RWE And The German Federal Elections

Sep.16.13 | About: RWE AG (RWEOY)

RWE (OTCPK:RWEOY), based in Germany, is one of Europe's largest electricity and gas companies. In addition to electricity and gas production and supply; the company also owns distribution networks, upstream, and trading operations. Profitability from RWE had been badly hit by falling wholesale electricity prices, as renewable energy capacity greatly expanded. The company has been slow to adapt to the changing energy environment, as it still heavily relies on conventional thermal generation. Nevertheless, RWE trades at a very low multiple on EBITDA, and the upcoming federal elections in Germany could bring about reform of the 'Energiewende', which should lead to an improvement in market conditions.

Energiewende, Germany's energy transition

Germany's energy transition, known as the 'Energiewende' is an ambitious plan to reduce carbon emissions, by expanding the proportion of electricity generated from renewable sources. Its target for the proportion of electricity generated from renewable sources is 80% by 2050, and for greenhouse gas emissions to fall by between 80 to 95%. Following the meltdowns at the Fukushima Daiichi nuclear power plant, the German government also announced that all nuclear plants were to be closed by 2022.

It is therefore a great disappointment that despite the huge cost of the Energiewende, CO2 emissions in Germany have been rising since 2012, and the trend is likely to continue in the near term. Declining nuclear generation, falling coal prices and the surplus of emission permits have led to increasing power generation from coal, the most polluting of fossil fuels. The intermittent nature of generation from wind and the sun, means that conventional thermal generation from fossil fuels are required to plug the deficit, whenever a shortfall occurs.

The rapid expansion of renewable energy and declining prices of hard coal and emission allowances have caused wholesale electricity prices to fall substantially in Germany and its neighbors. Although traditional utilities, including RWE and E.ON (OTCQX:EONGY), have built substantial electricity capacity from renewable generation, they still heavily rely on conventional thermal generation. Consequently, they are seeing their profitability decline substantially.

Although Germany has one of the lowest wholesale electricity prices in Europe, electricity prices for consumers are also one of the highest in Europe. The paradox is primarily the result of the increasing cost of the EEG levy, which is a tax on electricity consumption to fund renewable subsidies. Given that energy intensive industries are exempt from paying the EEG levy, households have been particularly hard hit.

Observers outside of Germany may well think that most Germans are happily paying more for clean energy. But with the cost of its energy transition becoming increasingly costly, the public is increasingly more concerned about the affordability of electricity. The Energiewende has led to an inefficient and extremely costly transition towards cleaner energy. Der Spiegel, a German news magazine has even described it as socially unjust, because of the regressive nature of the system. The current system means the poor would contribute to subsidies provided for property owners to install solar panels.

German federal elections held on September 22

With the German federal elections looming, Angela Merkel, leader of the Christian Democratic Union (CDU) and Peer Steinbrück, leader of the SPD, the Social Democrats, agree that reform of the energy policy will be an urgent issue after the elections.

A coalition between the CDU, its Bavarian sister party, the CSU, and the FDP, the Free Democrats, is the most likely outcome of the election. The betting markets, usually a reliable indicator, imply a probability for this outcome at above 50%. The FDP are serving as the junior partner in the current coalition; and they are also the preferred coalition partner for the CSU/CSU.

The FDP are strong proponents of free markets, and have long been opposed to the renewable subsidies. They are certainly opposed to the current system, where bureaucrats dictate that more subsidies are provided to the less efficient renewable technology. Thus, a coalition between the CDU/CSU and the FDP is likely to result in substantial cuts in the Feed-in tariffs (FITs) for generation from renewables, and structural reform of the 'Energiewende'. Reform could include creating incentives for building energy storage, which would create opportunities for RWE. The cut in FITs would moderate the pace of additional renewable generation capacity. This would, in turn, lead to the higher electricity prices, which RWE and E.ON need to restore their profitability in conventional power generation.

A 'grand coalition' between the CDU/CSU and the SPD, similar to the one struck after the 2005 elections, could be less advantageous for RWE. SPD leader, Peer Steinbrück has proposed to give the regulator the power to lower retail electricity tariffs, if the supplier charges more than 10% above the lowest comparable tariff within a specific region. The SPD is also looking to cut the electricity tax and reducing industry exemptions, amongst other methods, to reduce the impact of the Energiewende to households. However, the SPD are pragmatic, and they may also concede that reducing renewable subsidies and structural reform of the 'Energiewende' may be the only ways to contain the rise in electricity bills for the long term.

