….and work…. and keep those German coal plant on

The likely prospect of an absence of the coal levy is a great relief for the German generators. Contrary to previous developments, this time the biggest beneficiary is RWE. We short term relief, but prefer E.ON for longer term exposure.

According to German news source ARD, the Economy Minister will drop the planned coal levy. The Ministry has said it is looking at alternative plans. Reportedly, the government is looking to mothball 2.7GW of old coal plant over a time frame of four years, in order to push forward towards its emissions reductions target. Old hard coal plant under the CHP (combined heat and power) regime would be shut first, in order to substitute that plant with gas CHP. The government would look to cover the 5.5mt shortfall against its emission reductions target through other measures, such as support for heat pumps and unspecified measures at municipalities. The Minister has said he will publish a final decision July 1st. Gaging from the wordings of comments by several senior government and State level officials across the coalition parties on the matter over the past couple of days, we see the likelihood as the coal levy being off the table.

Realpolitik and industrial policy seems to have won the argument. The impact on the domestic lignite industry would have been too important to bear. Further, under energy considerations, especially security of supply and affordability, lignite is a fuel that is abundant and cheaply available from domestic sources. It is clear, that there will be another impact on affordability. The chp repartition will increase end user prices. But so would the coal levy ad power price impact have done.

Mothballing of old capacity would almost certainly hit RWE alone. It has over 7GW of coal capacity that is over 37 years old. 2.1GW is hard coal plant of aged over 30 years. But, on balance it might be a positive. The plant runs on very low load factors. On the other hand, the Minister has said there would be compensation for such reserve plant. RWE and Vattenfall would thus receive capacity payments. On a side note, the part of the mothballed reserve plant invites questions relating to potential capacity payments. The government has several times articulated a less than supportive position for capacity payments. And certainly, if any they might be for gas in the first instance. But these plans could be interpreted as a de facto start of a remunerated capacity reserve.

With that, we see the relief bounce for RWE as justified. But we doubt that there will be any reversal of performance. For that, the structural challenges on the overall profitability of the generation business are too steep (for more detail, see my previous article on www.montpellieranalysis.com – Why RWE remains uninspiring).

The sun shines again on solar – musings on batteries, growth, deals and more

Below, we outline our impressions and views on the key points that stood out at Intersolar in Munich. The message is: growth is back, and storage is the centre point of attention. The Siemens (SIE GR)/SMA (S92 GR) deal was a highlight. 

As a whole, Intersolar suggests substance of the solar recovery. Visitors at the main solar show were stable for the first year since 2012.

The PV Market alliance, formerly EPIA, suggests 50GW of annual installations for 2015, or 25% y/y growth, first and foremost driven by China, but also Japan and the US. China has installed 5GW in Q1, the US 1.3GW.

Storage was as expected the big focus. The storage focused exhibition saw a five-fold increase in visitors.

The BSW li-ion storage price index has fallen by 26% y/y. The combination of falling costs, availability of subsidies and a very strong competitive drive in the sector should provide an acceleration in momentum of availability of solutions, and finally, adoption. As one example, Samsung has presented new residential storage systems of 5.5kW and 8kW based on a li-ion battery and with built-in inverter, specifically targeted at the German residential market.

The German Economy Minister has said in a key note speech that he considers solar as the backbone for energy transition. We find that a striking comment, less because of political significance, but because we believe structurally, there are valid points to the assertion.

We do not expect any change with regards to the political climate for solar by the German government. The downward trajectory of subsidies will continue. The government is keen to support SME’s, the Mittelstand, as the backbone of the economy. That is found in sectors that are no longer solely focused on solar. Small trade and services, as well as technology is where the interest lies, rather than manufacturing.

