Nuclear champ(explos)ion?

Risk outweighs benefit from a potential minority investment by EDF in Areva.

French press reports suggests that EDF is considering a bid for a stake in Areva. EDF management had previously ruled out any minority investment in Areva. The change of mind could have various origins, but we gather the market will take a specific interpretation, the political one, as the most probable.

EDF’s investment would be concentrated onto the former Framatome activities, ie nuclear build, engineering and services. Below, we consider the potential positives and negatives.

Tighter integration of the nuclear engineering capacity could yield a benefit to EDF’s nuclear new build. Integrated execution could lead to improved project management, greater timeliness, in tandem with it materially lower financing cost. Ultimately, EDF should be able to build at lower cost per MWh and ease the case for new build. It will not likely reap any enhanced benefit of standardization, because according to our calculation its capex strain is too great to deliver a larger new build fleet within a shorter than currently envisaged time frame. And, permitting and external processes do not correspond fully to the required background environment for that either. Lastly, its new build is (other than the UK fleet) geographically diverse.

It is uncertain whether EDF would have real operational influence in such a way that would benefit its own new build programme. Reportedly, EDF has made an investment conditional upon majority control of the above mentioned activities. It could thus be a manager, but would not be a capital allocator to these activities from the wider Areva group. It may have to rely on help from political powers’ interest in the business as the core of the French nuclear industry.

Assuming EDF achieves operational control, investors should consider EDF’s expertise. The company’s core skills are in power plant management and not necessarily in the OEM, construction and services parts of the business. Those demand very different expertise and management.

EDF would acquire exposure to a business with great litigation risk and liabilities. Amongst others, investors should have questions on their mind regarding liabilities relating to existing projects but also future litigation risk management. They might remain with Areva, but ultimate exposure might still be there.

EDF’s ability to source a global nuclear new build order book and execute on it for the business also merits a thought. The French government’s commitment to reduce nuclear from 75% to 50% of electricity production deprives it of domestic growth. There might be growth potential for the utility business as future operator or stakeholder of plant to be built in new geographic markets. But, the company would be taking on a big task.

It is worth noting, that China, the most important global market for nuclear new build, is increasingly developing its own technology. Western suppliers’ share is continuously falling.

EDF might be in control of operations, but it will not be in control of capital allocation to the business, other than from its own sources. And those are constrained by the heavy capex burden over the next years.

There might be some relief on return on capital. If EDF could classify the investment as dedicated asset offsetting against nuclear liabilities, there would be a lower ROCE requirement. The trouble is the risky nature of the business to which is not akin to such a view.

Any transaction would highlight the prevalence of industrial policy over corporate management. The state intervention overhang weighs heavily and repeated reminders are unhelpful for market perception with regards to overhang.

The reality is not far from perception. In the event of a transaction, there would be many points where various interests cross and many issues of conflict. Political intensity of the company’s profile would certainly increase.

Gulf investment in RWE?

A minority investment in RWE by sovereign Gulf investors would make sense for both sides. RWE needs funding for balance sheet repair and growth and is looking for new growth regions. The Gulf region lends itself to that, and a stable shareholder and cooperation partner could facilitate the path. RWE’s multiples are low which could be attractive to a long term investor into an asset heavy business. I have been expecting M&A in the sector for a while, and the potential for a deal confirms my view that M&A prospects can underpin valuations.

RWE has confirmed that it is in talks with Arab investors on cooperation. The company has said it is looking at several potential routes of cooperation and would not rule out anything. Gulf investors could take a minority stake, possibly 10%. Dubai’s Sheik Mansur bin Zayed Al Nahyan is being mentioned. A stake at those levels would amount to c. Eur 1.5bn at RWE’s current market capitalisation.

A full take-over is very unlikely. German municipalities hold about 25% of RWE. That has been a hard stop of any potential deal in the past and will likely remain so.

The interest by RWE in cooperation with Gulf investors, including a potential minority investment could be on several levels. Firstly, to acquire a stable shareholder that would not likely take material influence on operational management decisions. There are other big German companies with minority investors from the Gulf region, notably Siemens, Deutsche Bank and. RWE could look for a similar deal.

The company needs funding for investment in renewables and down stream electricity, its new focus areas. Its capex is now close to maintenance levels, after the most recent reduction that came after company reiterated its focus on cash preservation during its 2014 earnings call. The company is barely cash generative in its generation business, which accounts for approximately 36% of total Ebitda.

