It's been an interesting couple of years for German utility giant E.ON (OTC:EONGY), and "interesting" is almost never a good thing for a utility. Not only has the company had to deal with the German government's decision to phase out nuclear power, but the economic and regulatory environment in Europe has been slipping around as though trying to walk on ball bearings. Nevertheless, the company's commitment to expand its unregulated and emerging market businesses offers the hope of more growth, though investors may question the likely returns on that growth.

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Gas Supply Issues Are Resolved ... for Now
One of the biggest developments for E.ON in 2012 has been the renegotiation and resolution of its gas supply contracts. E.ON is the largest European supplier of gas, but the company had found itself on the wrong side of punishing gas/oil spreads. While Norwegian energy giant Statoil (NYSE:STO) was relatively easy to deal with, there was a great deal more uncertainty about E.ON's ability to get a deal done with Russian giant Gazprom (Nasdaq:OGZPY). Contrary to expectations, though, the process went relatively smoothly and E.ON's gas supply situation looks to be in good shape - at least for the foreseeable future.

Generation - Good, Bad, Ugly and Confusing
E.ON's electricity generation business is still in less certain shape. Although E.ON has engaged in plenty of divestments over the last few years, power generation for Central Europe (including Germany), Southern Europe and Scandinavia is still a major component of the company's EBITDA.

Suffice it to say, this business is in flux. The economic chaos in Southern Europe has challenged pricing, demand and collections, while Germany's regulatory U-turn on nuclear power in 2011 is going to lead to some interesting decisions down the line (as E.ON was generating about 40% of its power from nuclear sources at the time of the announcement).

Renewables are also a headache to consider. Although the cost of renewable power (wind and solar, mostly, at the utility level) has indeed dropped considerably, it's still more expensive than gas-fired generation. Nevertheless, many European governments have put incentives into place that guarantee feed-in for renewables and interfere with the price clearing of the market. Making things even more challenging, while E.ON has a fairly hefty renewables business, a lot of it is located in North America where it must compete with very cheap shale gas.

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Growth Will Come With Risks
While E.ON already has a lower percentage of regulated businesses than comparables like Enel (OTC:ENLAY), SSE (OTC:SSEZY) or RWE AG (OTC:RWEOY), E.ON is looking to get even more EBITDA and cash flow from outside regulated European power and gas.

E.ON has already committed nearly $9 billion in capital to its own E&P efforts, largely centered in the North Sea. While the returns on successful E&P operations are much higher than those of utilities, and sourcing its own gas makes a certain amount of sense, even large companies like BP (NYSE:BP) and Apache (NYSE:APA) find North Sea operations to be challenging.

E.ON is also looking to emerging market power demand, expanding into areas like Russia, Turkey and Brazil. Certainly, the demand argument holds up - all of these countries have inadequate power infrastructures for their needs, and the long-term market potential for generation looks pretty good.

Unfortunately, the regulatory environments here are no less challenging - as investors in Latin American utilities like Enersis (NYSE:ENI) or CEMIG (NYSE:CIG) could likely confirm. In fact, many developed country utilities have pulled back or pulled out of emerging market generation due to local governments, either overfunding locally owned capacity expansion or being unwilling to allow for market-based rate increases (or both).

The Bottom Line
It may seem obvious, but the question of E.ON's value today really rests on how you see the company's cash flow generation in the coming years. Back in the good ole days, E.ON routinely generated solid (for a utility) free cash flow margins in the mid single-digits. More recently, low single digits has been about the best that the company can do.

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If you believe that E.ON's cash generation capabilities are permanently impaired, say on the order of 3% of revenue, then the stock is likely worth something in the low $20s, and isn't much of a bargain today (despite an appealing dividend yield of about 6%). If, however, you believe that the free cash flow margin could expand back to around 4% or 5% by 2016, the fair value leaps into the low $30s and this becomes a much more compelling stock idea.

Stephen D. Simpson owns shares of Statoil since September 2012.