewables, grid, this sort of revolution which was coming on the world around energy networks. And also within Siemens Energy, there'd been some problematic businesses. So the gas and power business, although it's profitable today, had actually had some challenges inside Siemens.

5:14They'd have been loss -making. They'd struggled with some of the platforms. They probably had too many products and a lack of focus. So So Siemens AG really from the top down was trying to improve capital allocation, start to focus really on shareholder value, which was a big change for Siemens AG, given that it was 150 year old German conglomerate and reduced complexity. So that's how Siemens Energy came about. And it was spun off from Siemens in 2020. Siemens AG retained something around a 30 % to 40 % controlling minority shareholding. They've subsequently sold down some of their stock and put some of the shares into the Siemens AG pension fund and the pension fund has sold.

6:01And you now have Siemens Energy listed today, about 20 billion euro market cap in Germany. And the most comparable business, probably GE Vinova. So also interesting to note that Siemens AG was slightly ahead of GE in doing this breakup. And really what the breakup is all about is simplifying and giving more transparency and more accountability inside a big conglomerate. And of course, that's the path which GE followed more recently. So now we have this somewhat more simplified, but still a beast of a business, as I think you would agree. If we were to kind of break it down a step further into the segments and how you think about them, what are the important business units to address here?

6:46So somewhat more simplified than the old Siemens AG conglomerate, but still quite a complex business to get into. And this is what has fascinated me as an analyst looking at it over the last few years. we have quite a history researching the company, which we can talk about later in the episode. But basically, Siemens Energy, you have around 35, 40 billion euros of revenue today for the whole company. But behind that, there's an order backlog over 110 billion euros. There's two businesses. The first business is Gas and Power. And that's a business with around 25 billion euros of revenue. Then there's just over 10 billion euros of revenue in wind.

7:31We can break that down even further within gas and power. There's three divisions. The biggest, probably the most important is the gas service business, which is actually quite a simple business in a consolidated market. That's about 11 billion of revenue, double digit margins. Grid technologies is another 10 billion of revenue. So these are bits and pieces to build power grids, HVDC converters, large pieces of substation kit, anything you need to make transmission work. That's also a double digit margin. Then you've got something they call transformation of industry, which actually has four subdivisions in it, sustainable energy systems, which is very small.

8:14That's essentially a hydrogen business. Then what they call electrification, automation, digitalization, which is a catch -all for bits and pieces for controlling power systems. Industrial steam turbines and generators, quite self -explanatory, and compression kit. And what brings all of that gas and power business together is that they are essentially selling into traditional grids. So the big customers here are national or state electricity companies, someone like National Grid in the UK or Tenet in Europe would be a big customer. It's very profitable growing, although it wasn't profitable and growing three or four years ago.

8:55And then you've got the wind business. That's about 10 billion euros of revenue. And it's called Siemens Gamesa Renewable Energy. That was formed through the merger of Siemens Wind and Gamesa Renewable Energy, Gamesa being a Spanish business that was previously listed on the Spanish stock market as SGRE, Siemens Gamesa. Siemens Energy or Siemens before them always had a majority stake in that business. And then a couple of years ago, they took out the minorities. They now own 100 % of Siemens Gamesa Renewable Energy. So that's a 10 billion euro wind business competing with Vestas and GE. It's massively loss making.

9:37It's been an absolute disaster, which I'm sure we're going to get into. It's probably going to lose close to 2 billion euros this year and maybe more on a cash basis. So you wrap it all up together, you have a 35 billion euro business by sales, which is not profitable yet at the group level because of those big losses in wind. I'm going to want to go into each of the kind of subsegments in greater detail, but I thought it may be helpful to kind of take a step back in that you kind of referenced that there are a number of divisions that are now profitable that hadn't been. And my guess is that just given the convergence of a number of themes, primarily around electrification and the green transition, that the business is now strengthening into that transition.

