E.ON looks outside of Europe for growth in post-nuclear age.

E.ON's EOAN earnings continued their nose dive in the third quarter but remain on track to meet our full-year expectations. We are reaffirming our fair value estimate and long-term outlook.
It came as no surprise that the nuclear plant shutdowns earlier this year and the unfavorable gas marketing conditions weighed heavily on third-quarter and year-to-date profits. Divestitures, particularly the sale of its U.K. distribution utility, also hurt year-over-year comparisons. Adjusted EBITDA has fallen 39% year over year through the first nine months of 2011 to EUR 6.6 billion, and net earnings are down 64%. Management attributed EUR 2.3 billion of lost EBITDA to the nuclear plant shutdowns, slightly more than we expected, but not material enough to change our long-term assumptions or fair value estimate. Its growth investments in renewables, Russia, and upstream natural gas production are offsetting its Central Europe challenges, and its cost-cutting program should right-size expenses with its lost profits elsewhere.
Management affirmed its 2011 EBITDA guidance at EUR 9.1 billion to EUR 9.8 billion and maintained its EUR 1.00 per share dividend for 2011, a positive sign that the recent turbulence in its business at least could be stabilizing. If conditions remain stable or even improve, we expect E.ON could raise its dividend as much as 10% for 2012 and continue with 5% dividend raises in 2013 and beyond. Although this won't come close to bringing the dividend back to its EUR 1.50 rate prior to 2011, it does offer an attractive yield and growth prospects at E.ON's current stock price as of early November.

Thesis 08/12/11
Nationalist protectionism and political meddling in European energy markets constrain E.ON's ability to create value from its attractive asset portfolio and have forced management to look beyond its core region for growth opportunities. Still, management has shown strict adherence to return-on-investment hurdles and free cash flow generation, both key metrics for investors. Even with the coming nuclear phase-out in Germany, we think it could be a good long-term investment for those seeking European diversification.
Founded in the 1920s as Germany's national power company, E.ON today has more than 28 million customers in 30 countries. It ranks among the world's three largest investor-owned utilities, along with France's Electricite de France EDF and GDF Suez GSZ.
Acquisitions since 2000 enlarged E.ON's international footprint to include the United States, the United Kingdom, Scandinavia, and continental Europe. Its largest was the EUR 11.5 billion purchase of Enel and Endesa assets in June 2008. E.ON also acquired stakes in U.S. renewable energy, a Nordic utility, power plants in Russia and Turkey, and an Italian utility in 2008-09. It continues talking with Russian gas giant Gazprom about joint energy projects.
However, management recently changed course and is more than halfway through its 2009 plan to divest as much as EUR 15 billion of assets. Part of this was due to a November 2008 settlement with the European Commission that required E.ON to divest certain power transmission and generation assets by December 2011. Although the timing is particularly bad with energy prices at cyclical lows and asset prices depressed, E.ON has been able to execute swap deals for most of the EUR 3 billion of required divestments, preserving shareholder value. It also recently sold regulated utilities in the U.S. and U.K. at what we consider premium valuations.
In addition to the divestments, E.ON also has moved to refocus operations by selling its minority interests in German municipal utilities (Thuga), its U.S. utilities, its U.K. distribution utility, and its 6% stake in Russian energy firm Gazprom. The U.S. sale brought in about EUR 5.7 billion (roughly $8.0 billion) and the Gazprom sale brought in EUR 3.4 billion net of its share swap for the Yuzhno-Russkoye gas field in 2009. With these divestments, E.ON has cut EUR 7.4 billion from its four-year, EUR 63 billion investment plan announced in 2007.
We believe management has shown good discipline to protect its industry-leading 11% returns on capital. Such returns could be more difficult in a challenging economic environment. In Germany, E.ON faces growing discontent from customers and regulators who pay some of the highest energy prices in the world while facing supply shortages. Legal battles in Germany following the nuclear shutdown legislation passed in mid-2011 likely will drag on for years. Political pressure also could jeopardize cost recovery in distribution rates. Politicians in Italy, Spain, and Russia concerned with challenging economic growth prospects continue to meddle in energy markets with mostly negative implications for E.ON.
If European markets stabilize and E.ON's investment plan continues, shareholders should see strong returns for many years.

