New energy, new models

E.ON’s split is validation and coming of age for new energy. Clean tech will face serious competitors with deep pockets, not only from utilities. Clean tech benefits from strong consumer and public brand equity. It may need to embark onto partnerships. I expect consolidation and M&A, including involving the private sector. Solar, heat pumps, storage and demand solutions grow in attractiveness. Oil is a negative, but even if price weakness is protracted, it will unlikely reverse the trend.

The gorilla has entered the room. The clean tech sector now faces a big competitor with desperation and deep pockets. E.ON has been active in the sector before, but now it is its main focus.

This is validation and coming of age for new energy. I have repeatedly stated my view that the sector is well under way towards a structure of limited clusters of large scale concentrated generation combined with a wide spread of distributed generation, smart features, new owners of generation assets and gas/networks as the backbone.

Integrated service and equipment offering is the new game in town. Clean tech stands at a disadvantage – to a point. The big utilities still have bigger customer account ownership. That can and in my view will change quickly as the competitive landscape changes.

Some clean tech companies have embarked on greater product packaging and services offering. I still see them struggling because of their lack of experience with long standing retail customer relations, billing and the tail end of customer accounts. They will struggle with aggressive competition from utilities, supermarkets and consumer goods manufacturers. The sector would need to embark onto consumer goods strategies, at least as a complement.

Consumer brand equity (not necessarily breadth of recognition, which I gage, is lower, but positive image perception) seems greater for the cleantech sector. The utilities are suffering from the negative image of perceived over-pricing, anti-renewables lobbying and coal and nuclear generation. Those issues are still – as a side note – not only consumer marketing, but also broader pr and financial markets communication challenges. The clean tech sector has got some tarnish from subsidies dependency and impact of bankruptcies. But, generally end market perception is strong. These points hold specifically for Germany, to a degree also for the UK.

There will be a demand boost from 2016. Solar, storage heating equipment and appliance management in the broader market in Germany from the pure change brought about by E.ON. I see no material impact on wind as the bigger change happens in the consumer driven market. That is the market of smaller scale technologies.

Manufacturers will lose pricing power. The market moves from retail to wholesale. The big actors looking to be intermediaries will tighten pricing. Changing ownership structures of equipment (see last week’s feature – Further musings on E.ON’s split) may contribute to that.

There may be consolidation and M&A, including involving the private sector. I would not be too surprised to see E.ON on the look for consumer brand equity. I would expect E.ON to avoid manufacturing operations. But, that could still entail split up of manufacturing businesses where manufacturing and downstream channels are sold separately or parts of businesses dismantled. Rapid technology obsolescence furthers the process.

Clean tech businesses that successfully build up partnerships to enter the E.ON bandwagon of change in the market can see a reduction of earnings volatility and, potentially share price volatility. Multiples will change to reflect new earnings patterns. I still see the sector trading at growth multiples for the near future.

I look for new solutions providers. Amongst the well positioned names, I see Solarworld despite its cling to manufacturing and negative pr impact from some of the CEO’s actions. Trina Solar (TSL US) also stands out, but will in my view not deviate from its core manufacturing. Conergy has achieved great recovery of its brand equity and is pursuing innovative business propositions, including new ownership models. Battery names should be of interest. ASTec, for example is expanding the storage business and has just launched an “electricity bank” with MVV. I can see more new energy features from its IT solutions. Vaillant, Viessmann, Stiebel Eltron, Danfoss and Bosch, the leaders in heat pumps, should benefit from the changing market.

Oil price weakness has taken some gloss of the clean tech sector, but even if protracted, I still see all the points above holding up.

Cool energy – can they make it hot ? Further musings on E.ON’s split, risk and opportunities

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.

E.ON (EOAN GR) – bad bank or good reasoning?

