By Leonard Hyman and Bill Tilles
Innogy (OTCPK:INNYY) had disappointing news. Innogy who? Not a household name. Originally, it was called National Power, the biggest of the electric power-generating companies privatized by Margaret Thatcher's Tories in the UK in 1990. Post-privatization National Power split into two, spinning off its international holdings into International Power and keeping domestic UK assets in a newly renamed Innogy. German utility giant RWE (OTCPK:RWEOY) then bought Innogy as the British sold almost all their electricity companies to foreign firms.
The European electricity generating market has suffered meaningful price decline despite the fact that Germany, in closing all of its nuclear plants, removed a substantial amount of supply from the region's generation market. RWE decided the best way to bolster its balance sheet - riven with impairments and nuclear related write-offs - was to engage in classic financial engineering. It spun off renewables, retailing and grid businesses into an affiliated company (still owned 77% by RWE and still called Innogy).
Critics disapproved of RWE's €5 billion-plus acquisition of Innogy over a decade ago. However, the recent sale of less than a quarter of the business for over €4 billion clearly vindicates management in this regard. In addition to meaningfully increasing in value, Innogy will continue to pay a hefty dividend to parent RWE. Shareholders are expressing optimism, and Innogy's share price is up recently. The French power-generating company Engie (OTCPK:ENGIY) (formerly GDF Suez) has its eye on purchasing Innogy, according to press reports, to burnish its green and non-conventional power generation credentials.
Innogy's sale would leave RWE with a lot of cash and a line of legacy businesses that has proven unpalatable, especially to European investors with an appetite for growth. The sale could also, paradoxically, render RWE uninteresting and unstable at the same time, depending on how much cash it receives, and especially how the company plans to deploy the cash. Using the cash conservatively and retiring debt could make RWE a takeover target, for example.
Interestingly, the other, larger power company in Germany, E.ON (OTCPK:EONGY), chose a different path and sold to the public 50% of its legacy generation business, now called Uniper. E.ON was in the news this week with an eye-watering €16 billion after the tax write-off. Interestingly, from an operating perspective, the company was solidly profitable, with future expectations for more of the same. The losses were due to payments the company has to make to the German government for nuclear disposal and storage. In addition, there were impairment charges taken for Uniper.
Both RWE and E.ON are dramatically reorganizing. The government hit them with a bigger-than-expected tab for nuclear cleanup costs, according to their respective managements, and they are responding. But they are also addressing their more fundamental problems in terms of aging, uncompetitive fossil and nuclear generation. By aggressively writing down old plants, we can better see what the underlying values of remaining businesses are. In the same press release announcing the big write-off, E.ON's management also promised solid dividend growth.
Let's be clear: Neither E.ON nor RWE has been a joyride for investors. E.ON's stock price, for example, peaked at around €150 in 2007 and trades slightly below €7 today. That's a not-so-modest 95% price decline. RWE's situation is not much different.
Now you know about Innogy. What's the latest? Earnings fell 7% last year due to the North Atlantic Oscillation, an oceanic phenomenon that shifts wind from northern Europe (where Innogy has its wind farms) to southern Europe (where it does not). This does not appear to be as serious as the day when all the wind stopped in Texas and the electric system operator scrambled to keep the lights on in the Lone Star state.
Continental Europe, fortunately, still has a glut of power plants, mostly aging fossil and nuclear. Air pollution, GHGs, and nuclear waste concerns aside, these are the assets deployed to keep the lights on when the seas, so to speak, are "becalmed" and the wind ceases to blow. This suggests several issues.
First, most of our readers know that renewable electric power generation is typically intermittent - not only subject to daily and seasonal fluctuations, but also to changes in climate patterns. And modeling these weather patterns themselves against the backdrop of ongoing anthropogenic influence and a warming planet is no mean feat. A wind farm resembles any other large, central station power-generating facility in one key respect: you can't move it (or at least not easily). Thus, grid operators will have to take into account climate-induced alteration in expected weather patterns. As a result, they might struggle to determine the appropriate levels of firm backup generation.
This is not an idle intellectual exercise. Maintain too much electric power plant as backup for a primarily renewable system and power prices rise, perhaps significantly. Having too little backup supply ready saves money, but risks having the lights go out. This could mean having extra physical plant in place despite the possibly low probability of an event, albeit one with high impact. Extra plant costs money to maintain.
Second, RWE has begun to sell off pieces of Innogy, and now has a potential suitor, Engie. The equity market does not at present reward legacy, dirty, low-growth electric power generators. Which is another way of saying the new resources, the clean energy, the simple grid business, all have a lower cost of capital than the legacy electric power generation fleet.
Investors have begun to discriminate among these asset classes despite shifting political moods in the U.S. and Europe. Some politicians favor heavily subsidized nuclear power construction, but seek to limit renewable subsidies. Have they stumbled on the right conclusion for the wrong reasons?
Renewable operating and capital costs have declined dramatically, and may continue to do so. Do they still need subsidies? On the other hand, the cost of new nuclear construction has not declined, and nobody seems ready to build without the helping hand of government financial assistance, preferably in the form of low-cost construction loans initially and then generous power price guarantees on the back end.
So, if governments continue to "need" nuclear power, then we should expect considerable above-market price supports. And if the choice is more renewables, investors may obtain adequate returns even without government subsidy. This brings us to our third and last question. Can large corporations in increasingly unpopular, low-growth businesses still make money for shareholders?
Recent activity suggests two answers. The first is classic financial engineering. In practice, this means selling attractively priced, high-multiple business to repair massive balance sheet damage - some of the damage self-inflicted, and some government imposed. The second path to possible corporate financial redemption, or at least above-trend growth, is to acquire, at presently lofty valuations, businesses and technologies they would/should have been vigorously pursuing decades ago if they had been listening to scientific and social discourse. Maybe the answer was blowin' in the wind.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.