Beyond that, there could be potential growth avenues for RWE in the Gulf. Energy demand growth is amongst the highest globally, and there is keen interest in renewables (aside from new nuclear, but I think it is unlikely that RWE will get involved there). RWE has mentioned it is looking for new geographic growth regions. Masdar, one of the largest global clean energy developers is owned by Dubai.

RWE has announced it is taking a minority stake in solar manufacturer and developer Conergy recently, in my view a transaction that makes a lot of strategic sense for RWE (see previous post – “RWE/Conergy – Let the sunshine in”). It might need funding for growth coming out of that deal. Gulf investors might find that an attractive proposition.

RWE is cheap on headline multiples, at a P/E of 11.4x 2015E, vs a sector average of 16x, EV/Ebitda of 6.6x and a yield of 3.8%. That is another attraction for a potential investor, despite the weak earnings outlook. Sovereign investors tend to look for long term underlying assets. Even though those have below average cash generation prospects, there still of high asset quality which makes them appealing for such a deal.

While I only see short term out-performance for RWE from this, there is some positive from the funding impact and potential signal towards valuation underpinning. I have been expect sustained M&A activity in the energy sector going forward. This confirms my view.

RWE/Conergy – Let the sunshine in

RWE’s investment in Conergy makes strategic sense as it takes the supply business towards the direction where we see downstream electricity heading over the long term. RWE gains brand equity, rejuvenation of its perception, a renewables offering and with it possibly long term stronger retail margin. We do not see a material short term impact on sentiment, but this is a step in the right direction.

RWE (RWE GR) is taking a minority stake in Conergy for an undisclosed amount through RWE Supply and Trading as part of a USD 45m capital increase by Conergy. RWE and Conergy have already had dealings through cooperation and partnerships. Last year, the companies have agreed a partnership to lease solar systems to commercial customers. The deal is a logical extension.

Conergy will use the funds from the capital increase for funding of its project development pipeline. Its global pipeline is about 4GW. We would not be surprised to see RWE participating in Conergy projects.

The move makes sense for both parties, other than the access to Conergy’s project pipeline, particularly from a supply perspective. It goes into the direction that Montpellier Analysis has been anticipating for the downstream energy sector to develop into for a while. We see increasing convergence between electricity supply, renewables equipment packages, smart energy, integrated services and consumer appliances and applications. We sense that downstream electricity must develop a very strong brand equity proposition from a retail standpoint, in order to compete with consumer businesses entering the market.

The RWE Conergy deal corresponds to these requirements. Conergy has a very strong brand position, despite the insolvency, and arguably one of the strongest in the German market. The Company has morphed from an unprofitable module manufacturer more and more to a downstream package and project provider.

Conergy gains customer access, RWE gains in branding, communication and package offering, as well as rejuvenation of its perception.

During recent trips to Germany, we have noted a big step up in RWE’s marketing, with a focus on new energy solutions and integrated packaging. We take that as another sign that a re-shaping of the supply business is on the way.

There might initially be a mixed reaction in the market on concern over strategic focus by RWE – on the perception of Conergy as a struggling module manufacturer and RWE being a late comer. But that should give room to appreciation of the underlying sensible strategic rationale. RWE has taken a step that gets it closer to a long term supply model that is more viable in an intensely competitive market. A renewables offering is indispensable and acquiring a stake in marketing leader in the field with hardware added in makes sense.

 Conergy is looking to grow revenues to USD 700m in 2015, from USD 500m in 2014. If the company achieved only 100bps of margin improvement, which it should with greater scale, Ebitda could double y/y, to c USD 20m, according to our gage. There could be a very small positive equity earnings contribution for RWE.

The deal is a small step and will not make any material difference to RWE earnings expectations for 2015. As such, it will not move consensus or sentiment significantly. But it is a step in the right direction. Eventually, it may be a contribution to long term stronger retail margins. Given the declining weight of generation, that is crucially needed.

RWE (RWE GR) and E.ON (EOAN GR) – It’s all about cash

Both German generators struggle with power prices weighing over new growth. E.ON’s stronger cash profile allows it to invest for growth. According to Montpellier Analysis’ estimate, E.ON’s growth capex will exceed RWE’s total capex. As a result of that and a stronger generation portfolio, E.ON stand good chances to report flat earnings for 2015, whereas RWE’s are still declining. RWE’s generation business is now hanging on a shoe string as it is even on the medium term struggling to be cash neutral. There is a great strategic void for the generation business, and management’s growth strategy through new energy is not yet delivering an earnings volume high enough to compensate. Meanwhile, the drop of the leverage target is understandable but not reassuring. A debate about leverage, and about coverage of nuclear liabilities is on the horizon for both names.