Still, solar is at the heart of structural change. As grid parity becomes the reality, growth will continue and the range of applications widen. As such, solar already offers and will offer more characteristics that are not quite infrastructure like yet, but have similarities to backbone resources. The assets are widely distributed and are close to the point of consumption. They are very flexible. Storage will have a game changing effect and indeed bring solar to something close to the core of the system: Solar can fulfill backup functions, smart energy functions, demand management and market balancing. Solar charged EV’s as means of larger scale energy storage with back into the grid, microsystems and off grid, and solar as technology of choice of the prosumer (producer-consumer) are just some examples.

The battery sector is clearly directly exposed to the paradigm shift. LG Chem (051910 KS) is the global leader in li-ion batteries.  GE’s (GE) strength is in wholesale and grid scale applications. We also highlight ABB (ABBN VX), Sharp (6753 JP), Samsung (005930 KS). Privately held Acquion Energy is a supplier to ABB and a number of other larger battery and storage system suppliers.

Eventually, the manufacturing sector will benefit through demand shift. But we see that point as still further out. In the meantime, we see Jinko (JKS) standing out as the name with the best relationship of multiples vs growth.

The Siemens (SIE GR) / SMA (S92 GR) deal was a highlight. The two companies will partner for a joint large scale bundled inverter and storage product offering. We see the deal as very synergistic for both parties. For SMA, it may be a piece in the puzzle to recovery.

Germany, working on the coal plants…. and work…. and work….

New plans call for certain coal plant to go into a strategic capacity reserve as it transpires the proposed coal levy is politically unfeasible. There would be positive impact on market prices from such a scenario, we estimate to the tune of Eur 2-3/MWh. We gather E.ON would be a greater beneficiary, due to its greater exposure to technologies that would benefit from a resulting merit order switch.

German press suggests that the proposed coal legislation will see further amendments, due to resistance from parts of chancellor Merkel’s CDU, but also parts of the SPD, the party of the Economy Minister in the grand coalition. There are suggestions by DPA that the climate levy on coal plant is becoming unfeasible. Instead there are alternative suggestions, to the effect that certain coal plant, old hard coal or lignite first and foremost should be brought into a strategic capacity reserve.

On the point of any capacity remuneration, investors should probably not hold their breath. Other markets have shown that there is potential for disappointment. Furthermore, coal is not a desired technology under current energy policy, implying any remuneration at very low levels. Security of supply is important to the government, but it is well aware that supply remains ample until the end of this decade. New gas capacity is built very quickly if needed. Lignite is more politically sensitive than hard coal, because of the greater domestic lignite exposure.

Clearly, such a capacity reserve would add costs to the system. There would be aftermath relating to affordability.

The effect of such a new plan would be a net positive: Contrary to the climate levy proposals, through the alternative plant, merit order shift would occur. The impact on power prices could be to the tune of Eur 2-3, according to our calculation. Further, the plant would receive capacity payments of some sort. That could on balance mean profitability improvement for generators. The plant that could go into the stand buy reserve would according to current discussions be particularly high emission reactors, ie old lignite or hard coal plant.

If all of old coal went into the strategic reserve, gas load factors would be practically unchanged on average days. New hard coal would be price setting. But, we estimate short run marginal costs for new hard coal in the order of Eur 31-33/MWh, ie below current market. Gas plant would benefit from slightly higher peak utilization.That would have some positive impact on pricing.

Generation profitability as a whole would improve as a result of both of the above. If old hard coal was going to the strategic reserve, the effect would be stronger on E.ON than on RWE, due to its greater exposure to the benefitting technologies. That would weigh stronger than the impact of capacity payments for RWE, most likely. The contrary would be the case, if the political decision was for lignite going into the reserve, despite its earlier merit order position. In this case, the effect would actually be strongly negative for RWE, as lignite is running on high load factors still. Capacity payments would not make up for volume loss. The problem for profitability above all is hard coal. On average, German hard coal plant was running on load factors below 40% last year.

