E.ON: Another Gift from Germany

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Juan Velasco
May 23, 2011
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I just made myself another little gift from Germany to complement my Munich Re position in that productive industrial country. This time I bought E.ON, a major European energy player. I'll try to explain why; I will not focus excessively on technicalities or P/Es or whatever is your favorite evaluation technique. I am sure that the good investor already knows how to do such things, and I think that an investment has to strike out immediately without the need to justify it excessively with too much financial math, which is in any case quite basic.


E.ON stock is at a multi-year low. Negative press due to the European sovereign debt woes coming from the PIIGS, the nuclear moratorium and recent expectations of lower profitability gave me an additional opportunity to enter on the cheap side.


Lets start by exposing the negative factors. I started to follow E.ON after the Japanese earthquake when two of its plants were shut down for three months. I checked out the year reports and while it affects it, it has a small impact on earnings and as long as those 2 plants are not permanently shut it would just be blip on earnings. But there are some other mid term impacts to earnings. First, the margins on the gas business are at a low point because gas based energy is currently being sold at a low price on the spot market but the gas to produce it was procured at high acquisition costs that were negotiated by past contracts on long term futures. That is a temporary situation inherent to the business because as months go by new acquisition costs are being negotiated at much more reasonable prices reverting the situation. Another concern is that there are plans to extend all nuclear plants by at least a decade and people fear that they will not be extended. In any case even if they are not it is not a drama since E.ON gets a minor part of their earnings from those older plants and even if they are extended the lion's share of the profits is going to the government anyways. And the last concern is an additional nuclear tax which is fortunately offset in 2011 by gains derived from their trading unit but that will affect earnings from 2012 on, It is expected therefore quite understandably for the reasons just exposed that 2011 and 2012 will have lower earnings and that the 2010 level will be reached back in 2013, In any case the reduction is nothing dramatically smaller, you can check the exact expectations in several sources, the questions then are; does it justify such a pronounced reduction on the P/E; does it deserve to trade under book; are write downs expected?


On the fundamental side, the P/E is low. It's below book value, which has almost never been the case for this company. It has an excellent dividend of 1.5 euros per share, so you can calculate the yield depending on where the stock price is when you read this. It has a commitment to pay between 50 to 60% of their earnings via dividends and since they expect to earn less next year, they already announced that for 2011 and 2012 they will not lower the dividend beyond 1.3 euros/share even if it that mean paying more than 60% of their profits, so that puts an interesting floor on the stock.


E.ON is big mainly in Germany, but in the last recent years it has built a big presence in five other major European countries and now is strategically focusing on expanding to eastern Russia (with gas), the U.S. (with renewables) and two other continents; South America and Asia is my guess but it could be north Africa. I say this because north Africa is part of a multi-year, multi-company and multi-country project to build the worlds biggest solar plant in the Sahara desert to supply more than 15% of the European consumption. There are few companies that have the scale and know-how to do that. Some people think the debt is high; I personally do not consider the interest to be high compared to their earnings. In 2010 they had earnings before interests and taxes (EBIT) of 9.5 billion euros and paid 2.3 billions in interest. And in 2009 the relation was the same, so the interest coverage looks to me quite decent. (Side note: You can get very well informed at their investor relations website, with all the documents in English and several video presentations of conference calls). Their debt leverage has been enormously reduced in the recent years due to disposals of non strategic businesses. For example, they sold to the American company Pennsylvania Power and Light (PPL) their American unit for $6.7 billion, and now PPL is quite a bit more leveraged than they used to be. That is just one example. In only the last two years they had disposals which resulted in cash-effective effects totaling 9,601 million in 2010 (prior year: 5,384 million) which was used to pay back debt reducing it materially.


On the country side, I feel comfortable buying this company in Germany for several reasons:


- It is the strongest economy in Europe.

- They hate inflation and have proven they want to control it; they are averse to printing currency.

- They are strong exporters.

- They are strong savers.

- Their economy is based on industrial excellency; the root economical nucleus is not finance and banking.


Some others are worried that they are investing in a populist government. Here is what I think of that: German social control is good, period, and workless people are well taken care of and at the same time have incentives to work. That is a good combination. Health insurance is good. In simple words: I would rather be sick or without a job in Germany than in many other parts of the world, not to mention specific countries (I do not want to hurt nationalistic sensibilities here).


I do not consider Germans to be populists with regards to company control; actually I would have liked more control back when E.ON started growing inorganically by buying companies in the 2002-2007 period. The government does push energy companies to develop renewable energy, but that is for social benefits, that is the reason why E.ON is world-class in renewables, specially hydraulic and wind, and it is now expanding to solar (see it's huge project in the U.S.). There is also a government-sponsored project to build a solar plant in the Sahara desert to provide 25% of the European energy needs.