10:22What exactly has occurred, which has led to increased demand and revenue drivers for the business broadly before we just jump a little bit deeper into the segments? So gas and power, as I said, was actually loss making in 2019 and 2020. And back then, Siemens was struggling with cost base, the manufacturing footprint, the complexity of the business. And of course, the demand was also in a much lower place. It was a completely different demand picture from what you see today in 2023 and 2024 when grid investments are booming. So back then, the core gas service business, which sells large generators for gas power generation that was a shrinking business with large losses on the new units.

11:08The grid technologies back in 2021 was only taking less than 10 billion euros of orders a year. It wasn't really growing and it had low single digit margins. Now roll forward three or four years and demand is booming. So what's happened really is that as you add more renewable energy to the grid, as you put solar and wind on the grid, that creates more variable load and that creates a need for resiliency. So you have to reinvest in gas capacity to balance for when the wind's not blowing or the sun's not shining. On top of that, countries are becoming more interconnected. So if you think about Germany, they may have solar generation in the south, they may have wind generation in the north, and it may be that at night the wind is blowing, but the sun isn't shining.

11:56So you need to find ways to move that energy from the north to the south. And that requires a lot of resiliency and interconnection, new cabling, a new substation around the German grid. But not only that, the European countries, including the UK, even after Brexit, are starting to integrate their power networks. So there'll be cables run from Scotland to Norway, Denmark to the UK, and each country individually is realizing that they need to interconnect to manage the more variable generation and of course, move away from reliance on Russian gas. The Ukraine war really highlighted a need for energy independence.

12:35So there's plenty of strong drivers overlay that with legislative changes, targets towards net zero, and then also big changes on the demand side. So as you connect data centers or electric vehicles to the grid, as there's more electrification of industry, that creates a much bigger pull on the demand side, and that stimulates increased demand for low -voltage and medium -voltage components on the demand side. And of course, the more you load in there, the more resiliency you need in the high -voltage and the core grid. So basically, what you've seen is the CapEx budgets and the multi -year strategic plans at the national grid operators have increased materially.

13:17So companies like Eon and National grid have doubled, tripled, quadrupled their CapEx plans. You're seeing the same in the US. And I think the state of Texas is talking about interconnecting with the rest of the US. Some states are starting to talk about moving to high voltage power, direct current instead of AC current. So there's these big megatrends happening, and that's really put a fire under the demand side. So grid gas and power at Siemens Energy, the order books exploded. It's more than doubled over the last four years. It's still growing strongly this year. You see that on the grid technology side, also on the gas service side, which we'll probably get into next.

13:59There's an expectation that there'll be an increasing demand for gas power generation units. Five years ago, the consensus would have been that that's a terminal or a structurally declining market. So these businesses are actually capacity constrained. Siemens Energy and GE, Vinova, However, if you go to them now as a large grid operator, you're going to struggle to get delivery slots in the next few years. So the order books are lengthening. I think these companies have pricing power, which they didn't have before. And on top of the pricing power, they're able to cherry pick the best contracts and then place those contracts into their order backlog in a more efficient way.

14:40They've simplified their product portfolios. If you look elsewhere in the sector, there's other listed stocks in Europe. Companies like Prismian, NKT, and Nexen's, which simply do the high voltage DC cables. And those companies are now taking orders, which will be called off into the 2030s. So it's almost like all these companies that supply power grids are becoming sold out, at least until the end of a decade. So a big shift in the demand supply picture driven by these megatrends. So in the context of a strengthening backdrop, I love to spend time on the business units themselves and just better understand what the competitive landscape looks like, the basic revenue model.

15:23Perhaps it makes sense to start with gas services, given that it's the largest and most profitable unit. We'll have to hear more about how the business functions and what its strengths are. So gas service, which is power generation, so gas and steam turbines, also some engines, controls, and electrical systems. But think about Siemens Gas Service is selling the large gas turbines which generate power from gas. It's a very consolidated market. You've got Siemens Energy, Mitsubishi, Jiva Nova, and Baker Hughes playing that. And then there's a smaller company, Ansaldo Energia, which was taken out.