E.ON’s numbers were in line with expectations (revenues Eur 111.5bn, ccs Eur 117bn, Ebit Eur 4.6bn, ccs Eur 4.7bn, adjusted net income Eur 1.6bn, ccs Eur 1.68bn). The net loss of Eur 3.3bn was broadly in line (ccs Eur 3.2). The write-offs were well flagged and create a clean slate for the corporate split. Guidance for 2015 Ebitda of Eur 7-7.6bn is 5% short of the Eur 7.7bn consensus at the mid point. The net income outlook of Eur 1.4-1.8bn is in line with consensus of Eur 1.6bn.

RWE was in line line after a string of earnings misses (revenues Eur 48bn, ccs Eur 49.8bn, Ebit Eur 4bn, ccs Eur 4.1bn, adjusted net income Eur 1.28bn, ccs Eur 1.28bn). Guidance is for recurrent net income of Eur 1.1-1.3bn, the mid point being 6% below consensus of Eur 1.28bn. For this time, the dividend was in line. However, management has stated that the dividend policy will no longer be said in function of a payout target, but on much broader measures. That gives flexibility for cash conservation; but it may also be a warning message to politicians through the prospect of lower income for the company’s municipal shareholders.

RWE’s management has said it is now returning to growth mode, through renewables, networks and innovative downstream solutions. That resounds with our view that downstream and supply along with new energy will bring growth opportunities. The company looks for low single-digit growth from that and double-digit growth from renewables at large scale.

But, capex is now restrained close to maintenance levels at c Eur 2bn pa. In total, RWE will spend c Eur 1.5-2bn on renenewables growth and the grid businesses over 2015-17. That will not be enough to compensate for the decline in the conventional business, according to my estimate. It will not stop the earnings decline at group level.

E.ON’s capex is twice the amount of RWE’s, with a correspondingly higher level of growth capex. I estimate that at least Eur 2.5bn will go into growth in 2015 alone, most of which into renewables. That will build a stronger foundation for growth post 2015.

There are many other moving parts at RWE, and most of those negative. Cash generation in the power generation hangs on a shoe string. The company has taken one commodities hit, and there will be another one this year. Management has confirmed that only about 25-35% of plant delivers an operating result in excess of the company’s WACC and 55-65% is cash positive. At current power prices, RWE’s generation park is just about cash flow neutral. Power prices will not deliver the rescue. Even in a scenario of recovering commodities, structural oversupply is such that there is no prospect for a material enough recovery. The company has stated an expectation on policy action eventually, but we think that is highly unlikely. Rather, the German climate bill equates to a de facto coal shut down. The generation business is and remains a source of great uncertainty for future cash flows. Cash neutrality is by no means guaranteed.

Leverage is a target in flux for both, though we see RWE as more  in the defensive.

RWE’s Management has dropped its net debt/Ebitda target of 3x. It reasons with large amounts of liquidity post the DEA sale that it will offset against pension and nuclear liabilities as dedicated assets. Our estimate is in line with management’s assertion that net financial debt will be below 1x Ebitda post the sale. But full leverage, as considered by the rating agencies currently stands at 4.4x Ebitda and will remain well above 3x. We are surprised by the build-up of dedicated assets and sense there could be increasing pressure on utilities to build up dedicated assets for nuclear liabilities. As a side note, increasing dedicated assets will bear an impact on overall group ROIC. Management denies any connection to the debate around a potential outsourcing of the liabilities. But clearly, a dedicated asset structure would make such a structure easier.

E.ON’s leverage of 4.1x is not far away from that of RWE. But, cash flexibility is greater.

E.ON’s ability to meet its nuclear liabilities after the corporate split is subject to intense scrutiny. The government has recently commissioned legal studies, but those have not led to any conclusive outcome on stopping the deal or intervention on the structure. We expect intense debate on the issue, but see intervention as unlikely.

There is risk on consensus momentum for both, but significantly higher for RWE than for E.ON.

