Reaching for Growth Beyond Its Border

12/02/2008 12:01 am EST


Allan Nichols

Equities Strategist & Editor, Morningstar InternationalInvestor

Allan Nichols, editor of Morningstar InternationalInvestor, likes the acquisition and dividend strategies of a German energy power.

E.ON (LSE: EON.L; OTC: EONGY) ranks among the world’s three largest investor-owned utilities, generating, transmitting, and distributing electricity and natural gas to 28 million customers in 20 countries, primarily in Europe. The firm is the largest German gas company and generates one-third of Germany’s electricity, sourcing about half with nuclear power.

Frustrated by nationalist protectionism throughout Europe, E.ON has turned to acquisitions elsewhere to prove it can scale its impressive value-creation ability. The latest is its largest, a EUR 11.5 billion purchase of Enel (Milan: ENEL.MI) and Endesa (NYSE: ELE) assets that closed in June 2008.

Despite regulatory hurdles that nixed recent acquisition attempts of Scottish Power (LSE: SPW.L) and Endesa, E.ON recently worked deals involving US renewable energy, a Nordic utility, power plants in Russia and Turkey, and an Italian utility.

Political pressure from record energy prices, as well as supply shortages in Germany, could jeopardize cost recovery in rates, cutting into profits for its distribution unit. An economic slowdown could reduce energy demand.

As the worldwide economy weakens and credit markets remain constrained, we cut € 5 billion from our capital investment assumption for 2009. This, along with falling commodity prices, reduces our assumed operating profit growth to 3.0% from 3.6% through 2012. We continue to assume E.ON’s operating margins fall to 12% by 2010.

Aside from growth, the company’s long-term capital structure remains a critical component of our valuation. In mid-2007, the company planned to reach 50% debt in its capital structure by investing EUR 60 billion and repurchasing EUR 7 billion of stock. However, we now believe management likely will invest only € 55 billion and could trim its stock-repurchase plans to conserve cash. We are lowering our fair value estimate to $44 per ADR from $49 after updating the foreign currency exchange ratio and our growth assumptions.

However, if European markets stabilize and E.ON’s investment plan continues on schedule, we expect shareholders should see strong returns for the next few years. We believe management has shown good discipline to protect its industry-leading 11% returns on capital. As long as E.ON avoids punitive government intervention, we think it could be a good long-term investment. I’m intrigued by its diversification and high yield (3.38%, currently—Editor).

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