E.ON has taken the deep plunge with its strategic shift to spin-off the conventional generation and upstream businesses. I gather this anticipates the energy sector transitioning to a shape that will not have much in common with its current form. But also, the upcoming coal legislation and with it the likely conclusion that market design and politics entail risk that needs to be managed differently were probably a catalyst for the action. E.ON will need to step up broad communication and create brand equity. The new co comes from a low base of struggling power generation and commodities volatility. But, amongst the peer group, the generation portfolio is competitive and expectations on commodities businesses are at a low point. I expect a boost to sentiment from the announcement and see upside with little risk.

E.ON has announced it will spin off its conventional generation and upstream businesses and focus on renewables and supply. A newco comprising the upstream business could get listed in 2016. I think there may also be other options for E.ON’s exit than a public listing. Much will depend on how profitability of the assets has improved until then.

This is the most radical reaction to the changing environment in energy seen in the utilities sector so far. I gather, the upcoming coal legislation with a risk of major closures has been a key factor that has speeded up any decision.

Management’s proactive approach is laudable, and that pure fact will play in favour of E.ON. It is a great enhancement of credibility and very effective from a communications point of view – in all directions, markets, governments/regulators, media and consumers. E.ON has clearly captured attention and competitive advantage as a first mover.

Is it a bad bank? To a point. The likely upcoming coal legislation in disguise (22mt CO2 reduction through technology agnostic legislation, but no choice but coal closure in reality) may well have been a catalyst. But it could have speeded up a transition that has been in the works for some time.

The move makes sense: profitability of up- and downstream activities are diverging significantly and synergies are reducing.

Supply is becoming a consumer and brand equity based service. I have expressed my view at many occasions that the competitive landscape will change significantly. Consumer goods and services companies will increase their foothold from a strong standing. They in most instances benefit from stronger brand equity. The utilities will have to spend considerable effort in improving perception and positive brand equity. Of the major utilities, I see E.ON’s brand equity as reasonable but with need for improvement.

Through distribution and supply, E.ON will be able to build a smart and energy efficiency based service offering that gives it an advantage over other suppliers that come from the consumer side.

The renewables assets may fit the customer focused supply and services business. Distributed and smaller scale clean generation definitely fits and offers service, system integration and other opportunities. Large scale renewables development is out of that scope, synergies are limited but management has the expertise.

The weight of regulation for E.ON will increase. But arguably, it is a type of regulation that may be lower risk than the one the company is currently facing: Its regulatory risk exposure is within distribution and towards renewables incentive schemes. That compares to political risk that stems from market design and drastically reshaping policies.

The newco will  have a generation portfolio that is struggling, but amongst the European peer group one of the most competitive. The up- and midstream assets provide hedge and system integration synergies. There is some upside from the capacity scheme, and towards the end of the decade from a tightening power market, according to my calculation. There is commodity volatility and low oil prices are unhelpful, but the timing is good with expectations on commodities at a low point.

I believe there is room for large scale centralised power generation in a new energy world. But I expect it to be highly centralised and much focused on few high performing assets. E.ON has taken a step to take the sector towards that concentration.

I would not be surprised to see follow-on activity from this. Other integrated generators might follow. The most likely ones are RWE and some of the UK names.  Germany and the UK are the regions where the benefit of vertical integration vanishes the fastest and where public scrutiny on that aspect of the energy business is the highest.

RWE though would have a harder sell for its upstream power assets even though the lignite plant fulfils some of the criteria that I would view as essential for future large scale generation. I can see a scenario where RWE cannot escape closures, whilst divesting other plant and keeping a rump.

E.ON’s Eur 4.5bn write off for Southern Europe is not surprising, it is a clean-up exercise.

The dividend is confirmed at Eur 0.5/share for 2015 and 2016, in line with expectations.

I sense that E.ON has delivered another proof that it is one of the most proactive companies in the sector and that it is not afraid to take strong action. Earnings are bottoming out, and this latest strategic clarity with a prospect of new profitability should give a boost to sentiment.

I estimate a value in the order of Eur 25-40bn for the upstream company and in the order of Eur 35-38bn for the remaining business. That is a wide range, but the upstream business valuation is very conditioned on future commodities. In any case, that implies a combined share price of Eur 14.80-17.40 before any impact of operational improvement.

Renewables: M&A in the Western plains

An exemplary deal has been announced in the US renewables sector with Sun Edison. I expect that to open a trend within the sector. Operators looking to diversify or rotate their asset base provide private equity with exit opportunities. Conversely, financial investors may be attracted by a growing base of mature assets. I expect deal activity to intensify and that to support multiples in the sector, primarily at the mature stage.

Sun Edison (SUNE) is taking over First Wind for USD 2.4bn In a joint deal with TerraForm (TERP), Sun Edison’s yieldco. Sun Edison will acquire 8MW of capacity, and TerraForm increase its backlog by 60%.

The strategic rationale is obvious. Synergies between solar and wind development are plentiful. The same goes for later operating synergies. In an environment of energy transition where system integration of renewables is a key challenge, wind and solar complement each other well. Often times, solar can make up for volatile wind conditions. Wind and solar generation tends to occur at opposite times of day.

I argue operators should have a diversified portfolio of renewables (and in the case of broader generators, other) assets in any case. This materially improves load factors and operating synergies.

For focused developers in either space, acquisition is the in my view the preferred route of entry into the other market. Synergies are strong as said as the build principle of development is identical. Still, both businesses are very local and at least initially require specific expertise.

Incentives for solar in the US will decline in the next two years. This could well be a catalyst for more M&A activity as solar operators may seek to diversify. Wind incentives are still limited to the roll over of ptc’s.

On a side note, one could read a bearish view for US solar demand into this. I can see a dent to demand, but expect grid parity induced demand will be the prime driver.

The price, c. USD 450/MW for pipeline projects under the assumption of a USD 1.1m/MW valuation of existing projects, is in line with average pipeline multiples. M&A multiples for installed capacity were around USD 1.6-1.7m on average in 2013 across the sector.

USD 1.9bn are upfront and USD 510m conditioned on development mile stones. I have attributed no value to the 6.4GW of long term development opportunities for this calculation. There will be USD 1.5m of non recourse warehouse financing by SunEdison in relation to the assets that will be brought into TerraForm.

I see this as supportive for US multiples in the sector in the first place, but also for European developers. Most European developers have sizeable positions in the US, particularly Iberdrola Renovables (IBR), EDP Renovaveis (EDPR PL) and Enel Green Power (EGPW IM), but also EDF (EDF FP) through EDF Energies Nouvelles. A number are trading at capacity multiples below construction.

Some Europeans may well see the opportunity for asset rotation and consider becoming participants in M&A activity. That may go in both directions, ie wind to solar and solar to wind.

I see the entire renewables developer/operator sector diversifying its asset base and converging across technologies over time. That bodes for plenty of deal activity.

I would expect involvement of private equity, trade buyers and sellers, as well as long term financial investors such as pension funds for whom a maturing renewables asset base provides a growing pool of opportunities.

Centrica (CNA LN) – On hold

The profits warning should not come as too much of a surprise. The company’s business mix is attractive long term, but current headwinds make risks prevail.

Management has reduced guidance to 2014 EPS of GBp19-20, down from GBp 21-22. The company expects earnings to return to growth in 2015.

The current 2014 consensus stands at the high end of the revised guidance. 2015 expectations are for 11% growth from there. I believe there is risk for downside.

The issues quoted should not come as a surprise to anybody. The warm weather and demand weakness are well known and hitting the entire sector’s earnings season. The nuclear outage is an additional unfortunate, but beyond Centrica’s control

Centrica has its strategic upstream position going for it. But, that is now compromised at least short term by weak gas prices. Management has cut upstream capex by GBP 100m to GBP 900m which is not a large amount. But, one of the company’s big earnings growth drivers is currently on hold.

For this year, the company’s hedge will protect upstream earnings, but a hit will come in 2015. That will be reinforced by a higher effective tax rate as the current tax allowances come to an end. Further, there is risk of asset write downs.

Supply is still struggling. Management highlighted account wins from its new tariff in cooperation with Sainsbury’s. But the reality is the company lost 50,000 accounts in Q3. Longer term, I believe supermarkets will step up their effort in the energy supply market and Centrica is on the right track with its cooperation with Sainsbury.

Even though the company is well positioned in its supply business, the risks from the CMA review, election overhang with potential price freeze and intense competition prevail.

The shares trade in line with the sector’s 14.0x 2014E P/E and at a 20% discount to the average peer group EV/Ebitda. That reflects a lot of the negatives, but does not make a case from upside from here at this stage. The longer term attractions of the company have the potential to attract higher valuations but the timing for that is uncertain still.

What the numbers tell us for Q4

The oil sector begins to feel the pinch of commodity weakness. Services are worst hit, as evidenced by Subsea 7 (SUBC NO). The E&P sector is still sheltered through hedging and selective names can outperform on production growth.
I see GDF Suez (GSZ FP)as the integrated utility major of choice for Q4 and beyond and expect its ytd out-performance vs the sector to widen. GDF Suez’s 9M numbers were short of consensus, but the underlying business is delivering stronger growth and profitability than most of the sector peers. E.ON and RWE have beaten consensus, but deliver weak fundamentals. Enel (ENEL IM)is far from a recovery still and its numbers are uninspiring. SSE is entering a phase of fundamental weakness, as witnessed by the latest cautious management statement.
The renewables sector is delivering good year end numbers and should benefit from positive seasonality into Q4. Canadian Solar (CSIQ) is this week’s example.

Warm weather, oversupply and weak power prices have hit the entire utilities sector’s 9m results. Regulation is unhelpful in the major European markets, now including the UK.

Those conditions will persist in Q4 and likely Q1 15. The unhelpful warm winter will be a negative as will be weak demand and pricing.

In that environment, European power generation and supply will underperform. Of the utility majors that have reported this week, GDF Suez stands out with two strong organic growth drivers that withstand commodity weakness and deliver sustainable growth.

I do not see major downside risk to consensus to most of the names. Consensus is bottoming out for E.ON and RWE. But the DEA uncertainty downside risk on RWE’s net numbers. Sentiment is flat for Suez.

Oil is continuing to deliver weakness on guidance and order flow, selectiveness is the answer.

The clean tech sector is reaping the benefits of restructuring and good demand.

E.ON’s numbers were above expectations (Q3 revenues Eur 25.5bn, ccs Eur 23.0bn, Ebitda Eur 1.6bn, ccs Eur 1.45bn, Ebit Eur 700m, ccs Eur 528m). But, the drivers – absence of nuclear fuel tax because of the Grafenrheinfeld nuclear closure, provisions release, and some better steam margins and capital gains from renewables asset rotations – only partially serve to become future earnings growth pillars. Rubel exposure remains an overhang for the time being.
Management has reiterated guidance for Ebitda of Eur 8-8.6bn and recurring net income of Eur 1.5-1.9bn. That is in line with consensus. The current consensus on net income stands at the bottom end of the guidance.
I do not see risk to sentiment, but these numbers are not likely to provide material upside either.

RWE’s results were also ahead of consensus. (Q3 sales Eur 10.7bn, ccs Eur 10.3bn, Ebitda Eur 1.3bn, ccs Eur 1.26bn, Ebit Eur 700m, ccs Eur 645m). Management has reiterated its guidance for operating profit (Eur 3.9-4.3bn) and recurrent net income (Eur 1.2-1.4bn).

I see sentiment continuing to be negative. The operating profit guidance is in line with consensus, but I see downside risk on earnings. Current consensus stands the high end of a guidance that is far from certain.
The DEA disposal is uncertain as ever. Management has said there will be further delay because of Russian sanctions. The British government can revoke DEA’s licence, which means there has to be agreement. The energy secretary has said he was not minded to give assurances to the Russian acquirers of DEA. The British licences account for about 25% of DEA’s value according to RWE, but I doubt that a sale would go through without them. I expect negotiations to be complicated and lengthy. The risk that the sale may fall through is real in my view. That would put Eur 5bn of debt reduction in jeopardy.

