Third Point invested in German utility operator E.On (XAMS:EON) during the First Quarter. Following a spin-off of its generation assets into Uniper last year, the company has emerged as a regulated grids and renewables business that is currently misunderstood by the market and attractively priced. The German government’s policy of “energy transition” caused the precipitous buildout of renewables, forced nuclear plant shutdowns, and a number of poor capital allocation decisions that led to an 80% decline in E.On’s market capitalization over the last decade. In our view, the worst is in the rear view mirror.
First, the German government has agreed to set up a state -administered fund to finance the storage of radioactive waste from decommissioned nuclear plants. E.On’s portion of the payment into this “nuclear bad bank”, which is scheduled for July 1, 2017, is approximately €10 billion, including a risk surcharge to cover the contingency that costs exceed current provisions. While this has temporarily pressured E.On’s balance sheet, we believe it will result in imminent, significant, and permanent reduction of the company’s risk profile.
Although investors remain singularly focused on E.On’s weak balance sheet, we believe there are multiple and significant sources of capital from sales of non-core activities that will deleverage E.On’s balance sheet over the next 12 months. When financial leverage is reduced, management has signaled its intent to increase the dividend payout ratio to an industry norm of 70%+, implying annual dividend growth in the low-teens range over the next few years.
E.On’s renewables portfolio is comprised of regulated vertically integrated on- and off-shore wind parks with planned expansion opportunities at relatively high regulated rates of return on equity. Recent transactions suggest that E.On could monetize its wind portfolio at very attractive valuations given the interest in such assets from investors with low costs of capital.
Management is focused on cost cutting by addressing E.On’s lagging labor productivity, which is an outlier in the industry. A €400 million efficiency program is in place but our benchmarking analysis suggests management could pursue much more ambitious targets in order to right size the business for its reduced footprint.
E.On’s core electricity and gas distribution grids are exceptionally valuable as they cannot be replicated. Furthermore, they are now set for decades of profitable growth. We like utilities that operate in benign regulatory environments where the regulator has a clear objective to stimulate investment and guarantee attractive returns. To achieve its ambitious plans of full decarbonization by 2050, Germany will have to encourage significant investments in its power distribution network such as grid digitalization, EV charging stations, smart meters, and large-scale storage stations that allow a much greater portion of peak demand to be covered by renewables. Recent purchases of comparable assets have highlighted E.On’s mispricing. In 2015, Finish utility Fortum sold its Swedish electricity distribution business to a consortium of pension funds for 16.6x EBITDA. Last month, Portuguese utility EDP agreed to sell its Spanish gas distribution network Naturgas to a consortium of sovereign wealth funds and life insurers for 15.9x EBITDA. E.On trades at less than 8x EV/EBITDA.
From Daniel Loeb (Trades, Portfolio)'s first quarter 2017 Third Point shareholder letter.
