Vestas Wind Systems, the Danish wind energy giant, celebrated its return to profitability in Q3 2023, prompting a wave of relief across the industry. But amidst the jubilation, a subtle shift in the Service business's narrative might be foreshadowing a more profound change than analysts currently recognize. The culprit? Two words tucked away in Hans Martin Smith's response to an analyst query: "time materials."

The CFO's comment, almost a throwaway line, suggests a growing reliance on "time and materials" contracts within the traditionally stable Service business. Unlike fixed-price service contracts, which offer predictable revenue streams and margins, time and materials contracts expose Vestas to fluctuating costs for labor and components.

This shift, while seemingly minor, could have far-reaching implications. For one, it raises questions about Vestas' ability to maintain its ambitious 25% EBIT margin target for the Service business. Time and materials contracts inherently carry greater margin risk, particularly in an environment marked by inflationary pressures and supply chain volatility.

Furthermore, the growing prevalence of time and materials agreements hints at a potential underlying issue: increased complexity in servicing Vestas' installed wind turbine fleet. While the company insists there are "no negative surprises" in existing warranty cases, the need for more time and materials contracts could indicate difficulties in accurately forecasting repair and upgrade costs, potentially stemming from unforeseen technical challenges or component availability issues.

Declining Service Margins Throughout 2023

The data supports the hypothesis that internal factors, possibly related to servicing complexities, are playing a more significant role in margin erosion than previously acknowledged. The chart below shows the consistent downward trend in Service margins throughout 2023.

Looking ahead, the implications for 2024 and beyond are unclear. Vestas maintains its ambition to achieve a 25% EBIT margin for the Service business in the medium to long term. However, achieving this target hinges on the company's ability to navigate the inherent margin volatility of time and materials contracts, which will require a deep understanding of the underlying drivers of these agreements, particularly the potential link to servicing complexities.

Further complicating matters is the impending ramp-up of Vestas' offshore wind business, which will introduce a new layer of complexity to the service portfolio. While the company insists that offshore warranty provisions are not expected to deviate significantly from onshore levels, the inherent logistical and technical challenges of offshore wind installations suggest a potential for increased reliance on time and materials contracts.

As Vestas navigates this inflection point, its ability to unravel the "time and materials" enigma will be crucial to maintaining the momentum of its recovery and achieving its ambitious long-term targets.

"Interesting Insights:"

Record Order Intake: Despite the challenges, Vestas secured a record order intake of 18.4 gigawatts in 2023, driven by strong growth in both offshore and onshore wind, particularly in the U.S.

Low-Emission Steel Towers: Vestas partnered with ArcelorMittal to launch low-emission steel towers, a major step towards fully circular wind turbines and reducing Scope 3 emissions.

Focus on Quality: Throughout 2023, Vestas emphasized a "value over volume" approach, focusing on securing profitable projects and managing its development pipeline strategically.