Also, I like regulations when they seek to control carbon dioxide emissions. By the end of 2013 the CO2 emissions market will be fully operational in Europe, giving an example to the world. Regarding German power sales regulation: E.ON used to be mainly a German player in the past, but not as much anymore. From their $92 billion sales in 2010, $43 billion came from central Europe, and from that only $11 billion were sold in regulated markets.


That said, not all is rosy: Gas margins are low due to high acquisition (procurement) costs and low spot prices, but new contracts are being renewed at better prices. And there is uncertainty whether older nuclear plants will be renewed, but I explained in the beginning of the article why I think those concerns are overblown. And personally, I think that well-controlled nuclear power is an excellent source of energy with very low variable costs and no emissions. France alone gets more than 50% of their energy from nuclear, Norway almost is only dependent on it, and UK has a big program to build nuclear plants. I do not think nuclear will disappear (see Buffett's opinion on nuclear power in the last shareholder meeting). For those who fear that nuclear power will be reduced you can think about the recent nuclear 3 month moratorium. Seven plants were idled for inspection after the Japanese disaster, and it's consequences are having this side effects: It has had such an impact that Germany went from being a net exporter of energy to being a net importer (see recent quarter report), and the principal country benefited is France which is exporting their nuclear energy to the Germans. Now those German readers who know about their people can tell us, does the government like to be in such a situation for the long term?


I think that the German governments interests are aligned with E.ONs because Germany has a strong political interest for renewables and they depend on Energy companies to build them. On the other hand, energy companies need to be profitable enough to be able to invest in renewables, so they cannot be over regulated, especially due to the fact that renewables are expensive to build and operate, making them less economically interesting than traditional sources.


E.ON recognizes that renewables are just a part of the whole energy picture because they cannot provide a constant baseload energy flow and therefore need to coexist with traditional energy sources such as gas sources, but what should be adequately recognized is that it has all the resources and the know-how to integrate them on the grid to complement traditional energy sources in order to have a constant flow when the sun is not shining and wind is not blowing.


Regarding growth, I acknowledge that it will not grow like Google (GOOG, Financial) (which by the way I also own), but it has a solid tangible product that will not disappear fast. They also have good know-how in building top-class energy plants, especially new gas-efficient plants. They are needed to expand in eastern Europe and in Russia. Russia alone is the biggest energy market in the world, and it needs to renew 40% of their plants. E.ON is getting several projects to do just that. Additionally, Eastern Europe and foreign countries are on their radar. They have the scale, knowledge and strong competitive barriers. It's not an investment to get rich but it can have quite a decent return.


Conclusion: safe long-term play, with an excellent dividend and inherent protection against inflation and has some wild cards for future growth. All in all I am still studying; I just bought a small percentage of my portfolio (100 shares). But if I get more and more convinced that the company is good and the price is cheap I will add substantially more, especially because I want to diversify away from the U.S., too many of my eggs are in that basket for my taste. Let's hope that we can still get more negative news coming from Europe to push the prices even lower to let us buy at an even deeper discount!


Cheers!

Juan Velasco
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I was born in Spain and lived in France, Chile, USA and Belgium. I used to work in IT and Banking. I am a family man, I have a lovely wife, 3 sons and one step daughter. I have humble tastes, I like to stay home and read about companies. I started investing before the internet bubble. I knew little and liked technical analysis so my results were bad. Fortunately I did not have much to lose. Some years later in 2006, bored of doing real state investments, I opened an interactive brokers account and restarted. This time, not wanting to make mistakes, I decided to follow a model: Warren Buffett, he was at good making money via stocks. So I started reading about him, his shareholders letters, the books that he recommended, etc... I started applying his principles, reading 10K's digesting all sources of information. I started buying good and cheap companies to hold forever unless something changed fundamentally. When the housing crisis started I was 75% cash. By then I had identified good companies at very cheap prices so I invested most of my savings in stocks. It doubled fast. By the second semester of 2009 I turned my software company into an investment vehicle and dedicated myself full time to it. I changed lifestyle and moved from Belgium to the beach, Brazil, north east coast (www.kuchita.com). The goal was to keep fixed costs low in order to be able to live with a minimum 6-8% yearly return, to move away from the inhuman life of civilization and to have some peace and sunny weather. Now I can think and study about companies 60 hours/week. I can finally do what I want full time and can say that I have never been so happy, specially also with my just born 4th son, my other great kids and my sweet wife who supports me fully while I study most of the day and patiently wait for the opportunity to make a swing ! My portfolio is disclosed here: http://www.kuchita.com/view/sumo.php For more: