GDF Suez (OTCPK:GDFZY) is one of the largest integrated utility companies in the world, with revenues totaling €81.3 billion ($110 billion) in 2013. Through the acquisition of International Power in 2011, GDF Suez has a much more geographically diversified portfolio of power generation assets, but Europe still accounts for 79% of the group's total revenue.
GDF Suez is not only geographically diversified, but also in terms of its business mix, which includes power generation, gas infrastructure assets, LNG and energy services. 48% of its installed capacity for power generation is located outside of continental Europe, and more than 80% of contracted capacity under construction is located in emerging markets. GDF Suez already gets approximately a quarter of its revenues from outside Europe. This diversification ensures that operating cash flow for the group remains relatively stable during plant outages or even in the midst of an energy transition.
The company is looking to pursue further diversification away from European power generation, by focusing much of its growth capital expenditure on power generation outside Europe, regulated gas infrastructure assets, LNG and towards renewable generation. Divestments from its least competitive assets have been used to fund additional capital spending in more attractive markets, without having too much of a dilutive impact on EBITDA. Power generation in Europe currently accounts for 25% of the group's EBITDA, whilst international power generation accounts for 29% of EBITDA. Gas infrastructures, which primarily include its regulated activities in France, account for another 25%. Gas exploration and production and its LNG portfolio account for 16%, and energy services generate a further 8% of the group's EBITDA.
It is important to note that around 60% of GDF Suez's EBITDA comes from contracted or regulated activities, which generate stable cash flows and are less exposed to volatility in commodity prices. This does not only include its energy services business and its gas infrastructure assets, but also much of its international power generation activities. Over 90% of power generation in emerging markets are long-term contracted, which provides security and visibility over future revenues. These long term contracts also provide protections against rising fuel costs and inflation, which are uncommon in mature markets. With fast growth in energy demand forecasted in many emerging markets, policy makers in those countries are keen to attract foreign participation in order to benefit from technology and execution experience to meet the growth in energy demand.
In 2013, GDF Suez wrote down €14.9 billion ($20.4 billion) in the value of its assets, as the deterioration in gas storage and thermal energy production activities in Europe are expected to be severe and long-lasting. Its power generation business in Europe continues to be a drag on earnings, as wholesale electricity prices remain low and negative spark spreads persist. The expansion of renewable power generation capacity has undermined the competitiveness of conventional thermal generation. To make matters worse, much of GDF's power generation comes from gas, which has become particularly uncompetitive with low coal and carbon pricing.
In the longer term, we should be cautious with the effect of further integration of the European electricity grids, particularly with Germany, which would likely exert further downward pressure on wholesale electricity prices. Renewable subsidies are here to stay in one form or another; but European policy makers will at some point need to ensure the economic viability of efficient and flexible power generation, and energy and gas storage activities.
GDF Suez has stated its goal for net recurring income would be between €3.3 billion and €3.7 billion (between $4.42 billion and $4.96 billion), for 2014. First half profits in 2014 fell 13% to €2.1 billion ($2.7 billion), primarily because of unusual weather conditions, the 2013 gas tariff adjustment and the shutdown of two nuclear reactors in Belgium. Although the energy transition and less attractive regulatory pricing has much to do with the deterioration in earnings, short term factors have also played a major role. Poor underlying economic conditions are largely to blame for the sluggish demand for energy. The increasing nuclear contributions in Belgium, gas tariff reductions and lowered allowed returns on regulated gas assets in France have already impacted earnings and should finally mark an end to unforeseen policy shifts.
A combination of non-recurring factors including: exceptionally mild winter conditions in Europe, extreme hydrological conditions in Brazil and the outage of two Belgian nuclear reactors, would mean that net recurring income should come in at the low end of its 2014 target. The outage of two nuclear reactors in Belgium, which should be restarted by the end of this year, is costing the company some €40 million a month in net recurring income. As such, we should expect GDF Suez's earnings will bottom out in 2014. Its Perform 2015 restructuring program has been expanded and it is now expected to improve the group's share of net recurring income by €0.9 billion ($1.2 billion) in 2015. Beyond that, the impact from cost cuts, capacity withdrawals and the commissioning of new assets outside of power generation in Europe should support relatively strong earnings growth in the medium term.
In February 2014, GDF Suez announced a new dividend policy, which is to pay out between 65% and 75% of net recurring income for each of the next three years. The new policy also pledges to pay a dividend of at least €1 per share until 2016 ($1.34 per ADR). GDF Suez has already declared an interim dividend of €0.50 per share ($0.67 per ADR) to be paid on October 15, 2014, with an ex-dividend date of October 13, 2014. With the group's share of net recurring income expected to total between €3.3 billion and €3.7 billion; we should expect that the dividend for 2014 will be the minimum amount of €1 per share. Although we are uncertain about the exact dividend amount for the next three years, it would be safe to assume the dividend has been cut from the dividend paid in 2013, which had been €1.50 per share ($2.01 per ADR).
Although the company seemed to have prioritized shareholder returns by aggressively slashing its capital spending budget and rapidly disposing its least competitive assets, the dividend cut has not been completely unexpected. Analysts have long questioned the sustainability of the €1.50 per share dividend, and its futures have priced in a dividend cut. Free cash flow in past years had been insufficient to cover its large capital expenditure budget (which had typically been in excess of €8 billion) and the sizeable dividend, without making too many divestments. It appears that it is no longer sensible for GDF Suez to prioritize the dividend payment over further reductions to its capex budget or maintaining the rate of disposals. The dividend cut is expected to save €1.2 billion, which would be used to fund additional growth capex without increasing leverage. Nevertheless, the current prospective 5.3% dividend yield is stable and remains relatively attractive for its peer group.
GDF Suez has reduced its net debt by €3.2 billion ($4.3 billion) to €26.0 billion ($34.8 billion) in the first half of 2014. Net debt/ EBITDA now stands at 2.2x, which is lower than the company's 2.5x target and many of its continental European peers. Low leverage means that the company can spend between €4.5 billion and €5.0 billion (between $6.0 billion and $6.7 billion) in growth capex for each of the next three years. However, we should note the issuance of hybrid bonds had helped to lower its leverage. In May, it issued a hybrid bond for a total amount of €2 billion ($2.68 billion), These hybrid securities are generally considered by credit rating agencies as 50% equity and 50% debt, in their assessment of the company's credit rating. But, under IFRS accounting standards, they are considered only as equity. These hybrid bonds are dissimilar to senior corporate debt because interest payments can be suspended under certain circumstances, as long as dividend payments and buybacks have also been suspended. In the past few years, demand for hybrid securities have been particularly strong in Europe, allowing companies to borrow money at very low premiums above the yields of comparable senior corporate debt. Recent hybrid bond issuances have undoubtedly helped the GDF Suez lower its leverage and maintain its 'A' credit rating, without having too much of a dilutive effect to shareholders.
Shares in GDF Suez currently trade at 14.5 times expected 2014 earnings, which is a low multiple when you consider the company's strong growth prospects and the relatively high dividend yield it offers. The attractive growth outlook is underpinned by its asset optimization strategy and its investments in high growth markets. With earnings set to recover in 2015, GDF Suez would trade at 13.5 times expected 2015 earnings. Thereafter, we could expect earnings to grow in the mid to high single-digits, as costs take-outs materialize and income from new projects offset weakness in Europe. It would only be a matter of time before the dividend catches up with the progress made to earnings.
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Additional disclosure: The author is long GSZ.PA.
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