EDF/Areva or: the big French solution

The French government has decided for the big French solution for the nuclear sector, ie EDF (EDF FP) acquiring Areva’s entire reactor business. As things stand, there does not seem to be a chance of Engie acquiring parts of the business. An expensive multiple paid by EDF ads to compounding financial strain, risk and limited benefits. The impact on market perception is certainly negative. Chances that EDF gets recompensed through a 2.5% pa tariff increase under a three year deal as is being suggested in France now, are limited. Engie will find other productive ways of acquisitive or organic growth and on balance stacks up better, even after a lot of risk has been reflected in EDF’s share price.

The French government has decided, not surprisingly, to execute its plan A, EDF acquiring Areva’s entire nuclear reactor business. EDF’s offer stands at Eur 2.7bn, or 0.74x book. EDF will acquire a majority and Areva retain a minority stake in the business. The potential for the business to be structured in a joint venture, but with the same majority EDF/minority shareholding structure. Areva itself will become a front end and nuclear fuels company.

As things stand, Engie would not be able to acquire any part of the business.

This is still a sell on the news. The take out multiple is expensive for a business with large unknown liabilities. The most important liability is the Finnish project, but there are others, too.

As I have previously argued, reactor construction and export is outside of EDF’s core competencies. EDF will further strain its balance sheet. In addition to the straight outlay for the deal, it will have to take on provisions.

The benefit for EDF, streamlining of its own reactor build and maintenance will be marginal when compared to the risk and financial strain.

The market’s perception that EDF is a political vehicle has just received new substance. EDF would be well advised to put a very strong communications strategy together, in which it addresses the political issue and the benefits of its new reactor build, maintenance and service exposure. Communication would have to address markets, but also business partners and be all comprehensive. It would have to adress risk, finances and quantify long term benefits. Addressing a strong vision by management about the entire integrated business as a whole would be advisable.

At the same time, EDF is asking the government for a 2.5% increase to regulated tariffs over three years. It is the time of the year where the negotiations for the annual tariff increase begin, to be confirmed in August. This increase is particularly sensitive, because it comes after the Energy Minister froze tariffs, and now because of the Areva deal. There are suggestions that a stronger tariff increase might be a reward for EDF’s offer for Areva’s reactor business. The government will tread very carefully, in order to avoid any negative interpretation on the Areva recapitalisation vs consumer vs taxpayer interests. Also, the new formula fixed by the government gives some framework for tariff increases. The government had just devised that formula last year, in order to reduce tariffs, and asked EDF to reduce costs. A u-turn would be difficult.

I maintain the short EDF/long Engie trade on the grounds that risk or downside has not increased for Engie (I have argued before that there was no down side for Engie, almost irrespective of the Areva outcome). Engie has shown it has the ability to source and execute credible growth acquisitions and/or organic growth. The share price has under-performed over concerns over lng margins. That is now a consensus view. Over the longer term, the over-supply will reverse. Meanwhile, all of the other businesses are delivering positive earnings outlooks.

French nuclear sector: Ménage à trois?

EDF has made a Eur 2bn offer for Areva’s reactor business without specifying for which parts.  Engie (GSZ FP) may focus on the international part of Areva’s nuclear reactor business only. That would make sense, but may be politically less desirable. Conversely, the prospect of such an offer may push EDF (EDF FP) to a weaker negotiation position. Engie already shows it holds a strong position in this landscape. There is a lot of upside with very little downside for Engie in this, but a lot more risk for EDF.

EDF has made a Eur 2bn offer for Areva’s reactor business. What parts the offer comprise is not clear at this stage. This an indicative offer and first step for negotiations. Now, there is due diligence and negotiations over risks and liabilities, notably the Finnish project.

Engie has been reported previously to want to bid for the international parts only. That makes sense, as the French business is by and large EDF. Engie might not want to take on the service for its biggest domestic competitor. However, there is already some cooperation between Engie and Areva on international projects.

It gives the impression of cherry picking. But, Engie can afford to be selective. It does not need a deal, and clearly, the international part is the most attractive one. It may enable Engie to materially raise its profile as a French nuclear name of reference, ie improving its position for high profile global contracts in the sector.

