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.

The wrong kind of exposure – and the right one

RWE’s earnings warning weighs stronger short term than its strategic moves. The company will continue to struggle with weak commodities and high leverage in 2015, despite the DEA sale. It may embark onto some rescuing of value through power plant sales, but it does not have the potential to deliver a similar strategic boost to E.ON. RWE is at the heat of the political storm that still has high potential to deliver more unpleasant surprises. Infrastructure and the private sector, conversely, might be beneficiaries. There are signs that private investors with longer strategic horizon are circling around distressed assets. They will gain a more important part in a decentralized energy market. Asset rotation will be a feature. My view of increasing M&A activity remains underpinned.

RWE is not out of the woods yet; investors who were hoping on earnings stabilization as indicated by the company in April 2014 may be disappointed. Management has warned on earnings, saying that the earnings trough may not occur in 2015 yet. Consensus has not bottomed out for 2015 yet and it may still come down.

Power prices are the unsurprising cause of the problem. Futures are pointing nowhere to a meaningful enough recovery, and the broader commodities environment is not any more supportive. RWE more than any of its peers, needs significant commodity recovery.

In tandem with the above comes relentless balance sheet stress. I find see little chance of material decrease of leverage. The Urenco sale will not come through short term. The CEO has further confirmed that leverage falling to 3x net debt/Ebitda by 2016 will be “extremely difficult to achieve”. I estimate just short of 4x for 2016. Attention will swiftly return to risk to the dividend.

RWE may rescue some value through selling its power stations that are unprofitable abroad as announced this week. That is clearly a strategy to mitigate cash losses. It would bring minor debt reduction.

Some of the company’s plant is new and competitive technology. The bulk of the RWE’s mothballing and closure programme is less than 20 years old, some plants are not even three years from commissioning. That concerns particularly gas. It is sensible that management looks to maximise value of otherwise potentially stranded assets.

But, a power plant cannot be displaced and sold into another location like other capital assets. High quality and well performing equipment may still find a market value in locations with tighter reserve margins and new build demand. The CEE region comes to mind. There is also an active secondary plant market also in Asia.

There will clearly be a loss of value for RWE. Investors should not hold up high hopes of significant earnings contributions from the process. Signaling power to the political powers may be stronger than actual earnings impact.

Infrastructure investors have begun to look at power generation with a view of power price recovery over the long term. The prospect for capacity payments may underpin that kind of activity. Germany is uncertain on that note, but plenty of European countries putting into place capacity markets could keep M&A activity up.

The services sector should be able to recoup order potential.

All of RWE’s strategic moves could in the end amount to a similar outcome to E.ON’s corporate split. The company has been vocal about reducing the share of generation to 5% of earnings. Most recently, the CFO has now said it no longer rules out a similar move even though management decided against it in 2012.

RWE is in a different situation to E.ON, in that it cannot bring as diversified a generation park into any potential new co. Merging renewables into a genco may remedy to a point. But in that case management would have to have a clear strategy about how it would pursue downstream brand equity and service/product packing for which renewables exposure is important. A split co will also not have the same upstream and oil and gas diversification as E.ON. That would make a genco or upstreamco resemble much more of a bad bank than in the case of E.ON.

Importantly, it would in my view have to raise capital in order to fund the nuclear liabilities that the genco would inherit.

RWE might embark onto greater strategic change beyond its already announced transformative steps. That would be a positive.  But with the chances increasing that more steps are taken, so does the probability of a capital increase.

I see significant potential for large parts of RWE’s business going private.

Meanwhile, the debate over capacity payments rages on. The Economy Minister’s has again repeated he is opposed to capacity payments, which is out of line with market expectations. The political debate bears high potential for disappointment.

Politicians quote over-capacity as eliminating the need for any capacity payments. But as capacity markets are circular, absence of capacity incentives could remove the over-capacity faster than thought. Markets would be left in great disarray. Politicians are quoted as not finding price spikes problematic. But affordability, system stability and the like will then come back to haunt.

My preferred exposure in all of this is infrastructure, engineering and market backbone.

GDF Suez on track for growth

The positioning of GDF Suez in global energy across various value chains is unique. Management has highlighted an area of strength and taken the next strategic step in the current energy cycle: Return to growth. That should see a positive reaction and lead to a re-rating of the shares.

GDF Suez has highlighted its areas of strength for growth, Asia, Middle East and Africa. The company is building these as core growth regions. That makes sense given its already strong position in those regions and above average growth. Looking through current weakness, energy demand growth will likely exceed 7% CAGR to the end of the decade (source: IEA).

Management also has proactively moved to the post deleveraging phase by committing to new growth. The company targets growth capex of Eur6.5-7.5bn for 2014-18. It is looking to dedicate about 20-30% of growth capex spend to Asia, Africa, and the Middle East.

Asia, Africa, China, on a regional, IPP LNG and energy services are the core of growth.  Suez’s target regions account for over 80% of global energy growth over the next 20 years.

The latest guidance implies power capacity growth in the above target regions of 6% CAGR, 2P reserves growth of 8.8% CAGR and energy services revenue growth of 7.9% CAGR  to 2020 on the target areas. The regions currently account for c 7% of Ebitda.