15:57I believe that's an Italian company, but it's a very consolidated market. And you basically have somewhere between 100 and 110 large gas turbines built every single year. And that's been broadly in line with the demand in the market. Demand more recently is expected to go up. So there's a belief that data centers could add demand for at least another 30 or 40 large gas power plants a year. So this is about the growth in electricity demand. So it's a consolidated market. Siemens Energy, one of the largest. They're good at it. And as I said, over the last few years, they've consolidated their product line into a sort of more modular offering.

16:40So that's about an 11 billion euro revenue business, double digit margins. But I think the interesting thing about this business is it's all about service contracts. So if you look at the revenue breakdown, although maybe 35, 40 % of revenue is from new units, the profitability is really coming from the service contracts. So there's a very high attach rate for the customers. Siemens Energy, very sticky on the service contract. Obviously, it makes sense for a Siemens engineer to service a Siemens turbine. And the turbines and the gas service businesses have very, very long duration. So they'll be in place for decades.

17:19So you have very long -term, sticky service contracts. And we think that service margins are probably now above 20%. So if you can break even on new units and build up the installed base and then attach those service contracts at 20 % plus margins, you have a very attractive business. And I think the other thing maybe just worth highlighting here is that it's a very capital light business. So although Siemens Energy don't disclose anymore the capex by subdivision, we do know that the capex for the whole gas and power business is only around 500 or 600 million euros a year. And that's a business which is 25 billion euros of revenue.

18:02So the economic profile of gas service should be extremely attractive. Double -digit margins, capex to sales ratio below 2%, and a very simple long duration service business, essentially. To the extent that they can reinvigorate growth in that particular segment, where would that growth come from? Again, going back to where we got into 10 minutes ago on this episode, four or five years ago, the common view was that the number of gas power generation units in the world, particularly in Europe and the US, would decline. And then what's happened is that governments and grid operators have realized that as you add wind and solar to the grid, and you increase the renewable mix, you actually need more resiliency in the grid.

18:50So you need a base load. And if the most simple way to think about it would be in the case of a peaker. So a gas peaker is quite a simple gas turbine, which you can turn on and off, depending on the needs of the grid. So in the UK, we've added plenty of wind. Now, when the wind isn't blowing and Coronation Street is on, which is a big soap opera on ITV, famously in the UK, in the advertising break of Coronation Street, everyone goes and makes a cup of tea. That creates a huge load on the grid. Everyone puts the kettle on. And of course, if you don't have wind at that point, you'll be short of electricity.

19:27So you need a steam peaker or a gas peaker, which you can turn on in anticipation of the load. So that gas business is moving back to growth as the energy mix changes. And then also governments are trying to phase out coal. So particularly in Germany, the phase out of coal to meet their larger objectives around net zero and all the German government's commitments. The phase out of coal is requiring more gas capacity and more baseload. So that's a market which is probably going to start growing the installed base. And then you add data centers in, which create a huge step change in energy demand.

20:06If you assume North American and European energy demand starts growing at 2%, 3 % a year, you're going to need more power generation capacity. And you can meet it by adding solar and wind. But if you add more solar and wind, as I said, you need backup. And no one wants to be on coal anymore. So you need gas and Siemens Energy of a market leader there. The growth engine of the business today is seemingly grid technologies, which is outpacing the rest of the group meaningfully. What is that business value prop and who is it competing with and what are the core services it's providing? So we keep dropping down through the gas and power business.

20:45So that was gas service, which was expected to be no growth, but now is expected to be growth. And then we get into the exciting bit of Siemens Energy today, which is grid tech. To my mind, this is their best business today from a growth and economic profile perspective. It's about 10 billion euros of revenue. But in the last two years, the order intake has at least doubled. It's gone from taking less than 10 billion euros a year of orders to around 20 billion euros a year. And the backlog has more than tripled. The backlog in 2021 was 10 billion. And it's now well over 30 billion euros. and the company's guiding for grid technologies to grow revenue above 30 % this year.

21:30And they had a capital markets day in Germany at the end of last year. And they talked about, they described it as low double digit growth, which I suppose could be anything between 10 and 45%. So they've been kind of unclear on what the growth rate is. But last year, they grew 17 % comparable. This year, as I said, they're guiding for over 30. The order intake has doubled, the backlog has tripled, and their core customers have doubled or tripled their capex budgets. So this will be a very, very strong growth business. It could grow around 20 % top line to the end of a decade. So much faster growth in gas service.