That in turn might not be desirable to the French government. The policy so far was clearly for EDF (in conjunction with Areva) to be the nuclear champion. EDF will very likely put a lot of effort into retaining that position. That again, may have had some impact on the valuation it has offered for the Areva business. It may contain strategic value, that investors, however, are highly unlikely to find agreeable.

The CEO of Engie has now mentioned the possibility to take a stake in Areva. That would be a less desirable outcome but could still give Engie the parts of the business it is looking for.

Ift Engie succeeded, it would be a master stroke.

There will now be a phase of convoluted negotiations that will likely cloud performance of both share prices, but EDF more so.

Coal fired power generation in Germany: Realpolitik?

The improvements in the draft for coal legislation in Germany could imply a better than expected outcome for the sector. Montpellier Analysis estimates no early closures on the back of the current proposals. The relief is greater for E.ON than for RWE.

The German Economy Minister has presented amended proposals for new coal legislation. By and large, the new proposal is an improvement for the sector, chiefly Vattenfall and RWE: The amount of CO2 reduction from coal has been brought down to 16mt, from 22mt. Further, coal plant would have to pay emission levies after 37 years of operation, rather than 20 years in the previous draft. The levy itself would now be indexed to power prices, as opposed to being decreed according to the old proposal.

The final shape of legislation is far from clear. Chancellor Merkel needs to be seen to take some action, in light of her comments at the Paris climate change meeting. But, large parts of the CDU are against the coal bill sponsored by the junior coalition partner. Emotions on coal, for and against run high, and the mining lobby is strong, it must not be forgotten.

A shut down would have implied the end of operation of all coal plant of RWE and E.ON that is older than 37 years. RWE’s share of coal plant with current operating age of 37 years or more is 7.2GW, E.ON’s 2.8GW.

A levy according to the previous proposal would equate to a shut down. Montpellier Analysis estimates a marginal cost of old coal plant in the region of Eur 28/MWh. A levy of Eur 18-20 Per ton of CO2 as it has been in the early discussions, would bring that to Eur 46-48/MWh, compared to the current power price of Eur 32/MWh.

In the theoretical case of such a shut down, and not considering any nuclear shut down, the big winner would have been gas. There would have been an immediate shift down the merit order, even if some of the demand would have been filled by more renewables.

Adding the nuclear closure would have left the system in perilous undersupply by 2020 already, according to our models, even when building in full achievement of the country’s renewables build and energy efficiency targets. That thought may contribute to the final shape of legislation.

About 5.5GW of plant by E.ON, RWE and Vattenfall would no longer be covered by the emission levy under the new draft.

According to our calculation, the new proposal leaves enough room before the emissions levy kicks in to let coal plant run at load factors of 65-70%. That is a normal utilisation rate for hard coal or lignite plant, but far above the actual runs rates of plant in Germany currently.

The direct implication is that there would be no impact on power prices from the legislation in the medium term.

There is risk of a gradual reduction of the emissions ceiling, in our view.

The chance that upward movement in CO2 prices on the back of political measures will accelerate the process can also not be fully ruled out.
On balance, the near term impact is bearish for gas plant, but there is a marginal improvement to prospects for gas plant profitability over the longer term.

Whilst the immediate relief reaction on RWE shares is intuitive, fundamentally it may be less than commonly thought. RWE won’t de facto lose 16% of its fleet. Still, the underlying problem of low utilisation and weak profitability of conventional generation remains. We gage the impact of all of the above is worse for RWE than for E.ON. E.ON benefits from a more competitive hard coal exposure and stacks up relatively better.

French nuclear sector – Big or little French solution?

A “big French solution”, ie a purchase of the bulk of Areva’s nuclear reactor and engineering business by EDF, is currently favoured by the State. But a “little French solution”, a purchase of the maintenance business by Engie, would be a more favourable outcome for all parties involved, investors included.