E.ON has outperformed RWE by 8.7% ytd, but both have underperformed the European utilities sector by 2.3% and 10%, respectively. The potential upside for E.ON is larger on the basis of the split. To that comes stronger underlying cash generation and growth spend. That and upstream commodities gearing is a foundation for out-performance on a primary commodities recovery and on the back of investor appetite for growth in the broader energy sector.


Clean energy should continue to outperform oil as short term forces justify a further disconnect. The sector’s fundamental earnings drivers are positive despite oil price weakness and any recovery in the oil price will restore some of the old positive correlation.

Clean energy performance has been historically and remains still correlated to the oil price.

During the oil price fall out, global clean energy has outperformed the commodity by 420pbs on the downside and 80bps on the following recovery. Note that there is long private tail end in both sectors. Those latter are very disconnected, particular as clean tech in the private sphere contains a much higher tech and new product component that oil/gas.

Clean tech outperformance over oil/gas is justified on the basis of the demand outlooks for the major sectors. I expect global solar demand to grow by 9% y/y for 2015 and global wind demand by 7%. Other subsectors that start from a lower base, e.g. storage, could see high growth. That and  pricing that has become manageable will be enough to support earnings for the big constituents of public global clean energy, driven by the largest markets, China, North America, pockets of Europe, South Africa and the Middle East. The private parts of the industry comprise by and large the higher new growth areas.

In aggregate, clean tech will likely deliver still patchy earnings growth of 7%, with great variation around the mean.That compares to 38% for global oil and gas. But, Headline earnings growth for large global oil and gas is higher because of restructuring and deleveraging measures. Ebit looks very different: Growth on aggregate is -39% y/y for 2015. And there is further risk to those numbers from the commodity. Clean tech benefits from a better outlook on the basic drivers: Price erosion is moderate, over-capacity has reduced, and demand is sustained. The downturn in the oil sector will likely be prolonged and at an early stage.

Gas rather than oil is the direct competitor for relative economics for clean energy, and gas prices have come up on cold winter weather in North America and Europe, supply concerns due to geopolitics and some output restrictions.

Should falling oil as it appears to on all accounts lead to cut backs on unconventional gas production, the dynamic will be further reinforced.

On that basis, outperformance of clean tech over oil should continue.

Once oil recovers, that will lend support to clean energy, even though the recovery rally of the oil sector may then surpass clean tech.

The conceptual and argumentation struggle that clean energy faces with weak oil is subject to further consideration.

I can see the merits of bulk sector exposure.  For further differentiation, solar should continue to be supported by good demand (I forecast 9% global installations growth y/y) and improving cost, infrastructure and financing availability. Storage and smart energy is also on the list of preferred subsectors. I prefer those former on a relative basis over wind where demand growth is weaker and the sector’s order outlook comes up against difficult comps. Energy efficiency is conceptually a favourite sector, but the sector is highly dependent on the oil substitution case.

GDF Suez – rock in the oil waves

GDF Suez results show that the company has enough resilience to withstand the commodities weakness and that it still has flexibility to deliver small upside from cost efficiency. Capex will deliver a credible return to growth at the high end of the sector. That is initiated this year.

Revenues of Eur 74.7bn were below expectations, but Ebitda of Eur 12.1bn beat the Eur 11.1bn consensus. The outlook for 2015 for net income of Eur 3.1-3.3bn is in line. There was weather and commodities impact hitting the numbers, but in the greater scheme of the sector that impact was very contained.

The Doel/Tihange nuclear situation is largely resolved and a major overhang removed.

GDF Suez’s distinction is its diversification and growth pipeline. Despite strong sector headwinds, global gas still delivered organic growth of 4.5% y/y.

I see the business as resilient and continuing to benefit from structural growth going forward. Weaker LNG diversion margins should get compensated for by volume and new projects as well as the company’s integration hedge. Further, management has announced credible opex efficiencies that should compensate for about one third of the commodities impact for this year.

GDF Suez is still in a strong commodities position when compared to most names across the energy sector. Gas oil spreads have actually been favourable for the company as it is net short oil. Long gas short oil price exposure will in my view remain a favourable position going forward. And, the company currently benefits from oil LNG indexing in its sourcing portfolio. This is the big attraction of the company’s integrated energy business: It has arbitrage and diversification potential that gives optionality and hedge second to none.

The power capacity pipeline currently amounts to 10.4GW under construction. There is a good share of renewables projects in the pipeline.

The company has enough flexibility for Eur 6-7bn growth capex including acquisitions despite the overall capex reduction. Net debt/Ebitda of 2.5x stacks up very favourably within the sector comparison.