Such an outlook in turn poses a risk to the dividend. In any case, the debt reduction impact will not come through for the end of this year.

GDF Suez has reported Ebitda below expectations (Eur 8.9bn vs consensus of Eur 9bn).
As expected, the company has cut its guidance for net income to Eur 3.1-3.5bn, from Eur 3.3-3.7bn, due warm weather and nuclear outages in Belgium. That is on the basis of the low end of its unchanged Ebitda and Ebit guidance of Eur 12.3- 13.3bn and Eur 7.2- 8.2bn, respectively. The dividend outlook is unchanged at 65-75% with a minimum of Eur 1/share for 2014, in line with expectations.
With consensus below the bottom end of the guidance, I see potential for an uptick in sentiment.

All businesses outside of Energy Europe have delivered positive organic growth ytd. I still believe that the GDF Suez’s portfolio of activities is amongst the most positively geared towards long term growth. It is getting hit by several soft patches, but especially the gas based businesses will return to positive growth according to my expectation. The LNG business is actually showing positive growth despite weak commodities. I put this down to the company’s global positioning across the value chain within North America/Europe/Asia growth. That allows for full arbitrage and sustained volumes. The 9M numbers have shown this with volume growth despite weak global commodity pricing.

I also believe the company’s energy consultancy business is one of its major competitive strength. Not only, is it a big growth business in the broader context of global energy transition. It is now the second most important growth driver after global gas & LNG. It also is competitive advantage for several of the company’s other activities.
GDF Suez’s balance sheet still stands out as one of the strongest in the sector with net debt/Ebitda at 2.1x 2014E on the basis of the reduced guidance. That compares to 3.7x for E.ON, 2.7x for Enel and 4.6x for RWE without the completion of the DEA disposal.

Enel’s 9M results were below consensus. Net income was down 55% y/y to Eur 298m (consensus Eur 320m), due to Iberia and Latam. Euro strength didn’t help either. Management has reiterated its guidance for Ebitda of Eur 15.5bn and net income of Eur 3bn. Net debt stood at Eur 44bn as of the end of September. Guidance is for Eur 39-40bn by year end through asset sales. The debt target is within reach with the Endesa and Eastern European disposals.

At SSE, political risk is beginning to bite and adding to a weak market environment. The company has issued a profits warning in a broader context of a very cautious tone in its statement: Management is now looking for EPS at the low end of its guidance, ie flat at GPb 123.4. That is still above consensus and allows for the dividend to be maintained. But clearly, the risk for 2015/16 has increased.
Retail competition in the UK has significantly intensified which leaves little scope for margin improvement. Irrespective of Labour price freeze promises and the outcome of the 2015 election, there is margin risk from the reshaping supply market and regulation in the UK. And demand weakness will persist, and there are no other positive earnings drivers. I see more attractive yield names in the sector.

Premier Oil’s(PMO LN) Q3 production run rate was strong and at the high end of management’s 52,000-63,000 bpd average guidance for the year. But, the reduction of its Sea Lion Falklands project has become this week’s example of the E&P sector being hit by oil price weakness. At this stage, there is still a good hedge ratio in place, 43% at USD 105/bbl to end 2015.

Subsea 7(SUBC NO) has delivered weak order in take and cut its revenue guidance. Backlog fell 21% to USD 9.43bn, another casualty of weak oil prices and capex retrenchment in the sector. That continues the trend we have seen throughout the oil services sector. I sense that order weakness is here to stay for some time still.

Canadian Solar (CSIQ) has reported Q3 results above expectations and guidance (shipments 770MW vs guidance of 720-750MW, revenues USD 914m vs guidance of USD 760-810m, ccs USD 803m). The company is running at full capacity. Guidance is for USD 925-975m revenues (ccs USD 977m) with a 17-19% gross margin, but it was heavily caveated with regards to the trade case.
North American exposed names are my preferred sector within solar, with the note of caution that the US trade case may bring further volatility.

