Marginal Utility

As an economics student many moons ago in universtity I was fascinated by the concept of utility & the measurement of utility. Many years later, while employed as an investment manager, I was responsible for the research and analysis of the global utilities sector. The more time that I spent analysing the sector the more my marginal utility diminished.

With that said, it was with some interest that I began research of Endesa, E.On and ENEL in my latest attempt to find some worthwhile value in the equity markets. Interest, that principally stemed from the combination of valuation and contrariness. But in the back of my mind I have these nagging dounbt that if this was all that was good value (utilities, banks, beaten down retail stocks etc), then maybe the market was not really good value? I want to buy able to buy strong franchises or undervalued assets at levels of valuation that ensure my 5 year and 10 year compound returns are of the type that I greedily crave. Is this it?

E.ON (€14.56)

E.On  is the largest electricity and gas utility in Europe by assets. Originally the company came about as a merger between the German utilities VEBA and VIAG back in 2000. If my memory serves me, that merger was not a kind one for VIAG shareholders, as some facet of German takeover law meant that a state municipality received a higher share price on exit than did private shareholders.

Once the two German energy giants combined, they set about aquiring almost any electiricty or gas asset that wasnt nailed down. I have alway been deeply sceptical of highly acquisitive companies. Gluttony has a way of leading to digestive problems! Assets were aquired in the UK, Sweden, Central Europe.  The cyclical bull market that followed rewarded so called ‘carry play’ equities. The share price of E.On tripled from €12 to €46 excluding fat dividends that were paid along the way.

Since the 2003-2007 cyclical bull market ended in 2007, utilities have fared remarkably poorly. In fact, in the European equity arena, the sector is the second worst performing sector after financial stocks. E.On has been amonst the poorest performers, with the stocks down 73% from its 2007 highs. It has fallen every year in the past four. Equity investors that wanted stability of cashflow and balance sheet have sought refuge in consumer staples and health care stocks as opposed to utilities. Investors wanting growth and exposure to the BRIC’s have pursued industrials and basic resources.

Finally, during the summer of this year, E.On had to cut the dividend in reponse to a forced re-organisation of its business brought about as a result of the German state demanding concessions from the nuclear industry in the wake of the nuclear disaster in Japan followng the earthquake and tsunami. Whereas nuclear power stations were to have remained open until 2036, they now must be closed by 2022. This is one of the reasons that I have long been wary of this industry. Energy policy is highly political in many countries. An investor in this sector can always be wrong footed through a change in direction of energy policy and regulation.

All of this has conspired to create a set of circumastances whereby E.On looks to be very attractively valued on the basis of a number of multiples. At the present share price, we have one of the worlds largest utilities trading on a Graham & Dood PE of 6.9x. In terms of book value, E.On trades at 0.69 P/B. There is however Goodwill and other intangible assets of €20768 million on the balance sheet, which gives a P/tangible BV of 1.37x. Suddenly not as appealing.

Despite my scepticism, E.On isnt that bad a company. The comapny generates a strong and reasonably consistent level of net operating cashflow annually. However, the acquisitions and capex policy means that in any one year free cahsflow is likely to be very low if not negative. Over the course of the last decade operating cashflow as a % of assets increased steadily from 3% to 5.5% to 7.3%. In most years free cashflow was negative.  E.On is an investment bankers dream – due to the highly acquisitive nature of the beast and the historical conglomerate structure, there have been significant acquisitions and disposals in each year. There is no business as usual.

It makes me wonder, if there would be an opportunity in the shares for management to consolidate what they have and focus on cash generation going forward?

Profit margins have drifted down from mid to high teens to single digits recently, but this has been offset by asset turnover almost doubling to 0.61x. Gearing has expanded and the net debt/equity ratio now stands at 107%. EBITDA/Interest Cover was 7.1x at the end of 2010 and came in at 4.2x at the half year stage.

So we have lower margins, better efficiency and more gearing – bit of a curates egg really. It really is difficult to get excited about E.On at this stage. margins at the half year stage have collapsed due to a large increase in the cost of goods sold line (due to write down in nuclear fuels and materials relating to the immediate shoutdown of some nuclear power stations in the wake of Fukushimya). So for sales that grew 20%, EBIT declined by 65%. Future earnings potential will now be rebased to reflect the new levels of profitability.

With regard to the ongoing contract dispute with Gazprom regarding the supply of gas, there has been no ongoing solution.

However no agreement was reached with our biggest supplier, Gazprom. In late July, we called for the intercession of an international arbitration panel. Nevertheless, we’ll continue talks with our Russian partner in the hopes that we can perhaps still reach a mutually acceptable solution for our long-term supply contracts.

Oh, thats alright then. The strategy is built around the hope supplier of a key input see’s fit to sell this scarce commodity at a lower price. Best of luck with that!

At this juncture I can find too many areas of the business that would keep me awake at night. Given that we are only 1qtr into reduced earnings from the forced closure of nuclear power stations, I would prefer to see what happens over the next few quarters. On the dispute with Gazprom, I think that in this case, E.On only have themselves to blame – they entered into a contract at too high a price. That’s hardly anyone elses fault.

At the half year results stage, the company announced that its own forecast for year end EBITDA would be reduced to between €9.1 and 9.8 billion. To put that in context, EBITDA for 2009 and 2010 was of the order of €17.7 billion. In my experience, company management teams regulalry underestimate the negative impact from restructuring of businesses. If the management is correct, EBITDA Interest cover will fall to approximately 4x.

In over a decade since the merger of VEBA and VIAG, the combined company has failed regularly to generate any free cashflow. Acquisitions have been a way of life. In that ten years, net cash inflowhas grown from €2.6bn to over €11 billion at the end of 2010. This increase in net operating cashflow has been consumed by a combination of capital expenditure and ongoing acquisitions, such that it has not been possible for me to determine what is underlying maintenance cashflow. To my mind, if a company cannot consistently generate cashflow, then to find value it must become a asset play. That is, are the assets on the balance sheet presently undervalued by a sufficient margin that there is an investment opportunity. With E.On I dont have the confidence that this is the case. The stock trades at a discount to stated book value, but at a big premium to tangible book value.

At this point in time there are simply too many issues to prevent me from investing in E.On. The valuation is low enough that any positive outcome is not really being priced in, but there is not as much of a margin of safety that I would require given the poor cashflow profile and the deteriorating interest coverage metrics. I would not be surpries if over the next few years that E.On begins breaking itself up in order to improve the balance sheet. In that situation, it would be interesting to see just what level of cash gerneation is yielded from the present collection of assets.

Having looked at Endesa, I quickly decided against pursuing further work. It seemed to me that capital expenditure has collapsed since being acquired by ENEL. Now this maybe a good thing up to a point. But I have a sneaking suspicion that ENEL needs the cashflow from Endesa. Given the tiny freefloat (8%), I have no idea as to what sort of shareholder rights I would enjoy in the event of a squeeze out. It could be the case that this company is being run for the benefit of its dominant shareholder. I am not confident that they have my best interestes at heart.

The search for an investment in this sector, makes me feel that I have been wasting time. Perhaps that is the case, but at least I know what I am not looking for.

My next project is a more indepth piece on Irish equities. As I have mentioned in other posts, the European equity markets are becoming increasingly attractive in terms of long term valuation. I am of the opinion that they could be more attractively valued yet. The Irish equity market seems to offer opportunities many opportunities relative to its size. I will be looking at Ryanair, DCC, Aer Lingus, Bank of Ireland, FBD and a few smaller food producers (Ffyfes and Total Produce).

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John McElligott

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