by Travis Miller (Analyst at Morningstar)
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.
Valuation
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.
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 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
Financial Health:
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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