The underlying business is delivering the proof in the numbers. Bottom line growth is likely to come in at low single digit levels in 2015, but return to 10% y/y in 2016. That is an earnings profile that stands out within the peer group.

At 15x P/E 2015, 6.8x EV/Ebitda 2015E and a prospective yield of 5.3%, GDF Suez stands out as good value quality with one of the best growth underpinnings in the sector.

Commodities, squeeze, politics and sentiment – differentiation

Of the last round of reporting, Centrica (CAN LN) clearly stands out as by far the most negative. More important than the weak guidance are structural difficulties. Technip (TEC FP) has delivered a strong enough outlook and backlog that despite weak commodities, it is now a favourite in the sector. Ibedrola (IBE SM) is coming out of the trough and should see further upside, whilst risk still outstrips the potential for reward at EDF (EDF FP).

Centrica’s new guidance implies further downside to consensus. Management guides for 2015 EPS of to be below the 2014 adjusted number of GBp 19.2, ie below consensus of GBp 20.6.

The 21% dividend cut to GBp 13.4 is disappointing but was in my view reflected. Post cut, the shares yield 4.8% which is in line with the utilities sector. That Centrica was unable to sell three UK CCGT power stations is one of the underlying reasons for the dividend cut. That plant has become unsellable is a new. The prospect began to shine through when the plant did not qualify for capacity payments.

The GBP impairment charge on E&P assets is not surprising but a warning sign that more of the same is likely to come in the sector. Other E&P names with more favourable hedging may not need to impair yet, but risk is high for the next reporting rounds.

Altogether, Centrica is a very illustrative case of the fallout of the combination of commodities and policies that affect the energy sector. As quoted by the CEO, the company is “completely compressed”. I see it as having pursued a viable strategy, but the speed of the commodities fall is not something it can withstand whilst being hit with the supply margin squeeze on the other end of its business. For the time being, I see no prospect of any turn in either earnings or sentiment.

Contrary, Technip (TEC FP) has beaten expectations, reiterated 2015 guidance and increased the dividend. 2015 Ebit consensus stands at the low end of the Eur 11.2-11.5bn revenue and Eur 1.02-1.1bn Ebit guidance. Further, the company’s reported Eur 21bn order backlog gives it a very comfortable shelter in the weak oil capex environment. The Yamal project illustrates good execution and cash management. All of the above combined makes it stand out in the oil services sector and justify the premium rating. Technip may well lead an oil services sector recovery rally.

Iberdrola (IBE SM)’s in line earnings now have a sustainable structure. 2014 was the tail end of the Spanish problems by and large. Industrial demand has recovered, hydro production was strong, and renewables in new geographies are positive earnings drivers. Those new earnings drivers are now strong enough to make up for other weak spots, such as UK demand. I note the performance improvement in the UK as a particular differentiator on the side. Management guides for Ebitda above the Eur 6.9bn reported for 2014, in line with consensus.  Positive sentiment should continue to drive the share price.

EDF (EDF FP) is on a rockier path, on balance still the wrong side of nuclear. The existing operations suffer from the ailments of ageing technology with high and growing capex requirement while new build is all but on track. Good French performance could not make up for the impact from the UK. The latest delay to Hinkley Point may hang on relatively minor points, but is another negative for sentiment. The details on the cfd contract need to be fully hammered out, the Chinese partners appear to have become more demanding. With both of those issues, there is a political dimension – partly because of the upcoming election, but also because of wider political considerations with regards to Chinese involvement that are tied to the project. If there is slippage beyond the election, there will be a new level of political risk to the project as a whole.

Not to forget, there is the French political dimension. Signs amount that the French state might push for an involvement with Areva. That would undoubtedly be seen negatively. Management denies any intention to make a financial commitment, but beware of who has the last word.

Consensus is in line with Ebitda guidance. But, I see sentiment as very cautious and likely to remain so. The 2018 target of positive free cash flow after dividend will be a challenge.

Transformation, risk and opportunity at SMA Solar and whether to get involved with inverters

After three profits warnings, a 60% share price decline over the past year and a new restructuring strategy, sentiment is still not yet likely to turn positive. Pricing pressure in the core market is there to stay. The company is well positioned to ship into a growing smart energy market, but it will encounter new and strong competitors. Consensus is still too high.

