It was with great interest and excitement that I followed the various press releases, conferences, interviews and public relations activities of the German utility E.ON earlier this month. It is not everyday that the CEO of a major utility comes out and say things like: “EON will in the future totally concentrate on renewable energy, the distribution grid as well as customer solutions and with that concentrate on the most important elements of the new energy world.” But this begs the question why E.ON is doing this and whether the strategy of breaking the company into two companies E.ON and a no named new company, (E.OFF as some of the German media are calling it) make any sense.
The reason why they are doing it is simple, it is called weakness in E.ON’s core power generation business which have negatively impacted profitability as well as pressure from its investors which have seen the share price fall 70% from its 2008 highs. Until the recent strategy announcement E.ON’s market capitalisation had been below its book value for a long period of time meaning that the financial markets have been pricing in that the company cannot generate a significant enough return to keep its shareholders happy.
The 10% increase in share price in the week following the announcement of the new strategy shows that the capital markets are happy with the decision to split the business in two, one a largely regulated business (E.ON) and the other “E.OFF” which will contain a mixture of poorly performing businesses and unregulated businesses.
The rational behind this move is the view from many in the financial markets that the breakup value of E.ON is greater than its current market value. A quick look at sector-average valuation multipes seems to bear this out. E.ON traders at a 7x EV/EBITDA 2015E multiple while regulated businesses across Europe are trading at a much higher 11x EV/EBITDA 2015E multiple. By splitting the company into a largely regulated business and an unregulated business E.ON’s shareholders should be better off; at least in theory.
One item that the financial community has largely ignored is E.ON’s impairment write-down of €4.5bn in the value of mainly generation assets which means confirms that the company will probably loose €3.5bn at the net income level this year. Now many of the investment bank analysts covering the company talk in terms of adjusted earnings (meaning that they ignore the write down) arguing that these type of losses are non-cash which means that they do not impact the cash inflows of the business in the future as these assets have been paid for in the past. They are partly right. However, such write-downs are a good way of judging the past investment decisions and strategy of the company and the numbers don’t speak well for E.ON management.
E.ON management wants to focus on renewables, grid and consumer solutions which combine a very interesting mix of regulated returns and unregulated returns, but they are very late to and small in European renewables (1.9GW of renewables out of 900GW across Europe) and they are not very good at dealing with customers so it will be challenging, to say the least, on the execution side. On the other side, they are getting rid of all of their businesses exposed to commodity price risk into “E.OFF” by transferring a majority of that company’s capital stock to E.ON’s shareholders. “E.OFF” will include all “problem children” businesses of E.ON including trading (which is regarded in the industry as being below par), its oil and gas E&P business (not a good place to be with oil prices being what they are) and generation. The latter deserves a special comment.
E.ON management over the last decade (most of whom are still in the company) never understood the “technological” changes going on across generation. They did not understand the impact that renewables would have on power prices. They did not understand the impact that energy efficiency technologies would have on power demand and most shocking, despite owning an E&P business, they did not understand the impact that shale gas would have on global coal prices. And so E.ON made lots of poor decisions over the last decade which they are not trying to rectify by dumping the mistakes all into a “bad bank”, and bad bank is the right phrase because there are significant hidden risks in “E.OFF” not least of which is the decommissioning of its existing nuclear power station.
Over the last months the German utilities have been in talks with the German government to establish a fund to decommission all of its nuclear power stations, following the UK model. Why would one do that given that the German utilities have been setting aside reserves for decommissioning for years, and in the case of E.ON. it’s a substantial amount of money, circa €15bn? You would only do this if you do not believe you have enough money set aside for decommissioning. And the idea of E.ON is that these reserves and the nuclear assets as well as the decommissioning responsibilities go to “E.OFF”. A stroke of genius for E.ON management perhaps? Let the “E.OFF” shareholders deal with the risks of decommissioning as well as all the other problem children leaving E.ON with the opportunity to reinvent itself and create a new position for itself in the changing world of European power. There is only one issue. The German government will not allow E.ON to offload its nuclear responsibilities that easily. And you can be guaranteed that they will bring in legislation requiring E.ON to guarantee all the liabilities in E.OFF, and if that is the case then the break up of the company may not make that much financial sense…