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Summary

  • RWE AG is Germany's largest seller of electricity. Therefore, its profitability is heavily linked with the 'Energiewende'.
  • This program has induced a huge decrease in electricity wholesale prices and made many of RWE's production facilities unprofitable.
  • After the German elections (last September) reform of the 'Energiewende' is realistic. RWE should profit from it.

The 'Energiewende' is the transition to sustainable energy production in Germany. Sustainability basically means power generation from renewable sources like wind, sun radiation (via photovoltaic cells) or flowing water (hydropower). All other energy sources (coal, oil or nuclear energy) should be reduced to a minimum. The 'Energiewende' was introduced in 2010 and consists of a lot of governmental regulations and laws. Among them the EEG (Erneuerbare Energien Gesetz) is the most prominent and most controversial one. It includes the 'Einspeiseverguetung'. This means that the German government guarantees a (very high) price for electricity that is produced from renewable energy sources and fed into the public electricity grid. It is easy to understand that this regulation created a boom in the installation of photovoltaic cells and wind turbines. Therefore, due to the law of supply and demand, wholesale prices of electricity fell, making the operation of coal power plants unprofitable. Among the companies most affected by the 'Energiewende' is RWE AG (OTCPK:RWEOY), Germany's biggest seller of electricity.

Overview

RWE is active in most areas related to generation and supply of electricity. It has divided its operations in 8 divisions: the core division is Conventional Power Generations, containing all non-renewable power generation facilities. The second one is Renewables, generating electricity from sustainable sources. Then there are the supply/distribution networks, organized in areas: Germany, Netherlands/Belgium, United Kingdom and Eastern Europe. Additionally RWE is active in Upstream Gas & Oil (through its subsidiary RWE Dea) and Trading/Gas Midstream.

In 2012 RWE produced 227.1 billion kWh and employed 70,208 people. (source: corporate website) At the moment, RWE has a market capitalization of approximately €19 billion ($26 billion). There is one thing worth noting regarding the structure of its shareholders: due to historical reasons more than 25% of RWE's shares are owned by German municipalities. Most of them are located in the Ruhrgebiet, one of the industrial areas of Germany.

Future of 'Energiewende'

It is hard to deny that RWE's future is linked to the 'Energiewende'. Since implications of this program determine the prices for electricity, they also determine RWE's profitability. This does not only refer to Germany. Because of the synchronous grid of continental Europe prices in most other areas of Europe are affected too.

The panic following the events in Fukushima led to the German government's decision to ban all operations in nuclear power plants until 2022. This law was another backlash for RWE, since its nuclear power generating operations have always been very profitable. Additionally, Chancellor Merkel ordered a shutdown for certain power plants for a three-month moratorium period. This temporary shutdown was later declared unlawful by the German Supreme Adminstrative Court. Nevertheless, this decision does not affect the ban on nuclear power plants.

The 'Energiewende' does not only have fans. One of the points most criticized is the different development of prices for electricity. While wholesale prices slumped, the opposite is true for consumer prices:

(source: BDEW)

It has always been clear that someone has to pay for the 'Einspeiseverguetung', especially after its huge success. (There are fields in Bavaria that do not longer carry crops, but instead solar panels because of the better risk/return relationship). Unfortunately, this was not clear to a lot of German residents without solar panels on their roofs. They suffer on high electricity prices while the countries' heavy industry gets huge discounts.

There is another paradox: Germany is burning more coal today than it was before the 'Energiewende'. Since nuclear power is banned, electricity has to come from another source. And the most inexpensive one is still coal. Because of the increasing usage of this raw material CO2 emission in Germany is rising again, after it has fallen for nearly 20 years.

Another import issue is security of supply. Since the sun does not shine twenty-four hours a day and the wind does not always blow when one desires so, a certain level of base load is always required. This load can only be delivered by caloric power plants. Therefore RWE's dilemma: some of its power plants are not profitable anymore, but are necessary for security of supply and, hence, the authorities forbid RWE to shut them down. Some models have been deceived where companies like RWE get paid for providing base load, but up to now no one really knows what to do. Only one thing is sure: Germany, like any other modern society, needs base load and somehow has to pay for it.

Additionally, the 'Expertenkommission Forschung und Entwicklung' (a scientific task force appointed by the German government) heavily doubts the effectiveness of the 'Energiewende'. In its report (unfortunately the English version will only be available in June) it states that the EEG (the German law introducing the 'Einspeiseverguetung') does not support climate protection/innovation at all and recommends to abolishing it.

There are more than enough arguments for a reform of the 'Energiewende'. German federal elections have been held last September and the new government is familiar with the situation. It has assigned Siegmar Gabriel (who is also Vice Chancellor) to be Federal Minister of Economy and Energy. Mr. Gabriel is a member of the SPD, a party that has always had good relationships with RWE. Most municipalities that own shares of the company are also governed by the SPD.

I am quite sure, that the new concept for the reform of the 'Energiewende' will be extensive. Germans have always been known for doing things thoroughly. Ten, twenty years ago no one thought, that any country would be able to enhance its share of renewable energy in the way Germany did. I am also quite sure that RWE will profit from the reform, as the government will realize that it cannot ruin a company that is so essential for the country.

