Engie (OTCPK:ENGIY), the French integrated utility company formerly known as GDF Suez, is preparing to accelerate its transformation plans as it faces challenges from falling oil & gas prices and overcapacity of electricity supply in developed markets. In a bid to restore profitability and reduce earnings volatility, the company is looking to pare back its struggling thermal power generation business in the US and Europe and re-direct investments towards renewable energy, infrastructure and energy services.
Engie's 2015 Results and Its 2016 Guidance
After €8.7 billion ($9.7 billion) worth of impairments were booked on its income statement, Engie's net income fell deep into negative territory in 2015. The group's share of the net loss was €4.6 billion ($5.1 billion), compared to a €2.4 billion ($2.7 billion) profit in the prior year.
Falling energy prices meant the group's exploration and production (E&P) segment and its LNG business was where most of the impairments were made against, accounting for €4.3 billion ($4.8 billion) out of the total €8.7 billion figure. Most of the remainder of the impairments were booked against its European and US power generation assets.
When we look at the company's net recurring income, which is the company's measure of underlying profitability, we get a slightly better picture of the company's financial performance. Net recurring income is understood to be a better guide of its underlying earnings trend because it strips out impairment losses, restructuring costs and other similar "short-term" costs, and on this measure, income fell by just €0.1 billion (about 5% or $110 million) from 2014 levels, to €2.6 billion ($2.9 billion).
This exceeded consensus analysts forecast of €2.5 billion ($2.8 billion), but fell short of its own October 2015 guidance of between €2.75-3.05 billion ($3.1-3.4 billion). Its earnings have fallen short of earlier expectations because of an unexpected futher deterioration of power prices and falling oil and gas prices, which lowered margins and LNG volumes.
Looking forward, management expects 2016 net recurring income to be broadly in line with 2015's earnings, with guidance of between €2.4-2.7 billion ($2.7-3.0 billion).
Accelerating Its Transformation Plan
With energy prices falling across the board, Engie is accelerating its transformation plan to focus on low carbon energy and reduce its exposure to volatile commodity prices. By 2019, Engie wants around 85% of its EBITDA to come from contracted or regulated activities -- the current figure is close to around 55%. These activities generate reliable cash flows throughout the business cycle and are much less exposed to volatility in commodity prices. It would also set Engie apart from its European peers, most of which are still heavily exposed to volatility in wholesale electricity prices.
Accelerating its transformation plan makes plenty of long-term sense, but it would likely lead to more short-term pain. The sale of its European thermal plants and similar mature assets would likely reduce cash flow generation, because despite the challenging trading conditions, these assets are still highly cash generative. What is more, falling asset prices would likely mean Engie may risk having to offload legacy assets at fire-sale prices.
But as low wholesale prices seem destined to stay lower for longer with growing generation from renewables and a weak outlook on energy prices, refocusing investment towards the "new energy world" seems to be the right strategy. Eventually, cash flows should improve, and perhaps more importantly, they will be more stable too.
Growth-focused capex plans
The group plans to spend €22 billion ($25 billion) in capital expenditure over the next three years, which far exceeds expectations of cash inflows after interest and dividend payments. However, more than two-thirds of it (around €15 billion or $16.7 billion) is being directed at growth projects and almost all of its growth capex will actually be funded by its "portfolio rotation" program.
Engie is planning to sell €15 billion worth of existing assets and re-allocate that capital to finance growth capex over the next three years. Essentially, the group is swapping its low-growth carbon intensive operations for faster growing assets in energy services, infrastructure and low carbon power generation. These disposals are necessary for the company to maintain its single-A credit rating, by ensuring that it can stay within its 2.5x leverage ratio in the medium term.
Engie has already made steady progress with its asset sales, after having agreed to sell 10 gigawatts of US power generation assets and interests in two coal-fired plants in Indonesia and India earlier this year. The completion of these disposals, which should take place by the second half of 2016, will have an impact of reducing Engie's annual earnings by €600 million euros ($670 million). But on the plus side, it would also decrease net debt by €5.5 billion ($6.1 billion).