Valuation
We are reaffirming our $31 per ADR share fair value estimate after adjusting our projections following management's mid-year operating update. We recently cut our fair value estimate 27% to reflect the impact from Germany's decision to retire its nuclear power plants. We estimate phasing out the 60 terawatt hours of nuclear generation E.On owns in Germany results in a EUR 4.0 billion cut in annual revenue by 2015 and a $24 per share reduction in our fair value estimate. That is offset by $6 per share of benefits from lower operating costs, higher margins for its fossil fuel and renewable fleet in Germany ($3 per share), and the phase-out of nuclear fuel tax payments as plants close ($4 per share).
Lower energy prices in Europe continue to have a significant impact on near-term profits. After incorporating Germany's nuclear fuel tax and plant retirements, we expect earnings to bottom in 2011 near EUR 1.10 then climb above EUR 2.10 by 2015 as a energy markets rebound and investments drive strong earnings growth in its non-European operations. A EUR 1.1 billion of increased costs from carbon credits in 2013 offsets the earnings from our projected EUR 19.5 billion of capital investment between 2011 and 2013 and our assumption that management achieves its EUR 1.5 billion of cost cuts proposed in mid-2011. We do not assume any divestitures beyond mid-2011 although management has said it would like to sell an additional EUR 6 billion of assets by 2015.
In our discounted cash-flow valuation, we use current market credit spreads and an 11.0% cost of equity to produce a 9.4% cost of capital. Our fair value estimate is based on an exchange rate of $1.40 per euro as of August 11, 2011.

Risk
Our medium fair value uncertainty rating stems from the sensitive political environment throughout Europe and increasing earnings exposure to volatile energy commodity prices. A key uncertainty was resolved in mid-2011 when the German government passed legislation to shut down all of the country's nuclear plants and impose a tax on nuclear fuel until the plants retire. Although the outcome was a significant negative for E.ON, it allows the company to move forward with its post-nuclear strategy. Government-imposed limits on power prices in Germany and elsewhere are another recent concern. E.ON also could have trouble continuing to invest its large amount of capital at value-creating returns, especially given the influx of cash it has received through its divestures. For U.S. investors, appreciation in the dollar relative to the euro will depress the ADR shares.

Management & Stewardship
The German corporate governance structure includes a board of management, which oversees day-to-day operations, and a supervisory board, which acts like the board of directors for a U.S.-based company. E.ON's supervisory board has 20 members, each with five-year terms. Shareholders elect 10 members, and E.ON employees elect 10. The strong employee presence is common throughout Germany and all but eliminates shareholder activism. U.S. investors should be comfortable with this power-sharing before investing. E.ON's 10 shareholder-elected supervisory board members read like a Who's Who of German industry executives, with ties to Deutsche Bank DB, Siemens SI, Allianz, and other large German firms. Chairman Ulrich Hartmann, 72, who has been chairman of the supervisory board for the last eight years and was CEO and chairman of the board of management for the preceding 10 years, retired in May 2011. The supervisory board approved Werner Wenning, 64, to succeed Hartmann. The loss of a long-time insider could be good or bad for shareholders, but we don't  expect any significant change in strategy under Wenning.
The board of management has seven members, appointed to five-year terms by the supervisory board. CEO and chairman Johannes Teyssen assumed the role from Wulf Bernotat in May 2010 after Bernotat passed the standard retirement age (60) and his contract expired. Teyssen has held key management jobs at E.ON for many years, including COO since 2004, and we expect a smooth transition. We like that compensation for the supervisory board and the board of management includes variable components linked to dividends, earnings before interest and taxes, return on capital, and stock performance.

Overview

Financial Health: E.ON's strong balance sheet has allowed it to re-sign credit agreements and issue debt through the credit crisis. The EUR 9 billion of divestments during the last two years have allowed it to cut its net debt nearly in half, supporting its premium credit rating even through trough earnings period. If energy prices rebound from recent lows, we expect interest and dividend coverage to remain strong. We were not surprised that management decided to cut the 2011 dividend to EUR 1.00 per share from EUR 1.50 per share in 2010 given our projections for its payout ratio to fall below management's 50%-60% target range. In August 2011, management guided toward a EUR 1.10 per share dividend in 2012 with a potential increase again in 2013 depending on commodity market moves and investment opportunities.

Profile: E.ON is one of the world's largest integrated power and gas companies. It generates, transmits, and distributes electricity and natural gas in 30 countries, primarily in Europe. As of 2010, the firm was the largest German gas company and generated one third of Germany's electricity, sourcing about 40% of this with nuclear power. However, the country's nuclear shutdown legislation will reduce its power generation share significantly.