E.ON split driven by nuclear risk, core business comparable to yieldco

11 Dec 2014  – Plans for E.ON [ETR:EOAN] to spin off its conventional power division are driven by a need to protect the remaining core business from liabilities associated with nuclear decommissioning, sector sources said. Germany is phasing out nuclear power and aims to close all reactors by 2022.

The German utility group will retain an unspecified stake in the spun-off company, which will comprise conventional generation assets (including nuclear), upstream operations and global energy trading.

What will be left of E.ON – renewables, distribution and “customer solutions” – could be compared to US yield companies or “yieldcos”. These are usually spin-offs of assets from energy companies that pay investors high dividends from cash flows generated by long-term contracts, said Thomas Deser, a fund manager at top-10 E.ON shareholder Union Investment.

By ring-fencing and separating the conventional power business, E.ON can safeguard itself against costs associated with nuclear decommissioning and waste storage, said the sources. E.ON has EUR 8.5bn set aside for obligations associated with nuclear waste. Swedish peer Vattenfall is pursuing international legal action against the German government for compensation for the financial losses associated with the nuclear phase-out.

“The split represents the fundamental future of the energy sector. There is a paradigm shift,” a sector banker said.

The spin-off will result in a cleaner equity story for both companies but it is hard to establish a value for either, added Deser. The new company could be compared to Spanish group Endesa [BME:ELE], which is majority owned by Enel [BIT:ENEL], and Fortum [HEL:FUM1V]. Whilst there is no ideal peer for the remaining E.ON, Danish group Dong Energy could be a competitor, according to Deser.

The divisions forming the spun off entity accounted for 49.57% of E.ON’s FY13 EBITDA. Applying this proportion to E.ON’s projected FY14 EBITDA of around EUR 8.3bn would give the new company an estimated FY14 EBITDA of EUR 4.11bn.

Applying Endesa and Fortum’s average EV/EBITDA of 5x, would give E.ON’s spin-off an EV of EUR 20.55bn, according to Dealreporter analytics. E.ON is now trading at 4.97x EV/EBITDA.

Security and cyclicality

The equity story for the spun off company rests on the security of supply – a key issue in Germany – and its cash position, according to an E.ON spokesperson.

The remaining E.ON will retain all debt, leaving the new company with a positive net financial position. The new company’s balance sheet will cover existing provisions for dismantling and disposing of nuclear assets. The new group will have a “high [dividend] payout with optionality”, according to a company presentation.

Whilst phasing out nuclear power, Germany is still dependent on fossil fuels to meet its electricity needs. The country’s vice-chancellor Sigmar Gabriel recently said there would be serious consequences for supply if Vattenfall sold its lignite (“brown” coal) assets, according to news reports. The Swedish group said recently it is considering strategic options for its German mines and generation activities.

The new E.ON and other generation companies will likely benefit from a harmonised Co2 policy in Europe as it would lead to rising electricity prices, according to Deser. The nuclear issue is “clearly difficult but not fatal” for the equity story of the spun out company, said a local ECM banker. It could find favour among institutional investors as a cyclical name, he added.

As with Osram [ETR:OSR], the lighting business spun-off by Philips [AMS:PHIA] in 2013, there will be initial flowback as investors play the liquidity in the market created by index trackers exiting their position, a second ECM banker added.

The new entity will become a mid-term candidate for the Dax 30, said the spokesperson. E.ON will sell down its remaining stake in the medium term but has no plans to float it, said the spokesperson.

E.ON’s spin-off faces execution risk due to the lengthy time frame and the political issues surrounding nuclear decommissioning, according to Deser. The separation is expected to complete in 2016.

Whilst “E.ON and RWE [ETR:RWE] do not have many friends among German politicians,” those in power will want to ensure that the taxpayer does not end up footing the bill for decommissioning, said Deser. The government wants to see a stable sector, noted the first ECM banker.

Alongside the spin-off, E.ON announced fourth quarter impairment charges of around EUR 4.5bn largely due to its Southern European operations and generation assets. This means the group will report “substantial” negative net income for 2014, the company said.

by Julie-Anna Needham, John West, Katie McQue and Johannes Koch with analytics by Amit Rawtani

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