Volatility Risks Remain
Engie cannot avoid all commodity price risks though. The company's repositioning efforts have already been taking shape for more than two years now -- and so far, global diversification and exposure to multiple fuel sources has not had the intended impact of reducing volatility.
Even with the divestment of much of its upstream oil and gas assets, the fortunes of its LNG business will still be dependent on changes in wholesale energy prices. Already, we can observe this from declines in its earnings and sales volumes. The group's external LNG shipment volumes fell by more than two-fifths to 71.4 TWh in 2015, as a result of fewer arbitrage opportunities caused by the recent narrowing of the spread in LNG sales prices between Europe and Asia.
Renewables are not immune to volatility in wholesale power prices either. Most electricity generated from renewable sources is sold at market prices per kWh, with fixed-rate tariffs topping up the total revenue for each unit of electricity produced. This means profitability is still very much exposed to market risks.
Increased adoption of CfD or variable premium subsidy models could change this in the future. Under these subsidy schemes, energy producers sell at market prices, but receive an additional variable payment from the government for the difference between the market price and the pre-determined strike price. In effect, producers earn a fixed amount per kWh of electricity generated. But, there is one major drawback of these schemes: the subsidies are typically far less generous.
Medium Term Headwinds
Restructuring and cost cuts can only go so far, and near-term earnings would largely remain at the mercy of uncontrollable market risks.
Pressure from weak commodity prices, particularly falling wholesale electricity prices in Europe, is not going away anytime soon. Despite significant cuts to thermal generation capacity in the industry, weak demand should mean the generation market across Europe will likely remain oversupplied. This would maintain the downward pressure on power prices and generation margins.
The company's hedges have mitigated much of the effect of falling prices in the short-term, but hedging is intrinsically temporary. With electricity prices continuing to decline, it would seem that there is more room for earnings to fall as existing hedges roll-off.
On top of the negative outlook on wholesale power and energy prices, there is a downbeat macroeconomic outlook. Global economic growth is expected to remain sluggish over the next few years, weakening the global outlook for energy demand. Brazil, one of its largest growth markets, is in a particularly poor state, with the government budget in a large structural deficit and the economy forecast to shrink by another 3.0% this year.
Engie's Energy Europe generation fleet is heavily exposed to gas and nuclear, which combined accounts for more than two-thirds of its generation capacity. This puts the group at a medium term competitive disadvantage against generation from coal and oil, because thanks to the US shale revolution, the import prices for those commodities have fallen more steeply than that for gas.
Another source of uncertainty comes from the regulatory review of its gas infrastructure business. Returns on regulated assets are reviewed every four years, and decisions by the "Conseil d'Etat" for the coming four year period are due to be announced between mid-2016 and early-2017. With a regulated asset base of €23 billion ($25.7 billion), a worse than expected review could have a major impact on earnings.
However, the company would also likely benefit from some favourable tailwinds too. Its Belgian nuclear power plants (Doel 3 and Tihange 2), which had been shut down after microscopic cracks were discovered in the pressure vessel of the reactors, were restarted earlier in the year. At peak capacity, these power plants should add back around €400 million to its annual net recurring income.
In addition, Engie is planning to make an additional cumulative saving of €1.0 billion in operational expenses between now and 2018. Much of these savings will likely come from its Global Gas and LNG segment, which has been particularly hard hit by falling commodity prices.
Long Term Growth Drivers
Longer-term, the reduced reliance on nuclear energy in France and much of Northern Europe would likely boost gas demand. Natural gas is an ideal fuel source for peaking power plants, which are necessary to maintain adequate capacity within an electricity system that relies upon intermittent and inflexible electricity generation.
The proposed introduction of a carbon floor in France, and potentially across Europe, could improve the competitiveness of gas over other fossil fuels. Other measures to reduce carbon emissions would make gas a more attractive energy source, too. This means that although gas may be somewhat less competitive now, the longer term outlook remains positive.
Energy Services, the group's consultancy and technology solutions, is another potential engine of growth. The group's recent acquisition of OpTerra Energy Services, a US company which helps schools, hospitals and businesses to improve their energy efficiency, shows management is keen to bulk up its business and support further growth in this fast growing industry. Energy Services also benefits from being less capital intensive, which boosts the group's return on equity.