Nordex(NDX1 GR) has doubled operating profit to Eur 59.9bn and increased guidance to Eur 1.65-1.75bn of revenues with a 4-5% Ebit marging. I see the company as well placed to capture growth in the mid sized market and upside to consensus and sentiment.

Endesa – Viva España

Endesa has attractions as a Spanish recovery proxy and a major investor headache, Latam has been removed with Enel’s corporate restructuring. Regulatory risk has materially decreased, even though risk remains. Under relative political risk consideration, Spain now stacks up well. Endesa’s dividend is well supported, and earnings growth, valuation and the dividend are attractive within the sector comparison. Whilst the placement is a step in the right direction for Enel (ENEL IM), I do not see the same recovery and valuation attractions for Enel yet.

Enel will place14.8-19.1% of Endesa on the Madrid stock exchange with pricing of the institutional tranche on November 20th.

This is in line with Enel’s debt reduction and refocusing strategy, thus not a surprise. Enel will be able to continue its drive towards new energy and emerging markets. The Endesa restructuring with sale of the Enersis and Endesa Latam stakes to Enel that was announced at the 9M stage is another step towards that.

Conversely, it is now Enel that is saddled with the headaches of the Latam operations. The company is now arguably the most important Latam exposed name within the European utilities sector. That ties in with its strategy, but I doubt that investors will be very at ease with the business where performance has never come beyond being patchy.

Endesa has been made more attractive, first and foremost with the Latam disposal gain and the resulting greater focus.

Then there is attraction on leverage to Spanish recovery – some uptick on demand on the back of that, electricity demand recovery; and pool prices have recovered over the past two quarters. Endesa has attraction as a macro proxy, however admittedly less so than the more macro geared construction sector. It is more of a Spanish recovery exposed name than Iberdrola or Enagas, though.

Major issues of regulation, namely the distribution framework and tariff deficit have been largely cleared; albeit the capacity mechanism and royal decree on supply are still outstanding. Tariff deficit recovery remains a risk, but I take that as a given by now for Spanish utility names.

Operational performance has improved with improved generation performance (better coal output, better prices) and cost efficiency. The last reported EBITDA margin is still 400bps down y/y, but most of that is due to regulation.

The yield is in line with the European sector, at 5.9% 2015E. I see the dividend policy as sustainable, but consensus is not fully reflecting it. Post the Latam disposal and special dividend, net debt will stand at 2.5x EBITDA which is strong compared to many of the large European names that are still struggling with net debt/Ebitda ratios well north of 3x.

Consensus momentum is positive as for Iberdrola, and I expect further continuation of improving sentiment.

Endesa trades on a 7% EV/EBITDA 2015E discount to the sector. The discount should shrink with increasing free float and reduced Latam risk. Iberdrola trades on a 30% P/E 2015E premium, but its medium term earnings growth profile is equally unattractive despite now greater exposure to growth market, and higher leverage. The now well understood 2014E hit to earnings from Spanish renewables is a great contributor, but even beyond that earnings will remain flat. Endesa’s EPS return to 3% y/y growth from 2016. That positions it in the minority camp of European utilities with earnings growth.

Southern Europe now stands out positively on a relative political risk comparison. Spanish political risk is high, but considering current political risk for the sector in the UK, Germany and France, it stacks up well in my view.

King coal the underdog

The German Economy Minister is reported to look for 10GW of coal plant closure and a long term exit from coal. My model assumes 12 GW of closures to 2020 and still suggests a market in over-capacity for the remainder of this decade. I believe the chances of legislation on the matter to be low. But the illustration of political risk is enough to be damaging for the utilities, first and foremost RWE.

The German Economy Minister has reportedly said he is looking to shut down a total of 10GW of coal fired power generation capacity in Germany. 5GW of that is hard coal and 5GW is lignite. Over the medium term, there could be a total exit from coal according to press suggestions.