The share price of SMA Solar has fallen 85% peak to trough and is now standing at a new all-time low. The EV/Ebitda multiple has contracted from 6.4x to 4.5x. The next points shed some light on bull and bear points.

SMA has delivered profits warning number three. That concerns 2014 and 2015. Reduced guidance is now for a 2014 net loss of EUR 115m and a net loss of Eur 30-60m for 2015. This is on 2015 revenues of Eur 730-770m.

Management quotes generally difficult markets, weak German and European demand, competition and pricing pressure.

None of these issues are new. The issue is that the company has long time communicated a message that was meant to dissociate SMA from all of the broader market problems and differentiate from the sector. Fundamentally, the building blocks of that messages are there: Strong brand equity, market leadership in a fragmented market, and a flexible cost structure.

The big question – it has encountered doubt in the market before – is barriers to entry. That is the very centre of SMA’s problems. The company communicates a strong claim of barriers to entry, through its market position and through IP.

I agree that SMA’s product has IP and differentiating features. But, inverters in its very basic form are undifferentiated products. SMA is coming to discover that. The announcement that the company will manufacture very basic version of its inverters as a response to Asian competitors is admission of the fact. Inverters in a simple form exist en masse and at very low prices. I do see it as a positive sign that management no longer insists that its basic inverter has great features of differentiation. That should open perspectives for strategic action.

High quality inverters improve performance of solar systems and also play an important part in bankability of an overall system or project. That has initially played in SMA’s favour. But, competitors have moved up the scale and SMA’s ability to differentiate has decreased, leaving the price point more vulnerable.

Management is now addressing the cost vs differentiation issue through the modular strategy where it tags higher value added components onto a basic inverter. That latter element clearly targets low cost competition: SMA is looking to manufacture as a low cost component.

SMA’s li-ion inverter and lead battery and storage packages are still priced at the high end of the market. The domestic version retails at Eur 13-15k including modules, of which I estimate an implied battery ASP of Eur 6-8K for the 2.2kW battery. On a stand-alone basis, SMA’s battery retails for Eur 5K. Average retail prices are at the Eur 8-11K level for 5-7kW batteries. The relationship is similar for the 4kW battery.

As a whole, the end price of the combined product fall. The basic inverter should trade on a very small implied premium vs low cost competition. By implication, the value added components will be the crucial margin drivers for SMA.

With that proposition, SMA’s case is conditioned on market take up of smart features, growth of storage, demand management and the like. It is also partly conditioned upon the company’s ability to develop that market.

SMA enters into a new marketplace, with new competitors. Its new competitors are battery manufacturers, appliance manufacturers and consumer and energy services companies. Do not forget Google – it is everywhere, and is developing an aggressive energy strategy for precisely the above new energy features.

SMA would be well advised to consider partnerships in those areas, particularly downstream towards customer management, packaged goods and services and broader relationships.

The other side of the equation, the cost base, is despite great flexibility (3 shift flexibility allows capacity to be flexed by a factor in excess of three) is not adequate yet. Inverter production is highly automated and materials account for 80-85% of total costs. But the remainder of labour can make a competitive difference. And, likely, there are material cost and working capital issues that need to be addressed, too.

I have argued for long time that there will be structural and persistent cost pressure across the solar value chain. That comes from its technology driven cost progress and price decline logic, and from the need to reduce costs in order to achieve grid parity. Now that grid parity has taken another step down with lower oil prices, solar has yet more pressure. Balance of system, ie inverters, bear the brunt. The sector has held up margins much longer than any other segment of the value chain. It has to deliver now.

SMA’s cost base is still too high and too fixed. Its former high margin markets are no longer the global demand drivers.

The internationalization strategy has worked to a degree. The company claims a 30% market share in the US. In terms of revenue and earnings contribution, the US accounts for c 40%. But, the company has hardly any presence in Japan, one of the most important growth markets. There initial inroads, but not strong enough for them to be a major turnaround driver yet. China seems closed to SMA, despite the Zeversol acquisition.

Management seems to be going back to its roots in a way: It is looking to adapt in such a way that it can make a profit with less than Eur 700m of revenues. The CEO quotes 2008 as the benchmark year. That is a return to the times before the great boom. In 2008, The SMA’s net earnings amounted to Eur 167m on Eur 680m revenues. But, at that time, its market position was that of an undisputed leader in the world’s largest solar market by a distance. The world has changed and with it margins. The company’s gross margin has halved. Future revenues are coming in at lower gross margins than those of 2008. The company’s cost base has to go below that of the pre-boom times.

