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Value Idea Contest - E.ON

April 10, 2013 | About:
Chandan Dubey

Chandan Dubey

97 followers
1 History: E.On (EONGY) is the result of a merger between VEBA and VIAG, which were founded in the 1920s to serve as holding companies for state-owned industrial enterprises. VEBA and VIAG were privatized in the 1960s and 1980s respectively and were part of the Dax until they merged to form E.On, one of the world's largest utility companies.

Company: E.On (EONGY)

Net Debt: €30 bn

Market Cap: €26 bn

EV: €69.4 bn

Sales: €132 bn

Dividend: 8.5% (before withholding tax of 26.38%)

BusinessUtility, regulated
ManagementPoor
Balance sheetAverage
RiskManagement, debt, interest rates, regulations
ValuationCheap


At the time of merger, E.On was active in energy and chemicals. In the first few years (i.e. until 2004) E.On concentrated its business by acquiring Powergen (British energy company with EV of €15.3 billion), Espoon Sahko (a Finnish utility company), Ruhrgas (a gas utility active in 20 countries in Europe), Édász (a Hungarian utility company) and selling Kloeckner & Co (a steel trading business), its packaging business.

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2 Business

E.On is active in nearly every area of power: generation, distribution, exploration, gas supply, gas storage, trading and sales. Following is the revenue by segment in 2012.

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The optimization and trading division dwarfs the rest of the segments in terms of revenue with nearly 88.4% of the slice. Unluckily, this is also the business with lowest margins. Optimization and trading buys and sells electricity, gas, LNG, coal, oil, biomass and carbon allowances. Being the most regulated segment of the lot, it ekes out the lowest profits. Here is the segment-by-segment EBITDA for the year 2012.

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E.On’s business, taken as a whole, has seen decreasing gross margins since its formation. The shrinking margins have been exacerbated by the economic situation in Europe and can be clearly seen from the graph below. We see a downward trend since 2009, the start of the economic crisis.

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3 Management

What does E.On do with its cash? Apart from a share buyback announcement of $58 million in 2007, I see no indication of buybacks. It pays nearly 50% of its income on dividends. The rest goes into acquiring businesses and servicing its huge debt. In my opinion, the acquisition has not fared so well for the shareholders, and I am happy to see that the debt is going down as E.On continues to sell some of its businesses.

mj2wNeJAvw8sYDH5GvTfSKZNAcwdTU7iba36xkBGOn a purely capital allocation basis — which is probably the most important task of the management — they have failed. They showed no foresight in acquiring businesses during the tenure of the their first CEO. The balance sheet was left bloated with nearly €45.6 billion in LT+ST debt. The interest expense itself was touching €3 billion!

I did an analysis of the business of Veolia Environment (VE) before and the similarity is uncanny. Veolia also formed around the same time and went through a similar strategy reversal, i.e. buying businesses until 2010 and then divesting afterwards. It seems that the management was trying to buy their way into growth and profitability, which did not work out so well. They took a lot of debt and ruined the balance sheet of their respective companies. Now the next CEO is trying to fix their mess by concentrating the business and selling non-core assets.

4 Balance Sheet

We first look at the development of long term debt over the last 10 years or so.

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During the tenure of Wulf Bernotat (2003-2010) the company was using long term debt financing to make a lot of acquisitions. Even though the acquisitions were in the core business segment, their effect on the balance sheet was bound to be a negative. This changed when the new CEO Johannes Teyssen took over in 2010. The effect become immediately clear from the graph above.

Still E.On has a lot of debt. It has been selling a lot of business recently and has managed to pull down the debt, i.e. in the last year (2012) it paid nearly €4 billion of its debt. The debt currently stands at €25.9 billion and E.On has an interest expense of nearly €1.4 billion.

The interest cover on EBITDA of €10.8 billion is nearly 7.7 and puts E.On in a good position with respect to servicing its debt. The debt maturity profile is shown below.

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Assuming that the EBITDA remains the same, the company will be able to pay its debt when it is due. Probably this will imply that E.On will not be able to invest a lot in its business but if push came to shove — E.On will fare quite well.

5 Risks

One of the major risk is from regulations. Most of the businesses in which E.On operates have been historically publicly owned. The price of gas, electricity and its services are regulated by the respective governments. Furthermore, some of its industry might be on a risk of closure because of changes in government policy (example: the risk of nuclear plant closure in the aftermath of Fukushima disaster). An increase in public awareness has led to a shift from traditional sources of energy to renewables and E.On will need to make significant capital expenditures to position its business accordingly.

E.On has a history of making huge acquisitions. It continually focuses and refocuses its portfolio. Prior to 2007 it acquired a host of companies (Skydraft - Sweden, OGK-4 - Russia, Powergen - UK, portfolio of Endesa - Spain, Ruhrgas - Germany). Later it started selling them, e.g. E.On U.S. to PPL for $7.6 billion. Just in 2012, it disposed of the following businesses.

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On a purely management of asset basis, this shows a lack of understanding of the business. We saw a similar situation with Veolia. Wulf Bernotat was CEO since 2003 and was succeeded by the current CEO Johannes Teyssen in 2010. While Bernotat was in charge, he tried to buy everything he could lay his eyes on and Johannes Teyssen seems to be trying to sell as much as he can. An explanation is probably the high debt load of E.On.

6 Valuation

Valuing a huge utility company like this is not easy. Let us first start by calculating the EV of the company

Item(in € mn)
Cash and Equivalents

Long term debt

Current portion

Pension provisions

Asset retirement obligations

Market Cap
- 6,546

+21,937

+ 4,007

+ 4,890

+ 18,225

+26,942

____________

69,445


The company has sales of €132 billion with an average 7.7% net margin and €1.71 billion in FCF in the last 10 years. Even if we assume that 5% is the “normal” net margin which is historically quite low, with P/E of 10 we get €101 billion in “price” of the company.

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The company has been paying dividends since its formation. It aims to pay 50 percent to 60 percent of its profits in dividend. E.On’s earning has not been consistent, as can be seen from the graph. This has also affected the dividend, and it has been cut a few times even in the last few years. Germany has a 26.38% tax on dividends and hence, a €1.2 dividend results in a payment of €0.88, which results in a 6.2% yield after tax.

[/i][i]Bottom line: The company has taken a turn for the better. The management is selling non-core businesses and paying down debt, and the effect will be seen in a few years. With nearly an 8.5% dividend and stable business (utility), I think E.On is a good buy.

[/i][i]Additional disclosure: I own 200 shares of E.On. The data is taken from E.On’s annual report, website, Wikipedia and Morningstar.com, and the graphs were made using Google Docs and Gurufocus.com.

About the author:

Chandan Dubey
I invest because I want to be free by the time I reach 40 years of age i.e., 2025. My investment style is to find a small number of bets with large margins of safety. I pay a lot of attention to management and their incentive. Ideally, I like to buy owner operator businesses. I am fortunate to have a strong inclination towards studying. I aid my financial understanding by extensive reading in psychology, economic, social sciences etc.

Rating: 3.3/5 (8 votes)

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