The E.ON Power Play

04/07/2009 12:00 am EST

Focus: GLOBAL

Allan Nichols

Equities Strategist & Editor, Morningstar InternationalInvestor

Allan Nichols, equities strategist and editor of Morningstar InternationalInvestor, warms to a big German utility with a growing reach.

E.ON AG ADS (FSE: EOAN, OTC: EONGY.PK) is one of the largest electric utilities in the world, with the greatest geographic scope. It has been hurt as European economies weaken, which means less electricity is needed. However, I think it's very well positioned as electricity markets are further integrated across Europe. It has the balance sheet necessary to build or acquire assets to maintain its growth, and it also pays a nice dividend. While the next few quarters could be bumpy, I think E.ON will show solid long-term returns.

Most of E.ON's power plants produce what is called base power. Many plants are nuclear and have a significantly lower operating cost than other plants, so they always run. As demand for electricity increases, other plants turn on that have higher operating costs, until "peaker plants" kick in that run for only short periods when demand is really strong.

These other plants kick in only if electricity prices rise enough to justify the cost of running them. Many of the most expensive use natural gas. E.ON makes a spread between what it costs to produce electricity and the price at which it can sell it, so obviously the greater the spread, the more E.ON makes. If natural gas prices increase, then that spread widens.

The electricity market in Europe has been undergoing massive changes between consolidation and the European Union developing an interconnected grid. When this is completed, E.ON will have had to sell its transmission assets, but it will be able to move electricity easily among the multiple markets in which it produces electricity. It has the most diversified collection of production assets, which should increase its market power. (The ADRs closed at $29.50 Monday—Editor.)

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