Visibility on growth is very good. The pipeline provides for 30% power capacity growth to 2020. I would only consider capacity under construction at this stage, which is just short of 1GW. The IPP model is tried and tested and merchant risk very low. GDF Suez has a very good track record of securing PPA’s at good conditions and in strong local partnerships. I expect that and the strong execution capability to continue to as the basic earnings driver.

E&P reserves growth of 5-7% is at the high end of the sector, and the gas focus in line with the broader sector. But I see GDF Suez better hedged than the average of the E&P sector, because of its vertical presence all the way through the chain. With that, I think it stands a better chance of profitable reserves conversion to earnings growth to 2020.

LNG is a risky sector at this moment. Asian demand weakness and weak oil prices are leading to price falls. Over-capacity is creeping into the market. New capacity build risks not meeting its hurdle rates. Suez currently has a feasibility study under way for an Indonesian LNG terminal. There I see risk of delay. The same goes for the floating LNG terminal project in India. I also see risk of lower utilization of the US terminals. The US Cameron liquefaction terminal may escape the heart of the storm, it won’t come to market before 2018. But the company’s vertically globally integrated business provides for mitigation. Pricing risk for the Japan and Taiwan LNG contracts is in my view relatively low as they were concluded at very tight pricing in the first place.

Eventually, gas demand in Asia will recover. On average, the IEA estimates demand growth of 4%pa to 2035 with corresponding infrastructure investment requirement. The industry estimates over USD 100bn of liquefaction and storage capex requirement alone. And for that, the company’s positioning across upstream, infrastructure and power generation is second to none.

The changing structure of energy markets with distributed generation, renewables and gas/power convergence are all playing to the company’s strength.

The energy services business will be a major beneficiary and additionally deliver strong synergies to these new growth businesses. It will also be a growth driver in its own right in China and a door opener for other business development.

GDF Suez has a unique advantage through the combination of its IPP, global gas and energy services business. That is in my view the true attraction of the company.

Sentiment will likely be cautious on commodities, but should increasingly return to reflect the early move and strong position on long term growth.

View on four themes for 2015

Commodities, reform and restructuring, yield and corporate activity will dominate the energy sector in 2015. I see engineering and consulting as well as power equipment and services as standing out. Clean tech stands to benefit from sustained activity despite weak commodities. Oil is better left for later in the year.

Commodities

Is it the great underweight or bargain territory? The energy sector globally has outperformed oil by 3000bps in 2014, oil services performance at the bottom end of the range. Oil futures point towards a late year recovery. I do think there will be some recovery, but equities may follow on a selective basis at best. The oil sector looks cheap on valuation, but the value case may not be there yet. Consensus across the board will still come down further in my view. Dividends struggle with tightening cash. Earnings impact is uncertain as are outlooks. I would let the Q1 earnings and guidance train leave the station before getting closer. Focused upstream if anything offers the most geared exposure for those looking for commodity recovery later in the year.

Gas capex cuts bear a negative impact on upstream, but gas is still relatively sheltered when compared to oil. Slow down in development will balance prices earlier. Gas is the growth sector of choice. The positive read from weak gas prices on gas utilities from 2014 will come to an end as pressure for pass through mounts (see below).

The LNG is in great danger of over-capacity. Thanks to the the oil price link prevailing for Asian contracts and weak demand, Asian spot contract prices are now around USD10/mbtu, down 50% y/y. according to Wood McKenzie. There is little prospect for recovery: Capacity is will stand underused and capital intensive projects risk not making their hurdle rates. Because of the long nature of project build, completions are now hitting the market. About 100mtpa of new liquefaction capacity is due to come to the market from 2015. Expect write-downs and weak profitability in the lng infrastructure sector on new projects.

Clean tech should be in a good position in 2015, even though the argument of rising commodities prices has weakened considerably. There will be an impact on perception of clean tech. The sector becomes more dependent on political and regulatory support and the sustainability argument. The grid parity benchmark has moved again. Particularly in the US, the impact of low gas prices will hit home.

Nevertheless, sector performance should in my view decouple from oil, in Europe more so than in the US. Consensus momentum is stronger and order books in a good shape. I see continued strong activity in 2015, not least as the energy sector builds clean tech as a substitute for low growth rates elsewhere.

North Sea offshore wind activity remains strong which will be one of the pillars of global offshore growth. But, increasingly, growth will shift from Germany and the UK towards China. Turbine size is the big battleground.

Global solar demand of 45GW in 2014 was a better than expected recovery, despite weaker than expected Chinese demand resulting from permit bottlenecks. China, Japan and the US will remain the strongest markets in 2015 in my view. Trina (TSL US) is gaining very good traction in Japan and stands out with a strong development business. Wacker Chemie (WCH GR) should benefit from the revival of growth and a tighter supply/demand balance. Wafers will bear the brunt of pricing pressure.

Weak commodity prices remove short term incentive for energy efficiency. Energy intensive industries will still be a long term end market in my view.

