By Mark Barnett
After completing its full acquisition of International Power in June, GDF Suez (GDFZY.PK) now owns the largest independent power generation portfolio in the world with 117 gross gigawatts of capacity. With a mix of long-term contracted and open generation, GDF enjoys cash flow stability, significant upside to higher power prices, and growing power usage in its major markets. The IPR deal augments its expansion into fast-growing markets outside of Europe and supports our belief that GDF's combination of operational resilience, financial strength, asset quality, and growth opportunities makes it more attractive than peers Enel, E.ON (OTCQX:EONGY), Iberdrola, and RWE, which have similar or greater levels of eurozone exposure.
Most diversified European utilities invested abroad during the last decade, but GDF's position outside of Europe and North America is, in our view, the most robust. The diversified space is a frothy one, as Europe's utility giants frequently trade assets, move in and out of countries, and create complex holding structures, earning themselves healthy conglomerate discounts. GDF has swapped its share of assets, but the merger with Suez in 2008 set a decisive course toward expanding power generation development outside of core European markets. The subsequent IPR acquisition has amplified this move, adding significant capacity in Asia and the Middle East and boosting the growth pipeline in Latin America.
On a gross basis, 53% of the company's 117 GW fleet is located outside of Europe. Prior to closing the acquisition of the final 30% of IPR, GDF generated nearly 40% of its power output outside of Europe and North America, including 15% from Latin America; these figures will continue to rise with full integration and as projects totaling roughly 12.5 GW are completed. GDF generated 23% of earnings before interest, taxes, depreciation, and amortization (EBITDA) from power generation outside of Europe and North America in 2011, a figure that also will increase. Compare this with Iberdrola, which generates 30% of its output outside of Europe and North America (nearly all in Latin America); or Electricite de France, E.On, and RWE, which generate nearly all output within Europe. GDF's international breadth -- from the United States to Brazil to Poland to the Middle East to China -- is unmatched.
A Worldly Sense of Well-Being
GDF's exposure to markets outside of Europe is crucial to its future growth and profitability. Higher taxes, renewable subsidies, environmental concerns, and regulated tariff changes are pressuring European utilities' earnings. In many ways, the perception of country risk is being turned on its head. While emerging markets have continued to honor contracts, support growth, and welcome large companies with the expertise required to modernize their infrastructure, Europe's policymakers have moved in the opposite direction. The largest emphasis on growth has come from renewables, which remain a relatively inefficient and high-cost generation source. Otherwise, taxes on energy companies (and industry in general) have risen and electricity market policy generally has been inconsistent and at times incomprehensible (read: Belgian and German plans to shutter all nuclear plants). Regulators have clamped down on utility profits, even at the consistent gas and power delivery cash cows that fed European utilities' investments abroad.
GDF is no exception to the bruising being delivered in Europe. In France, its gas distribution business has suffered tariff freezes, lower allowed returns, and increased taxes. The French courts ultimately have overruled the government's efforts to conceal the real cost of natural gas from voters, but persistent efforts from the nominally conservative Nicolas Sarkozy government and now Francois Hollande's new Socialist administration point to continuing trouble. In Belgium, the new government has committed to closing its three nuclear reactors at Doel (by 2016) and Tihange (by 2025), planning to fill the hole in baseload capacity with volatile gas and a pie-in-the-sky projection of new renewable generation. These nukes have been pillars of GDF's profits in Europe (despite increasing nuclear levies), generating EUR 650 million of EBITDA in 2007 by the company's estimate. That figure is lower today because of increasing levies but still would represent only 3% of our 2015 EBITDA forecast. We believe there will be further developments here, as new generation investments in other technologies are difficult to justify based on regional power prices.
