Can E.On Maintain Its Fat Dividend Through A Difficult Restructuring?

By Stephen D. Simpson, CFA | August 23, 2013 AAA

Experienced dividend investors know better than to just take a fat dividend yield for granted. While there certainly are opportunities every so often to pluck an overlooked or underappreciated income story, oftentimes high yields are best read as a flashing “danger” sign.

That brings me to German utility company E.On (Nasdaq:EONGY). A dividend yield of nearly 9% is certainly attractive these days, but E.On is still in the early years of a difficult transition that is seeing the company cut costs and scale out of its traditional generation business in favor of newer opportunities like renewable generation, oil/gas exploration, and overseas generation. On balance I'm bullish on E.On's prospects for remaking itself over the next three years, but I would caution investors that the dividend could get cut, and possibly cut substantially, before the process is complete.

SEE: Due Diligence On Dividends

Behaving Rationally In An Irrational World
Major U.S. utilities like Entergy (NYSE:ETR) and Duke Power (NYSE:DUK) that operate nuclear plants may think that the rules and regulations governing nuclear power in this country are difficult, but they're positively welcoming compared to the environment in Germany. In the wake of the Fukushima disaster in Japan Germany made the decision to phase out nuclear energy, and with E.On previously generating 40% of its power from nuclear plants, that created a significant new wrinkle in the long-term operating plans.

In truth, though, I don't believe Germany's phase-out of nuclear power is the biggest issue. Quite frankly, the way power is generated, distributed, and priced in Europe is nuts, and combined with the economic malaise across the region, it has made it much harder to make money.

With that, E.On is trying to remake itself and act as rationally as circumstances allow. European power prices have fallen by about 15% on average since the beginning of the year, and E.On is responding by shuttering capacity – deciding to close another 900MW in the first half of 2013 in addition to 6.5GW of capacity previously retired. Among that 900MW of newly-retired capacity is a gas-fired plant in Slovakia that is only two years old, but management is adamant about rigorous discipline with economic returns – if it doesn't make dollars, it doesn't make sense.

SEE: Fueling Futures In The Energy Market

Looking To A Different Mix Down The Road
E.On is increasingly trying to shift away from less-promising “old utility” operations like coal/gas/nuclear generation and energy trading and towards renewable energy (wind farms), oil and gas production, overseas generation (Russia, Brazil, and Turkey), and regulated distribution.

On the wind side, the company has over 3GW of capacity in place and is looking to add more (including 1 GW in Britain). On the E&P side, the company has over 1 billion barrels of reserves (boe) and operates in the North Sea with experienced partners like Statoil (NYSE:STO) and BP (NYSE:BP). As far as the ex-Western Europe assets go, the company has sizable capacity in Russia (nearly 10GW or almost 4% of the country's capacity) and is targeting more growth in Turkey and Brazil, though companies like CEMIG (NYSE:CIG) and COPEL (NYSE:ELP) have amply demonstrated that operating in Brazil is no guaranteed bonanza.

A Tough Adjustment Process
As you might guess from the fact that E.On shares trade at a low not seen since late 2003, this adjustment process has proven to be painful. The severe recession in Europe since 2008 has certainly been bad enough, but the ongoing changes in the European regulatory environment have only made things worse.

To that end, while E.On's reported EBITDA for the first half of 2013 was ahead of expectations (though closer to in-line after adjustments), it was down 15% on sizable drops in generation (down 21%) and trading (60%). More encouraging was the fact that the businesses that the company has prioritized for the future were much stronger, with renewables up 20%, E&P up 37, and distribution up in the high single digits (though Russia was down 10%).

There's still a lot left to do. The company is about three-quarters through its targeted asset disposal plans, but will achieve only about half of its cost-cutting goals in 2013 (and cutting labor-based costs in Western Europe is not often easy). With that, and over 33 billion euros in net debt, there is a risk that the company's liquidity gets dangerously thin during this multi-year transition and that management responds with a meaningful dividend cut.

The Bottom Line
I don't want to understate the challenges that E.On is facing, nor the risk that management cannot offset declining traditional generation profits with renewables, E&P, and overseas growth. Likewise, I wouldn't just assume that the dividend is safe.

On the other hand, there's quite a bit of pessimism in the shares already. Given the company's business transition, I'm okay with a 6.5x multiple to 2014 EBITDA, and that works out to almost $18 per share today. That's not a major discount to fair value, but for a utility with so much negativity already in the stock, E.On shares could be appealing to the more risk-seeking side of income investing.

Disclosure – At the time of writing, the author owned shares of Statoil.

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