Unfortunately, these potential tailwinds will likely take years to materialize into results, which means earnings could still get worse before eventually recovering.
On February 25, Engie announced that it would cut its dividend in response to falling profitability. The group would continue to pay a dividend of €1 per share ($1.12 per ADR) for the current financial year, but from 2017 onwards the new dividend will be €0.70 per share ($0.78 per ADR).
Engie's previous dividend policy stated an intention to maintain a payout ratio of 65-75% of net recurring income with a minimum annual amount of €1.00 per share until 2016. However, as expectations of net recurring income have come down since the old dividend policy was announced in 2014, it would no longer be affordable to maintain the €1.00 minimum amount.
Back then, the group had expected to deliver net recurring income of between €3.3-3.7 billion. But as expectations for net recurring income have fallen by about 30%, future dividends have too been cut by that same proportion.
Although not explicitly stated, the new dividend policy is still broadly in line with its previous payout ratio of 65-75% of net recurring income. This indicates that the 65-75% payout ratio is still a useful guide of the group's future dividend plans, even though it has not been explicitly maintained.
Engie's above average dividend yield has been the key attraction with the company's shares for several years now. But with a 30% haircut to its dividend, Engie now has a below average prospective dividend yield for the European utilities sector.
Shares in Engie currently yield a respectable 7.4%, but its prospective yield for its 2017 financial year would to fall to 5.2%. That's still a figure which is very respectable in comparison to US peers, but subpar compared to its European peers. The average 2017 forward dividend yield for integrated utilities in Europe is 6.4%, with regulated peers carrying a 5.3% yield.
It is also important to note that the company's new dividend policy has only been promised for two years (i.e. 2017 and 2018), a shorter timeframe than its previous dividend policies. The shorter period commitment could be taken as an indication of the increase in uncertainty of future trading conditions and management's more flexible attitude to adjusting dividend payouts. Dividends are after all at the discretion of the board, and recent cuts make it clear that the board considers growth capex to be a higher priority than shareholder payouts.
Earnings Forecasts and Valuations
Engie's return on equity has been languishing in the low-single digits for several years now, and there are few signs that the company can break its declining earnings streak anytime soon. And as earnings have consistently trended downwards, so too have expectations for future growth.
Given recent results, it's not surprising that analysts' estimates for Engie's adjusted EPS in 2016 and 2017 have steadily declined in recent weeks. The current consensus forecast for adjusted EPS is €1.10 ($1.23 per ADR) for 2016, while the 2017 figure is €1.09 ($1.22 per ADR). This would mean its shares trade at forward P/E ratios of 12.6 and 12.7, respectively.
Another important earnings valuation metric for the sector is the adjusted EV/EBITDA, because it is a capital structure-neutral measure of profitability. This makes it a fairer comparison of profitability between companies with varying debt levels. On this metric, Engie is valued at 7.0.
|National Grid (NYSE:NGG)|| |
Adjusted EV/EBITDA (NYSE:TTM)
Adjusted P/E (TTM)
Forward P/E (2016)
Forward P/E (2017)
Forward Dividend Yield (2016)
As expected, Engie's valuation multiples trade somewhere in between its integrated peers and the more highly valued regulated peers. However, given the company's recent dividend cut, its poor medium term outlook and the overhang of multiple downside risks, Engie's premium to its integrated peers may no longer be justified.
Engie has an attractive long-term business model and is positioning itself to benefit from future energy trends. With steady investment in renewables, infrastructure and energy services, the company is poised to benefit from the transition towards renewable generation and growing demand for energy efficiency.
However, with a substantial proportion of its operations still exposed to further weakness in energy prices and the group facing multiple downside risks, more short-term pain could still be to come. These uncertainties and a poor earnings track record diminish what would otherwise be a compelling long-term growth play. And as the company faces greater headwinds than tailwinds in the short- to medium-term, it would seem reasonable that valuations could become cheaper still.
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