This brings us to another fundamental weakness for European utilities -- pricing and demand. Heavy investment in renewables along with low dispatch costs, tepid demand, and state market intervention are weighing on spreads for almost all forms of generation, with the interesting exception of coal plants that are benefiting from relatively high local gas prices. As it's impossible to build new coal plants in most of the core eurozone, and with nuclear on its way out, gas and renewables are the only game in town. Gas generation's spreads, however, are razor thin almost everywhere and have gone negative in parts of Germany, for example. We see no economic incentive for developers to pursue new capacity in the current environment. Governments have axed renewable subsidies, even though they remain generous, and GDF's European renewables development effort is a small part of the overall business. The company is shutting down and selling its least competitive European capacity to focus its cash outside of Europe. While its peers are quick to tout their plans for diversification outside of Europe, GDF already has achieved it in a big way.
What Else Will the IPR Transaction Accomplish?
Following the acquisition, GDF management is targeting EUR 197 million-EUR 225 million of synergies from within International Power and an additional EUR 17 million at GDF Suez. Our forecasts remain in line with this guidance, but there could be upside. Realized synergies from its initial 70% acquisition began at EUR 90 million, but resulted in more than EUR 135 million and came in ahead of schedule.
We further expect GDF to begin buying out selective minority holders in IPR immediately, which will cost up front but could add additional synergies over time, especially on taxation and dividends to the parent. Expansion in Asia, Latin America, and the Middle East should help drive future business and strengthen relationships with key decision-makers in government, a crucial ingredient to winning development bids. We do believe strategic minorities will remain, as government partners and powerful regional companies are frequently valuable allies and a foot in the door to new business elsewhere in a given region.
In our view, it is too early to speculate (as some have) that competition in China and India will quickly crowd out premium returns on such projects. Most BRIC (Brazil, Russia, India, and China) power developers lack the expertise to pursue projects like these on their own. China's developers, who would have access to the greatest financing firepower, are still tainted by other Chinese industrial companies' frightful record of shoddy construction and operations. Over time, we expect this gap will close and partnerships with GDF and its peers likely will help accelerate development.
GDF's Shares Look Cheap, and Its Yield Is Hard to Match
GDF has taken a pounding along with the rest of the European utility landscape, as eurozone shakiness, tepid European economic data, and regulatory and political challenges have frightened investors out of the sector. But we see opportunity for investors to buy these businesses at significant discounts to fair values and consider GDF a top option for investors seeking yield and long-term growth. However, as we've discussed, there are significant risks. Commodity exposure, political intervention, regulatory setbacks, and the difficulty of parsing complex holding structures and accounting statements are major concerns.
Trading at just 10.6 times our 2012 earnings estimate and 8.8 times our 2014 earnings estimate, GDF's shares look appealing. However, given the relatively large contribution to cash flows of volatile and commodity-linked businesses, we prefer to also look at diversified utilities on an enterprise value/EBITDA basis. GDF trades at just 5.7 times our 2012 EBITDA estimate and just 5.2 times our 2014 EBITDA estimate. While we acknowledge the hair on this one, we think it's too attractive an entry point to ignore given the quality of the underlying businesses, the strength of GDF's balance sheet, and the significant upside to global growth and power markets.
Income-oriented investors often look to the dividend yield as both a significant component of total return and a barometer of expectations for a dividend cut in the future. With its shares yielding nearly 8.3%, GDF should both tempt potential investors and worry current and potential shareholders. We've seen this one before, right? Enel, E.ON, and RWE all saw dividend yields reach similar heights before financial troubles and significant future cash flow reduction led to big cuts in the dividend.
Could GDF be at similar risk of a dividend cut? We don't believe so. GDF's dividend is strongly supported by its regulated operations in France and its services segments with long-term contracted cash flows. We forecast GDF will pay out roughly EUR 10.3 billion in dividends in 2013-15 and generate about EUR 12.8 billion of EBITDA from those two business segments alone. On a consolidated basis, we expect free cash flow to the firm net of maintenance and growth capital expenditures to total EUR 12.4 billion during that same time period. In our view, cutting the dividend would not be a matter of necessity but of choice. On that track, the French government relies on GDF for a significant chunk of revenue from dividends -- more than EUR 1 billion annually. This combination of factors gives us confidence that GDF's dividend is safe and that the yield reflects our view that the shares are highly undervalued.