Sentiment had seen a short blip up after the strategic announcements of the capital markets day. But consensus movement is firmly on the negative side and I see further pressure. Current consensus for 2015 is for Eur 852m of revenues, but for a net loss of Eur 20m, well above the low end of guidance. There could be big upside if management can deliver on its return to profit. So far, the market is not giving any credit for that. The earliest it might do is in my view from H2 when the first impact of any successful execution on the strategic plans could come through.

SMA trades on an EV/Ebitda multiple of 4.5x 2015E. That compares to an average of 4.6x for the global solar manufacturers and 8-9x for the recovery driven electronic and engineering competitors. For 2016, the first year where consensus is for a profit, the shares are trading on a P/E multiple of 25x. That is a growth stock multiple and in excess of the company’s historic peak multiple of 18.6x. I do not see room for multiple expansion. Rather, there is downside risk as the underlying numbers will come down and SMA is a later stage than most of the solar peers that have already gone through restructuring.

I estimate a fair value between Eur 9.50 and Eur 12.0. The high end would require to sustain a competitive advantage and grow ahead of the market until about 2030, whereas the low end implies a business that will be somewhat greater in scale but much resemble the 2008 levels. I expect ROIC will not recover to peak levels ever.

Nuclear in Europe – will the mushroom cloud shift?

The German government may revisit a nuclear liabilities fund, but the latest proposals create cost rather than relief for nuclear operators. Areva (AREVA FP) meanwhile has warned on more provisions and write downs. Nuclear in Europe remains a high risk proposition. Not of explosion, but of continuous toxic leak.

Quoting discussion papers at the Economy and Environment Ministries, the German press reports the German government is looking to force the nuclear generators to make contributions to a nuclear decommissioning fund. The total is to amount to Eur 17bn. The current nuclear provisions would then only be meant to cover decommissioning and intermediate waste storage.

Collectively, the industry has nuclear provisions of Eur 36bn. The cost of decommissioning a nuclear plant lies in the region of Eur300-500/kW. The OECD estimates full cost of decommissioning for most Western PWR reactors of USD 200-500/kW. The German nuclear park would on that basis require decommissioning costs not to exceed USD 350/kW. At this stage, the amounts seem comfortable. But, the government may seek further protection.

This is in my view a result of the “nuclear bad bank” discussions last year and the much deteriorated financial situation at the utilities.

The utilities, particularly RWE (RWE GR), have communicated strongly on their much worsened earnings and financial situation. There is not much prospect for change as the energy transition continues unabated and power prices offer no relief any time soon. That could have heightened concerns over their ability to meet liabilities.

There have been public calls from various groups to shield the taxpayer from any potential costs at various times: At the respective earnings calls, the first nuclear liabilities fund proposal and E.ON’s (EOAN GR) split.

The government may have caught fear. E.ON’s split announcement, RWE’s comments relating to power plant displacement and reduction of generation activities, generally a harsher tone from utility managements, and the self-explaining earnings and finance directors’ comments may have led to a perception of higher risk of liabilities falling onto the taxpayer.

Final and intermediate waste storage may also have come into this. The utilities are now also suing over the Gorleben storage site. The industry has funded the development of the initial site. The government has subsequently put that site into question and is calling for a new search, with potentially further costs for which it will likely call upon the industry again.

The new debate is likely a follow on from the suggestions by the industry for a nuclear foundation last year. The discussions about the nuclear “bad bank” could have reinforced concerns over a potential funding gap. It may also have led to the idea of contributions. The industry itself had suggested openness for additional funding if the nuclear liabilities were centralised in one entity.

Much of the proposals goes towards the direction of the proposed nuclear fund.  But it looks more like a move of protecting the tax payer than relieving the utilities. They are to take full legal responsibility for the nuclear liabilities. Corresponding profit sharing agreements with the fund are mentioned. There is also suggestion of rules for investment of offsetting dedicated assets.

The nuclear provisions are dedicated, thus cannot be used for any other purpose. But offsetting assets are unlikely fully ring fenced from creditors.

The structure according to the suggested proposals would not relief the generators of the liabilities in any way. It goes half way towards creating a centralised structure to group liabilities, as suggested by the utilities. But, in the shape under discussion, it does not look like it would take the liabilities off the utilities’ balance sheets.

