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Cool Energy - Can They Make It Hot. Further Musings On Risks And Opportunities Of E.ON's Split

|Includes: E.ON SE ADR (EONGY)

E.ON's new strategy embraces the change and structural shift I anticipate for broader energy markets. It now needs to consider its pr and marketing in competition or partnership with much stronger brand equity consumer sectors. It will be involved in battles of boundaries, but may be able to turn that to its advantage. Equipment and consumer ownership, service provision and margin structures are all impacted. Commodity risk will arguably increase, as will financial risk. E.ON has reduced political risk, but increased execution risk.

E.ON's big bang announcement of the split of its generation and upstream businesses begs further long term thoughts on risk and opportunities.

Is this the emergence of "cool" energy companies, akin to the Apples of the consumer world? With branding that emphasises new energy, a young and dynamic image, smart features, and clean tech, all along with a pr strategy that brings it much further up the curve. From E.ON's current perception to cool energy, there is a long way.

Product, ie hardware may become an integral part of such a strategy. That means, branded appliances with consumer appeal. Those will more likely than not come from a different set: household goods and consumer goods manufacturers, but also the clean tech sector and broader tech sector. The utility will be involved in a battle of boundaries as every sector tries to get a share of new energy. It may find opportunities through partnerships that bring the benefit of a step up in consumer and public image.

E.ON will be well advised to bring package offerings to the market. It may have to enter into partnerships for hardware sourcing as said above. Services are an integral part of that, as recognised by management. In that, E.ON now stands out in the sector with a very consumer services driven model.

Should management eventually take things a step further and go down an acquisition route, I would anticipate a negative reaction. There are potential targets amongst the vast debris of renewables developers and equipment manufacturers with strong consumer brand equity.

Who will own the equipment? The utility? The consumer? The manufacturer? I gather, consumers will own small appliances. But, as they may develop new, energy related features, such as storage, there may well be interest in changing ownership structures. Distributed generation may be owned by the consumer or not. It may be leased. In which case, will the utility be the owner or the manufacturer? If the manufacturer remains the owner, the utility's ultimate share in the margin of the product has to be questioned. If the utility is the owner, it has to take distribution and channel risk and with it risk of depreciating working capital. That risk per se is not new, but it is new for supply utilities.

Commodity risk will increase. In absence of vertical integration, the generation hedge will disappear, leaving the company exposed to commodity risk - on the other side than what it has faced so far. I envisage forward purchasing rather than forward selling, as currently the case. At the moment, power price risk may not be a prime concern. But, power cyclical, cycles are very long, and eventually the cycle will turn.

Short term volatility and mismatches between commodities moves and end customer tariff adjustments will need to be managed. Working capital requirement will increase.

A supply business can command an Ebit margin in the order of 4-6% without vertical integration. An enhanced supply business, ie with value added service offering, service/product packaging and consumer brand equity, may be able to enhance that by 100-200bps. But, that is still less than an integrated generation business.

Compressed margins require reduced leverage in order to maintain financial ratios, particularly interest cover.

Has E.ON de-risked its business or increased risk? It is grasping the opportunity of a paradigm change in the shape of the energy sector. Without a question, in my mind, execution risk has greatly increased. Financial risk has increased. The flipside is a reduction in political risk - most likely.