Utilities are likely to continue to outperform on a relative basis. But, weak commodity prices will lead to pressure on supply margins. Public powers will put end customer prices under yet increased scrutiny. Consumer groups across Europe have already been vocal to the matter of price pass through. This would have been an opportunity for proactive perception management campaigns by utilities. It is late but not too late for that yet. Risk is highest in the UK where it is election year (see below).

Reform and restructuring
Utilities are most concerned.

The UK in an election year and with the CMA outstanding is the epicentre of political risk in Europe. The UK government has put energy at the centre of its campaign.

That is followed by Germany which is to enact big market reform and coal legislation. Both of those issues are not new, but risk to German coal earnings still has some way to work itself through earnings and share prices.

Even the French regulator is itchy, saying that EDF and GDF’s supply companies are too close to the parent in their identity.

Falling supply margins will accelerate the shift towards higher margin businesses, but it will be a slow transition.

Brand equity and packaged service offering is the quest. Intense  and proactive perception management has to come with it.

E.ON (EOAN GR) has led the pack on industry restructuring in 2014. This has been just a first in what I see as a paradigm shift across the sector. The UK CMA review may bring more, proactively or forced.

GDF Suez’s industrial services business stands out.

With regards to retail, I prefer to seek exposure to the changing nature of the business through equipment, engineering, services and consulting. Solution providers with brand equity are my exposure of choice.

Corporate activity
Big restructuring across the sector spans from asset sales for cash optimization in commodity businesses over to activity coming out of a paradigm shift in downstream electricity. Manufacturing and services are changing business models and may be both sellers and acquirers.

Clean tech yieldco’s should be acquirers, as may be developers diversifying their portfolios.

The oil sector may see asset sales, yet the environment is for weak valuations. Majors and names devoid of shareholder pressure for payout may be looking for bargains. The same may occur for gas assets.

Good levels of activity should support valuations overall.

Yield
As every indicator points to a low interest rate environment with uncertainty over growth, yield remains attractive.

I prefer utility over oil dividends. Oil will struggle to balance payout vs capex in a cash preservation environment. The sector is advised to invest fro growth in order to support future dividends. But it will sacrifice short term sentiment.

Clean tech yieldco’s are attractive while US tightening is very tempered. Growth in the sector is an added attraction.

Oil gas price link – slippery or sticky?

Oil price weakness begs the question of persistence of the oil gas price link for long term contracts. Economic recovery, correction of over supply and energy fundamentals speak for long term recover of gas prices, possibly in a disconnected fashion from oil. That might along with the current oil price weakness lend support to a degree of continuation of oil price links, in Europe likely more so than in Asia. European utilities will get a major positive earnings impact. Gas midstream remains attractive.
As oil hits one low after the other, expectations for a short term recovery have no come close to disappearance.
That may have a consequence for gas pricing structures: The welldocumented oil price indexing structures for gas contracts as prevailing in Europe and Asia may hold for longer than thought.
The oil price link may all of a suddenappear attractive. The contract structure that was damned not too long ago could be seen as not as bad after all as the other side of price volatility shows its face. There are indications within the industry that the once very strong pressure to move away from oil indexed contracting has decreased.
Much depends on the timing of expectations.At the current level, hub priced gas is very close to oil priced product, prior to transport variability. In a short and sharp correction, gas buyers would be well advised not to appear overly opportunistic. Retracting from the current positioning away from the oil price link will make a change of strategy difficult later.
Another major question is whether exporters will be looking for contract adjustments and amendments now, just like buyers did on the way up. Again,it comes to strategic thought vs short term revenue maximization as well as long term image and reputation management.
European utilities are getting a major break now. The sector may increase exposure to Russian gas again.That has not been reflected inprices, but should come through reporting from 2015.That may reinforce the oil gas price linked contracting in Europe, more so than in Asia.
Asian buyers are wiggling out of LNG contracts, even those concluded at tight pricing.But, they are not substituting with oil linked product on large scale. Demand weakness is the issue. Oversupply hitting pricing
now gets compounded by the oil price. Contract momentum for LNG priced off Henry Hub will remain weak for some time.
There should be competitive LNG sourcing opportunities in the market now. Eventually, the impact of inevitable project cancellations due to insufficient economics will drive prices up again.
If a view holds that oil will not recover as governments constrain demand through policy measures (climate change, energy conservation etc), there could be a strong disconnect from gas.
Gas prices could recover and continue the upwards trajectory, nevertheless, for various reasons. Reduced supply from cancellation of oil projects with gas by products is one, forced reduction of shale development due to cash constraints is another, economics from lng conditioned projects a further factor to lower supply.
Fundamentals of gas as a backbone to electricity,gas power plant build, gas’s classification as a clean fuel and oil substitute speak for long term demand growth and positive pricing dynamics.
Increased demand for oil indexed contracts will weaken hub liquidity and reinforce the oil gas price link.
In such scenarios, I look for those companies that pursue gas sourcing strategies that look through the short term (even if that may entail some continuation of oil linked sourcing), gas upstream in the conventional sector and mid stream.European utilities will also benefit.
I prefer the names with integrated gas/electricity portfolio and low oil exposures.

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.