The quote should not be taken that there will be a coal exit. Clearly, the government could simply legislate on coal closures, for example in the form of shortened remaining hours of utilisation – if it so desired. Thus, theoretically, it is full well possible. The question is if the government really does desire a closure of 20% of German coal capacity or 48% of the nation’s power generation capacity as a whole.

Mr Gabriel’s view is far from government consensus. The senior partner in the ruling grand coalition, the CDU, is unlikely to subscribe to the Economy Minister’s view as such. That means legislation is unlikely. There will not be a regulatory exit as no policy base for any such regulation exists.

Affordability of energy is currently greatly helped by the high rate of coal generation. As long as cheap coal and carbon prevail, the consumer gets a break from the impact of policy cost through coal. The government can only find that desirable. Coal usage is a result of the market, whilst clean energy policies are in place and capacity build comes through without actually showing their dirty face in terms of cost fully.

Affordability would greatly change with a material change to coal usage.

My market model assumes 12GW of coal closures on the grounds of economic decision and EU legislation between 2017 and 2020. The 10GW mentioned by Mr Gabriel are thus well worked into the market model already.

On the basis of coal plant closures, I calculate a reserve margin of 18% for 2018. That is still a market in over-capacity.

What is disturbing is that half of the closures are to be lignite. That is not within the model. Additionally, It is a politically sensitive topic, due to lignite mining in Germany.

Coal economics will change as soon as the cheap carbon overhang is removed from the market. That should be the case from 2016. And a new global mechanism might further help a recovery in the CO2 price.

A tightening market as a result of coal plant closures will deliver a big change to affordability. The latest economic data and sentiment suggest that negative news flow on cost of energy will be very unwelcome.

A complete exit is in my view entirely unfeasible. The energy transition looks to replace nuclear with renewables and energy efficiency. To replace a second fuel, and one that accounts for close to 50% of the countries entire generation fleet is not realistic.

I see little danger of short term legislation. That and all of the above being said, nothing is ruled out over the longer term. Political risk is high and will remain so.

RWE would be clearly the worst hit by far. Its BoA plant is high efficiency, high capex and not written off, currently one of the earnings savers. A coal exit would be close to catastrophic as hard coal and lignite account for c 60% of output, and derail the earnings recovery story. E.ON (EAON GR) fares better, but there would be negative earnings impact, and a renewed illustration of political risk would be very harmful. GDF Suez (GSZ FP) has coal plant exposure in Germany.

EDF: The heads are rolling

The replacement of the CEO is not a great surprise, but it returns the focus onto state intervention and political risk at EDF.

The French government has replaced the CEO of EDF, Mr Proglio, with Mr Jean-Bernard Lévy, CEO of Thales. The ousting of Mr Proglio is not a great surprise. Mr Proglio was close to the previous government, outspoken against the Hollande government policy of reducing nuclear dependency and struck by a scandal.

Nevertheless, I gage the market is seeing this as yet another piece of government intervention at EDF. That Mr Proglio’s contract was not renewed and the new appointment decisions have been taken on political grounds first and foremost.

The event will return the focus onto the malaise with regulation in France, no element of which is particularly favourable for EDF.

Mr Lévy is very close to President Hollande. But he clearly lacks experience in the energy sector. His ability to secure the best deal for shareholders in EDF’s very particular upcoming challenges, must be questioned despite his good track record.

The operational challenge, lifting availability back above 80% for the French nuclear fleet will be another important issue for Mr Levy. The 85% target seems far from reach still.

New nuclear will not be enough to distract from French political risk, and I see further down side.

EDF has underperformed the European utilities sector by 20% ytd. I expect the performance gap to widen as the yield attraction of the quality high payout end of the sector returns to favour amidst broader market uncertainty.

2015 consensus momentum has begun to turn negative, and I see further downwards pressure.