Any coalition with the Greens could have an immediate negative impact to RWE's share price, as the Greens are least inclined to slow the pace of increasing renewable capacity. Nevertheless, a coalition of the CDU/CSU and the Greens is very unlikely, because of the Greens are perceived to be further left than the SPD, and a 'grand coalition' with the SPD would secure an even greater majority. A coalition of the SPD, Greens and the Left is even more unlikely as the Left are highly controversial, and it is unlikely that the three parties combined can secure a majority.

RWE

RWE

E.ON

EDF

Iberdrola

Enel

Market Capitalization (€ millions)

15,370

26,910

41,360

26,420

25,840

EV/EBITDA

5.7

5.9

6.9

6.9

6.9

P/E (2012)

11.7

12.1

12.5

9.3

29.9

Forward P/E (2013)

6.5

10.8

11.6

10.5

8.7

Dividend Yield

6.3

6.3

5.7

5.7

4.5

Click to enlarge

Earlier this year, RWE secured improved price conditions for gas purchases from Gazprom. The result of the arbitration would mean that a large proportion of losses incurred since 2010 would be reimbursed, and the new pricing formula would take into account more of the changes in conditions in the gas market. The outcome has already boosted operating profit, and will ensure that recurrent net income for 2013 would be about €2.4 billion.

RWE has net financial debt of only €14.0 billion; but if we include provisions for pensions, nuclear waste management and similar liabilities, net economic debt for RWE Group rises to €35.0 billion. This gives RWE a net economic debt to EBITDA ratio of 3.8; which is high, but compares similarly to European utilities of comparable size and scale. The company has been looking to sell its upstream operations, which could reduce its net debt to a multiple on EBITDA of just 3.0 times.

RWE is rapidly cutting operating costs and capital expenditures, to offset declining cash flow from its power generation business, and expects to return to positive free cash flow by 2015. The company trades at a substantial discount to its peers, including its closest rival, E.ON, with a forward P/E (2013) of 6.3. Much of the negative market sentiment is related to its conventional power generation business, but RWE is diversified through its supply and distribution networks in Germany and internationally, upstream and midstream/trading operations. Together, they contribute more than half of RWE's EBTIDA, and offers the company with greater stability in cash flow than many analysts have appreciated.

Downside risks

Management has already indicated that the dividend could be cut, in order to reduce the level of borrowings, as the company is still producing negative free cash flow. Much of the dividend risk seems to be already priced in its market price; as management has already indicated that the dividend could be cut in 2013. With free cash flow negative, and high debt levels, RWE is likely to abandon its current payout target of 50 - 60% of recurrent net income. Although it has yet to indicate the size of the cut, it is likely that the dividend would not be abandoned in its entirety.

The new German government could be slow and reluctant to commit to reform of the 'Energiewende', perhaps as a result of indecision or political obstacles, such as passing legislation through the states. Politics is almost always difficult, and reform can usually take too long. But, with the price of electricity to consumers rapidly increasing, there is broad political support for energy policy reform.

Conclusion

RWE's low valuation is primarily due to weakness in its power generation business, as wholesale electricity prices have plummeted, and the accelerated plan to shut down all nuclear reactors in Germany by 2022. Although, the power generation business has historically generated much of RWE's operating profit, its sizeable infrastructure, upstream and trading operations offers the company with diversification; and the valuation of RWE Group, on an EBITDA and recurrent net income basis is low in an absolute and a relative sense.

The upcoming federal elections, especially a coalition between the CDU/CSU and the FDP, which is quite likely, could bring about the necessary reform of the 'Energiewende' and lead to cuts in renewable subsidies. This would serve as a catalyst to lift the valuation of conventional electricity generators, including RWE. These reforms could lead to a stabilization in the wholesale electricity market, including higher prices; and create greater investment opportunities in infrastructure and energy storage, which RWE and other infrastructure providers can benefit from.

After the elections, when the market anticipates that reform is a real possibility (which most analysts currently don't), we could see RWE's EV/EBITDA multiple rise to a more moderate level of between 6.0x to 6.5x. This would imply a potential upside of between 16 to 47%. Other catalysts include asset sales to reduce net debt, which may include the sale of its upstream operations and its UK supply and marketing business, nPower. Although reform and asset sales are definitely not certain outcomes, RWE's significantly lower valuation on EBITDA to peers, offers investors with substantial downside protection.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in OTCPK:RWEOY, OTCQX:EONGY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article..