The French State is reported to be pushing for EDF (EDF FP) to acquire Areva’s (AREVA FP) nuclear reactor and engineering businesses. The broad outline has been known for a while. Now, EDF is said to be finalizing an offer. Press reports suggest Area is looking for Eur 1bn for just the engineering business. A Eur 300m, EDF’s valuation is considerably lower. That compares to market valuations floating between in a Eur 1.5-3bn range for the reactor business. We estimate an implied EV/Sales range of 1.1-2.1x on that basis. But, on those revenues come the risks and liabilities which are highly uncertain.

Engie (GSZ FP) might emerge as a strong competitive bidder. The CFO recently confirmed potential interest. Engie seems to be interested in the reactor maintenance business, which it could be valuing at around Eur 3bn. That would imply just short of 2x sales, which is reasonable for a high margin and stable cash flow business.

In our view, a deal with Engie would be in the interest of all parties involved. Even the state could find reassurance, given its holding in Engie. It would be much better received by markets, too.

EDF would benefit from vertical integration, a potentially more streamlined and efficient new build operation, and all in all lower future costs of its nuclear fleet. Conversely, the reactor build business its outside of its core business and expertise. Lastly, a deal would not be helpful for EDF’s cash flow as it is already capex strained.

An EDF deal might not provide enough funding to Areva. The government might look for a more complex solution with Chinese investors.

Engie has existing expertise in large utility engineering through Tractebel and its energy engineering and services business. The nuclear maintenance business could tie in well with that. There would be much less of an issue with providing the service to competitors than in the case of EDF. Engie’s business does that already. The company would also derive synergies with its own large fleet of operational nuclear reactors.

Investors are prepared for M&A from Engie, following recent management comments. We gage a deal would, contrary to EDF, be perceived as coming from sound management rationale, and given all indications, free from political pressures.

Vestas is flying high again

Vestas is coming out of its turnaround and now fully benefiting from favourable macro factors with the added benefit of fx, regulation, good demand, and continued operational improvement. The positive winds are likely to persist for the remainder of this year and we see out-performance vs the sector peers ahead. Investors may take some heart in the name again.

Vestas’s (VWS DC) Q1 results beat was stunning. Net income was 88% above consensus of Eur 29.7m. Order intake of 1.78GW was very strong and management’s hints towards a good pipeline imply expectations for another good quarter. Management has upgraded guidance to Eur 7.5bn well covered by Eur 15bn of multi-year backlog, and above consensus of Eur 7.4bn. The upgraded guidance for EBITDA margins of at least 8.5% is marginally short of consensus of 8.6%. In line execution should deliver at Ebit at least at the level of current consensus.

There is positive impact from some tailwinds that could reverse: Euro weakness first and foremost helps US sales materially, but also other exports. Further, it improves achieved ASP’s. We do, however, acknowledge that there is likely underlying ASP recovery. Note that the favourable fx effect is not unique to Vestas, we have seen it coming through the entire sector and beyond. It is chiefly US exposed businesses with strong underlying product that are benefiting.

Any impact from weak oil prices is also yet to come through.

The company is still steps behind strong competitors in offshore, the sector’s big near growth segment.

Eventually, we see wind turbine manufacturing as a mid to high single-digit margin business. Thus, in Montpellier Analysis’s view, scope for margin expansion from here is very limited. The services business, a higher and stable margin and cash flow business is a potential source for further margin expansion.

Engie (formerly GDF Suez) – in transition

GDF Suez’s Q1 results were uninspiring and the current environment demands patience of investors. The re-branding is unlikely to help sentiment. The company’s assets and business mix is positioned second to none with regards to long term energy transition. It will, however, take some potential catalysts to return the shares to out-performance: Restart of the Belgian nuclear reactors, M&A, commodities.

