E.ON EONGY
reported nine-month operating income of EUR 4.0 billion and adjusted
EBITDA of EUR 8.8 billion. Both are up substantially from 2011, as we
expected, and remain in line with our full-year projections. Management
reaffirmed its 2012 earnings guidance of EUR 4.1 billion-4.5 billion and
EBITDA guidance of EUR 10.4 billion-11.0 billion. Management also
reaffirmed its intent to pay a EUR 1.10 per share dividend.
However,
management said it was reviewing its 2013-15 outlook, given increased
uncertainty since it issued its outlook in March and reaffirmed it in
May. We also will review our EUR 22 fair value estimate for a possible
cut. We are reaffirming our long-term midcycle earnings estimate, so any
near-term adjustments will have a minimal impact on our fair value
estimate.
Management initially forecast 2013 net income of EUR 3.2
billion-3.7 billion and EBITDA of EUR 11.6 billion-12.3 billion.
Management also forecast an annual earnings per share growth rate
exceeding 10% in 2011-15. Our projections were at the high end of those
ranges, and we will review our outlook for a possible cut.
Although
the nuclear shutdowns in Germany are behind it and the firm's wholesale
gas trading margins have improved, E.ON still had to take a EUR 1.2
billion impairment charge in the quarter across several of its
businesses.
E.ON also in November made two moves that demonstrate
its intent to sharpen its focus and pare back its growth capital
spending. The company announced it plans to sell its 34% stake in
Finnish energy company Fennovoima as part of its plans to exit the
Finnish market and focus on the Danish and Swedish markets. Fennovoima
had proposed building a new nuclear plant with E.ON's help. E.ON also
sold its joint venture interest in Horizon Nuclear Power, which targeted
new nuclear plant development in the United Kingdom.
Thesis 09/18/12
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 nuclear phaseout in Germany and
lackluster energy demand in the depressed European economy, we think
E.ON could be a good long-term investment for those seeking European
diversification.
Founded in the 1920s as Germany's national power company, E.ON ranks
among the world's three largest investor-owned utilities, along with
France's Electricite de France and GDF Suez. Acquisitions in 2000-08
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.
However, the European financial crisis, collapse in commodity
markets, and worldwide recession led management to reverse course in
2009. For 2011-13, management is targeting EUR 15 billion of divestments
and using much of that capital to reduce debt or invest outside the
eurozone. The divestitures included government-mandated disposals of
certain power transmission and generation assets in Europe, sale of its
regulated distribution utilities in the U.K. and U.S., and elimination
of its minority interests in German municipal utilities (Thuga) and
Russian energy firm Gazprom. Despite the challenging market conditions,
we think E.ON achieved good returns from those deals.
We believe management has shown good discipline to protect its
double-digit returns on capital. The prompt shutdown of 4 of its 11
nuclear plants in Germany in 2011 took a big bite out of those returns,
but we expect returns to rebound by 2014-15. In 2011, E.ON's regulated
and quasi-regulated businesses contributed the same amount of EBITDA as
its merchant generation portfolio, and we expect that mix to continue
for several years.
With a bleak outlook for generation margins and demand, management
has turned its focus to renewable energy and conventional generation
investments outside Europe. Management hopes to take advantage of the
opportunities for renewable energy growth to fill the lost nuclear
generation in Germany and to meet the European Commission's Energy
Roadmap 2050, which aims to cut carbon emissions 80%-95% by 2050.
If European markets stabilize and E.ON's investment plan continues, shareholders should see strong returns for many years.
We
are reaffirming our $29 fair value estimate for E.ON's ADR shares after
a first-half performance that puts E.ON on track to exceed our previous
expectations.
We are raising our 2012 EBITDA projections primarily because of
E.ON's faster-than-expected success renegotiating its gas supply
contracts. We now estimate E.ON can earn EUR 10.8 billion EBITDA in
2012, up from EUR 9.9 billion previously. Offsetting this near-term
benefit, we cut our 2013-15 EBITDA estimates 2%-3% to incorporate lower
hedged and open generation margins. Our new earnings per share estimates
are EUR 2.19 in 2012 and EUR 2.60 in 2013.
From trough earnings in 2011 to our normalized midcycle commodity
market assumptions in 2015, we estimate E.ON can double its net
income. Driving these results are our assumptions that European
commodity markets remain near current levels for the next two years and
that the nuclear phaseout in Germany proceeds as scheduled. This results
in only one additional nuclear plant closure in E.ON's fleet during our
five-year forecast. We discount our perpetuity value to account for the
final nuclear plant shutdowns in 2017-22.
Key profit drivers in 2013-beyond include E.ON's cost-control
program, its renewable energy growth projects, and its full realization
of benefits from its gas supply contract renegotiations this year. We
expect these positives to offset an additional EUR 1 billion of costs we
estimate from the full auctioning of carbon credits and mostly flat
generation margins.
We assume E.ON invests an average of EUR 6 billion annually in
2012-16. In our discounted cash flow valuation, we use current market
credit spreads and an 11.0% cost of equity to produce a 9.6% cost of
capital. Our fair value estimate is based on an exchange rate of $1.31
per euro as of Sept. 17.
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
divestitures. For U.S. investors, appreciation in the dollar relative
to the euro will depress the ADR shares.
Management & Stewardship
Management
has faced numerous hurdles the past three years and has embarked on an
aggressive restructuring plan. This makes it very difficult for
investors to determine core financial performance since 2007; however,
we think management has negotiated fair prices for its divestments, and
we like that it has retained its most valuable power generation assets.
E.ON historically has achieved returns on capital near 10%. That's
likely to fall, but we still think management has the right balance of
growth and cost management to maintain returns in the high single
digits.
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.
German law requires shareholders elect 10 members and E.ON employees
elect 10. The strong employee presence is common throughout all but
eliminates shareholder activism.
E.ON's 10 shareholder-elected supervisory board members have
high-level experience across many sectors. In 2011, the supervisory
board approved Werner Wenning as chairman. He succeeded Ulrich Hartmann,
who retired in May 2011 after being chairman of the supervisory board
for the previous eight years and the CEO and chairman of the board of
management for the preceding ten years.
The board of management has six 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
E.ON's
strong balance sheet has allowed it to re-sign credit agreements and
issue debt through the credit crisis. As it moves toward completing its
plan to sell EUR 15 billion of investments in 2011-13, E.ON has cut its
net debt nearly in half, supporting its premium credit rating even
through a trough earnings period. If energy prices rebound from recent
lows and management reaches its target of EUR 9.5 billion of
controllable costs by 2015, 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 2012, management reaffirmed its plan to
pay out a EUR 1.10 per share dividend for the 2012 fiscal year.
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 E.ON's power generation share
significantly.
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