22:09And this is where they're selling essentially large bits of kit to make a power grid work, to make sure energy and electricity is transmitted. so high voltage components interconnectors ac components if you think about driving around and you see the overhead power lines often next to those power lines you'll see a substation and that substation which from the outside looks like a bunch of gray boxes will be full of siemens energy component if you build an offshore wind farm you probably need an offshore substation, that would also be full of Siemens Energy Kit. Quite a simple business, also likely to be a double digit margin.

22:52The company's guiding 8 % to 10%. Also a very capital light business in terms of having a very low capex to sales ratio, so very high return on capital and a very high growth business. There's obviously a question here about how much they can grow. I think in the next few years, they'll probably be approaching practical capacity So their customers will now be screaming at them for more capacity and screaming at them to add factory footprint to meet demand. So I think in this business, Siemens Energy Management will have an interesting question around capital allocation. There'll be a big decision here about factory footprint towards the end of a decade, but essentially a very high growth, very attractive business.

23:36And in the context of this grid technologies business, clearly there is a supply -demand imbalance globally right now, perhaps a pull forward in demand. If you think about through a cycle how this looks, or even today from a competitive perspective, how do they pick and choose who to award business to versus not? And then I guess conversely, how do customers decide who to contract with and who they want to work with? What is the landscape? Very consolidated market. Very few players in here. Gee, Venover are more on the gas service side. So in this business, you've got Siemens Energy going up against companies like Hitachi, Mitsubishi, very large player.

24:20And customers here are looking for long -term partners. The technology in this area is very mature, but the orders are large. And they need a partner who can provide components and be there for them over the next 20 or 30 years. So these are governments and grid operators making very large orders, which will be pulled off towards the end of the decade. So they need large, reliable partners. Siemens Energy, it's a business employing, I think, around 90 ,000 people. It's a business with 150 -year history. It's a business with a very good reputation for engineering, maybe less of a good reputation for long -term shareholder value creation, if you look back historically.

25:04but as with many German engineering companies you sort of have the best of German engineering excellence in here so Siemens Energy are often the only game in town particularly in Europe extremely dominant the industry is now capacity constrained and you need someone who's going to be in business in 10 or 20 years time if bits of kit breaks down if the warranty is needed spare parts, upgrades, additional components. And really, Siemens Energy and other suppliers in this industry are working within very, very long -term strategic plans of the grid operators. It's quite a long cycle business. It's been a little bit boom -bust historically.

25:46Obviously, now people are starting to think, is this a super cycle? We've got the re -industrialization of grid networks, very, very exciting. But because of that capital light nature, and the stop -start investment cycles of the customers, and also the sort of lack of energy demand growth over the last few decades, it's a business which has been boom -bust. So I suppose investors are hoping that Siemens Energy shows some discipline, that they cherry -pick the orders, that their customers haven't pulled forward all the demand on the back of Ukraine war and a sort of panic around energy security and high energy prices.

26:22But I think a bit of context for that, although there certainly has been some pull forward of demand and the Ukraine war really brought the problems of grid resiliency into stark relief, the reality is these grids haven't had investment for decades. There is parts of the British electricity grid, which have not been looked at since the 1980s. So there may be pockets of demand as products, which have really been overlooked for maybe 30 or 40 years. So you could have really a long lasting super cycle here. Of course, subject to energy prices, subject to political stability, there's legislation needs to be passed, the governments need to maintain their commitments to take action on climate.

27:11You need data center and electric vehicle demand to keep growing, but the pieces are in place for a very long cycle here. And it's early. As I said, we're only two years into the upswing on this business. Yeah. I know if you look at some of the industry data, at least provided in the US, energy consumption and transmission growth was like a one -ish percent to maybe 2 % industry, which is seemingly inflecting. I think you have a lot of that globally. So it seems like everything is coming together for this business to have a very long cycle here. It looks like it. And as I said, these strategic plans of grid operators are running into the 2030s.