GDF Suez Q1 results were below expectations, chiefly due to commodities. Revenues were in line at Eur 22.1bn, Ebitda was Eur 3.6bn, short of expectations of Eur 3.7bn. Current operating income was Eur 2.39bn, below consensus of Eur 2.46bn. Management has reiterated its guidance for 2015, for Ebitda of Eur 11-11.7bn and net recurring income of Eur 3-3.3bn.

Sentiment on the numbers is weak. We sense that the realization of the commodities impact, particularly on LNG, along with higher risk attribution, is the main issues. LNG margins have reduced as pricing has reflected the LNG market weakness. LNG is going through a difficult period. We estimate that might carry well into 2016.

There is residual risk with regards to further delay to the nuclear restarts in Belgium, as well as with regards to Brazilian hydro conditions.

The re-branding exercise has created concern over costs while providing little help with transparency. The new structure will not foster a clearer view on the key earnings drivers.  As far as brand equity creation goes – one of the big new requirements for energy transition as I have often pointed out: We do not see any uplift from the name change, rather a challenge. The company already has strong reputational equity; it now needs to ensure that gets associated with the name change.

It is difficult to see any uptick in earnings momentum. Equally, these results are unlikely to have helped sentiment. There could be positive impact on sentiment from M&A. Do not expect a major transaction, but management is clearly in an acquisitions mode, according to my gauge.

The French state now has the ability to sell down its 30% stake as it the Florange law allows it to double voting rights. The declared policy is a disposal of energy assets for deficit reduction. The overhang has now crystallised as real.

Comps will get easier as the year progresses. Q1 was the worst y/y comp as far as commodities are concerned. Also LNG arbitrage was very favourable in Q1 14. Provided a restart of Doel 3 and Tihange  2 broadly as guided, y/y momentum on H2 will also be helped.

We note management’s comments that it could see a scenario where its conventional power generation assets may be pooled with those of other companies. We see such structures as a realistic possibility in the future energy world as it radically restructures. We will keep a watchful eye. Conventional power generation could change beyond recognition. This part of the business holds potential for positive catalysts.

Despite patchy performance, Engie stacks up well within the peer group. The shares have under-performed the European utilities sector by 8% ytd. Engie is the only name with positive earnings growth within the close peer group. Its conventional generation fleet is entirely free cash flow positive. It is trading on an 8% premium to the European utilities sector, with a P/E of 16x 2015E, and an EV/Ebitda of 6.8x 2015E. The yield of 5.5% is at the high end of the sector and well supported. At this stage, however, we cannot see a return to a greater premium rating and therefore we don’t see a return to relative out-performance. But long term, the company is positioned as a leader in the sector.

Petrofac (PFC LN) and that old risk: execution

Petrofac’s profit warning highlights execution risk. While the company’s backlog covers revenue expectations well, profitability is far more uncertain. As a name with an increased risk perception, the ytd relative outperformance vs the sector might reverse.

Petrofac has delivered its second profits warning on the Laggan-Tormore project in the North Sea on bad weather and cost overruns. The company will recognize a GBP 195m loss on the project. This follows the downgrade to guidance (USD 500m down to USD 460m) in February.

The company has a strong backlog of USD 21bn including 2015 order intake. The 2015 share covers 80% of consensus revenues. Even though that will provide some hedge, the oil price impact is clearly visible. And it has a good share of risky projects. Revenues might come through, but profitability is uncertain.

Even though the shares have underperformed the sector by 9% since the news, PFC is still outperforming the sector by 22% ytd. There is chance of reversal of performance, in fact performance has already reversed for the start of this quarter. A name that is not spotless and delivering very strong execution is likely to underperform a sector that where sentiment is already weak due to commodities. Earnings momentum is solidly negative. The attractive valuation of the shares will now be seen as a discount reflecting execution risk.

On that account, other names look less risky, namely Technip (TEC FP). Technip trades on similar multiples: Technip’s 2015e P/E is 11.1x vs 10.4x for Petrofac, the yield is 3.8% vs that of Petrofac 4.6%, but Technip’s cash dividend cover is stronger.