The latest suggestions look like the government reacting to suggestions and events in the power industry. It may be an opener for negotiations with the industry, laying out a first post for the government position. In that case there may be room for negotiations. The risk is that the government may not see much need for negotiation and legislate instead. Recent moves on other issues, eg. Nuclear disputes, coal, etc, suggest the risk is real. The relationship climate between the utilities and the government has materially deteriorated.

Amongst the two German generators, E.ON is in a stronger position as it has greater flexibility to absorb potential additional costs coming by way of legislation. RWE would benefit from greater clarity on the liabilities side, but at the price of another hit to earnings. Furthermore, because the potential contributions would likely be cash contributions rather than additional provisions, there would be a direct cash flow impact.

Meanwhile, Areva has warned of further additional provisions for 2014 and asset write downs. That is an execution problem. The delays at the Finnish Olkiluoto reactor are a big contributor as are broader issues with new build execution. The warning might mean there is further budget overrun, too.

The only bright spot was a 10% increase in Areva’s order book, but that came mostly from EDF (EDF FP) for fuel treatment and recycling.

Areva’s new CEO faces a deep challenge to redress operational execution and credibility with investors. The March 4 road map presentation will be crucial. Valuation is expensive at 10x EV/Ebita 2015E and leverage is high at 5.8x net debt/Ebitda 2015E. For sentiment to turn, credible changes to the numbers and operations have to come through.

Nuclear in Europe remains a high risk proposition. No longer of melt down, but of continuous leak.

UK shale gas: rocky times

The propositions on shale gas in the new infrastructure bill are less restrictive than market fears. The concentrated names should see a relief reaction. The macro environment is challenging with political risk and weak commodities, but operational successes in the sector are showing good prospects.

The UK government has made concessions to environmentalists in its latest provisions for fracking in shale gas exploration. The latest infrastructure bill now contains provisions that fracking will not be allowed in national parks, areas of outstanding natural beauty and areas important for drinking water collection. The trespassing provisions that allow fracking without homeowners permission are unchanged. The bill will go to the House of Lords next.

There is political resistance and the pre-election period has certainly sharpened ministers’ minds towards a sensitive issue.

No conspiracy theory, but there is OPEC’s long arm, too. I do not see any material interest by OPEC to slow down UK shale development. The quantities are important, but not of US size. But oil price weakness as a pure market phenomenon may have had an influence on legislators. Some urgency is removed.

I still see UK policy overall as supportive of shale gas development.

It may well be that further amendments are made to the bill. In the first instance, the House of Lords has the power to do so. More generally, specifications about allowed depths would not be unthinkable. The German government has taken that approach.

A stable framework that is respectful of natural assets and environmental issues is required and long term supportive for industry development. The main issues about fracking are risks to ground water contamination, wildlife protection and chemicals leaks. According to industry sources, water contamination risk can be eliminated when a distance of 800m to acquifers is kept. Noise is an issue brought up by local residents but not one of environmental scope.

The bill means a reduction of accessible reserves, but not large enough to alter the case very materially.

Scale development is required for swift build up of infrastructure and cost reduction.

Reserves in the Bowland Shale are largely 800m below the acquifers in the region. Shale oil resources in the South Downs shale are at least 650m below the acquifer.

UK shale gas is a high risk sector. This is a set back that a concept sector is bound to experience at some stage. It is a reminder that political risk is high as will be volatility in the sector.

The concentrated shale names have all seen falls in their share prices that now imply very little value for development. A reminder, this is an early stage sector where public names are very sentiment driven. The negative visibility is much stronger so than the positive operational performance of the private part of the sector.

The actual bill is restrictive, but by far not as bad as market fears. There might be a relief reaction.

Cuadrilla is the most exposed and sentiment and concept name. Its key exploration area is the Bowland Shale. There will be a negative impact over the short term. Its partner Centrica (CAN LN) is also impacted.  GDF Suez (GSZ FP)’s Bowland exposure is through its 25% stake in Dart Energy’s licenses.

Egdon (EDR LN) is also active in the Bowland Shale as is IGas (IGAS LN). Short term downside risk is larger for Egdon as IGas has greater underpinning from conventional assets. There is an impact on Total (FP FP) through its direct investment and partnership with IGas.

The large integrated names have bigger struggles at the moment, namely globally weak commodities. The shale news is a hit on a potential growth area. Albeit small, it does not help current sentiment.

The private names should see continued good prospects from operational progress even though they will need to address resistance constantly.