The slippery slope of oil

A 20% oil price decline has upset the directly impacted sectors and broader markets. Below, a short view on impact and action on oil, shale gas, utilities, renewables, and broader energy markets. That view is on the hypothetical case of more protracted weakness rather than just a short term correction. At this stage, there is no indication of that, futures are still up. Energy services are the most leveraged to the impact, look for power and gas exposure within services. Yield names are on the positive side as are gas utilities. I see the limited negative impact on shale gas and lng.

The unhelpful combination of materially increased supply and acute concerns on demand weakness resulting from the reduced IEA expectation has led to a 20% decline in the oil price over the past four months. The inaction by Saudi Arabia has contributed.

Conspiracy theories range from Saudi Arabia looking to hit US production to it looking to harm Russia in the context of the Syria situation.

In any case, there is unlikely to be any OPEC action on production cuts at the next meeting at the end of November. It is a question of discipline enforcement within OPEC.

The oil sector is broadly hedged, so the impact will come with a time delay, most likely one to two quarters.

Negative impact on shale oil, but not the end of it: Industry estimates for break-even for the bulk of projects range from USD 50-85, thus most projects are still viable at the prevailing level. According to IEA estimates, 4% of global shale projects require oil prices above USD 80/bbl. US tight oil accounts for less than 10% of global projects that require USD 80/bbl or above. The US IEA still expects good output growth from the Permian Basin, Eagle Ford and Bakken fields. But, a number of developers have been running on cash flow deficits for development capex. Capex cuts loom, but development is put out not put off. Risk of reserve write downs if the longer term view adjusts to current levels.

Limited impact on shale gas. Focused gas developers are few and far between. Gas activity will not be spared from impact on oil operations as companies consider global budgets. Some wells in the US where gas is a by product to crude as the prime driver might be on shaky grounds. Beyond that, gas has its own price and demand drivers. Henry Hub is down 18% but overall has had a more resilient performance than oil as a whole. Outside of the US, the quest for shale gas will continue on grounds aplenty, first and foremost energy independency. The focused names in the concept story segment will continue to see downside in the absence of uplifting other news flow. Short IGas (IGAS LN). Long Woodside Petroleum (WPL AU).

Positive impact on utilities and yieldcos: Positive inflation impact will lead to a prolongation of the prevailing low interest rate environment. Utility yields will support ratings. Long National Grid (NG/ LN), Enagas (ENAG SM), note on Abengoa Yield plc: The yield does not offer a high enough premium to the sector in my, when considering the risks of the business on a relative basis. Neutral SNAM (SRG IM), attractive yield stands against negative lng impact (see below)

Positive impact on utilities, II: European gas prices see a degree of weakness, much less than in the past, but still some impact from remaining oil price link. Positive for gas supply names more so than power generators. Power prices will not see a major impact, coal is the marginal driver. Gas will not see a materially higher rate of utilisation, for that over-capacity is still too large in the major European markets. There is no expectation in the pricing for materially improved gas plant profitability, according to my gage. Long E.ON (EAON GR)

Global gas prices: Asian gas prices fall, as a result of the prevailing oil price link. Assuming limited demand elasticity under current economic growth concerns, lng shipments will divert to Europe. Europe will benefit from lower gas prices (see above). Long Centrica (CNA LN).

LNG sees lower volumes and lower returns. Most of the more complex and higher cost projects are conditioned upon an expectation of lng as an enabler. Marginal projects will not make the cut. There is risk for a number of lng projects on the horizon. I retain my long term positive view on lng. Short GDF Suez (GSZ FP). Negative impact on Shell’s (RDSA NA) extensive lng business. Much less impact on Total (TOT FP) which has a higher degree of long term contract protection.

Negative impact on energy services from capex reductions across the board, the consensus view and in my view the correct one over the next quarter. Drilling equipment is worst of as drill rates decrease. USD 80/bbl is a first stop for capex cuts, USD 70/bbl the next. The opportunities lie in yield enhancement, undifferentiated underperformance provides opportunities.

Renewables. Negative headline sentiment from sector performance oil price correlation and perception of deteriorating relative economics. Real impact only in those areas where there is direct competition with gas, ie North America. Suggested pairs trade: long solar/short wind