Financial Situation

RWE's biggest disadvantage is its heavy load of debt. On December 30, 2013 the company had a debt-equity ratio of 6.7 (referred to total liabilities). Additionally, 16% of the balance sum (slightly more than equity) are intangibles. At first glance, this looks horrible, but one should remember that before the EEG was introduced, RWE stocks were considered to be nearly risk-free with a similar debt-equity ratio. Market does also not seem to be very concerned, as RWE was able to issue 10-year bonds in October 2013 at a coupon of just 3%.

The company's management is aware of its difficult situation and has announced a consolidation program also involving a huge number of job cuttings. The board has even reduced its own compensation.

Of course, no one can deny the huge disadvantages of such a capital structure. Apart from the steady need of new funds (more than one third of all bonds will mature till 2018), the potential for undertaking new investments is greatly reduced. To reduce debt load and because it is not useful for RWE's group strategy, the company has decided to sell its subsidiary RWE Dea, active in oil and gas exploration. Up to now there are at least three groups interested, with the highest bit of €5.1 billion ($7.1 billion). In 2012, Dea made a profit of €685 million ($940 million), but the number for 2013 was significantly lower with €521 million, mostly because of FOREX market changes and the aftermath of the events is Egypt. (RWE's 2013 annual report)

On March 16th RWE reported that the deal was closured with a company controlled by the Russian billionaire Mikhail Fridman at a price of €5.1 billion ($7.1 billion). The problem hereby is, that Fridman has close ties to Russian President Putin, and after the events in Ukraine it is not hundred percent sure, that the deal will be approved by the German authorities.

At least there is one development in recent energy market that will help RWE: at the moment its management is negotiating new contracts about the purchase of gas from Gazprom. Up to now those agreements have always been in the form of long-term contracts. It can be expected that any agreement will result in a decrease of prices for RWE.

The profit situation for RWE in 2013 was devastating. Before the presentation of final numbers on March 4 there were rumors that losses would be up to €3 billion ($4.1 billion). The actual numbers were only slightly better with a total loss of €2.4 billion. It should be noted that this number includes income taxes (!) of €956 million. The reason for this lies in the fact that RWE had total depreciation (mostly because of no longer profitable power plants) of more than €7.6 billion, costs which are only partially relevant for income tax calculation. Another reason for this bad performance lies in the higher costs of material (reflecting the necessity to buy CO2 certificates for the first time). One year before, in 2012, profit was €1.7 billion. At least Netherlands/Belgium UK supply division was able to increase its profits by more than 25%. The recurrent net income for 2013 was €2.4 billion ($4.1 billion), whereby one has to mention that 40% of this sum are because of the successful revision of old gas procurement contracts with Gazprom. (for details see Q2 report)

In the last year cash flow from operating activities (€5.7 billion) was sufficient to outpace the negative contributions of financing (€2.6 billion) and investing (€1.8 billion) activity.

The forward price for 1 MWh base load was approximately €37 ($50 - base load) and €47 ($64 - peak load) in November 2013. As RWE's average costs of electricity production are around €50 ($68.4), this explains the need for the huge write-offs. As European economy is expected to grow, it is likely that prices will rise again, but hardly realistic that they will reach the level they had in 2011 (€60 - $82).

The trend is quite clear. In 2012, RWE made an operating result of €6.4 billion ($8.75), of which slightly more than 50% can be attributed to conventional energy generation.

(click to enlarge)

(source: RWE)

This share is expected to decrease significantly in the next future.

RWE has always been one of the most reliable dividend payers in the DAX, although payment has been reduced due to the negative development in the last years. While dividend for 2008 was €4.5 ($6.2) per share and for 2012 was €2 ($2.7) per share, it is expected to be €1 ($1.36) for 2013 (Bloomberg).

Risks

The worst-case scenario is a continuation of the status quo, meaning another series of impairments and a slow worsening of the financial situation, till the company is not able to survive and is eventually nationalized. Other risks involve a severe incident in one of RWE's power plants or the inability to get cash via issuing bonds (with results similar to the worst case scenario).

Conclusion

With the introduction of the 'Energiewende' the German government has created a difficult situation for the German (and mid-European) electricity market and severely harmed the business model of the utilities. Nevertheless, security of supply of electricity is essential for any modern country. And so is RWE, Germany's biggest supplier, with its huge power plants (securing the base load) and its electricity grid (securing the distribution of power). To make sure that both classes of assets can be further used, it is in the country's natural interest to have a sound RWE. I am quite sure that the reform of the 'Energiewende' that is expected to come soon will recognize these facts and set the inevitable actions. This thinking is also depicted in the development of RWE's stock price that went up more than 30% since the elections in September. There is this well-known proverb that one should buy stocks when there is "blood on the streets" (the situation looks horrible). I think RWE is such a situation. I do not expect gigantic growth of this stock price, but when the situation finally settles down I expect a decent performance of the share price and a constant, high dividend yield.

Source: RWE AG: Closely Linked To Energiewende