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Why investing in the big 4 German utilities is still not for the faint of heart…

The European utility market is going through the biggest upheaval in a generation. It is especially difficult for investors to navigate. Leading utilities such as E.ON, Engie and RWE have seen their share prices halved over the last five years. In stark contrast, the share prices of Enel, Iberdrola and EDP have doubled. They have done so largely thanks to their focus on renewables as well as the internationalisation of those businesses into growth markets such as North and South America. And each of these utilities were fast to spinoff their renewable businesses. Now we have RWE and E.ON doing something similar except they have added their grid and retail businesses to the mix. E.ON keeps renewables, grid and retail with the new spinout Uniper taking over the conventional generation fleet. RWE did it slightly differently and spunout Innogy which has the renewables, grid and retail businesses in it. So now we have four utilities listed on the German stock exchange for investors to invest in. The question is whether one should invest or not.

The good news is that each of RWE, E.ON, Uniper and Innogy have cut costs, restructured, made substantial asset write-downs and cleaned up their balance sheets. This improvement comes at the same time as when the outlook for continental European power prices has stabilised. The current view of investors tells an interesting story. The E.ON share price is lower than it was one year ago while the price of its spinoff Uniper is up 50% since its listing. In contrast, the RWE share price is up over 50% with Innogy flat since its October listing. What this is saying is that investors are more interested in the conventional generation businesses of RWE and Uniper rather than their new renewable, grid and downstream retail businesses.

This has happened for a number of reasons, the first of which is that wholesale power prices have stabilised after 7 years of continuous declines. With much of the French nuclear fleet out of action over the next few years due to ongoing maintenance and upgrades we are likely to see supply tighten. We also likely to see a whole host of old gas and coal closures across the continent not to mention the 20GW of conventional power capacity (incl. the whole nuclear fleet) in Germany likely to come offline over the next 6 years. To add to that we will see growing demand for electricity thanks to electric cars which is likely to improve the market environment for power generators.

RWE and Uniper should be major beneficiaries of these trends. In contrast, E.ON and Innogy are facing headwinds in all of their core businesses. For a start, the grid businesses of both E.ON and Innogy are likely to come under pressure in the coming years. In Germany allowed regulated returns will fall from 2019 onwards with a requirement to increase investments in the distribution grid. This will impact the profitability of the whole group noting that over 50% of the earnings of both Innogy and E.ON come from grid.  And then we have the renewables portfolio of Innogy which totals 3.7GW which is clearly subscale compared to say Enel which has an installed base of 36GW, adding over 2GW of new renewables last year alone. At least, E.ON has a decent renewable portfolio at 5.3GW but let’s be clear this is still small compared to the installed base of 85 GW in Germany. To make matters worse, the highly profitable and fast growth days of European renewables are over due to increased competition for fewer projects and reverse auctions, which are increasing price and margin pressure. All of which is good for the consumer but not the utility. In such a world, only the big will survive which is why it may make sense to combine the renewable divisions of Innogy and E.ON.

The final issue with Innogy and E.ON is their legacy retail businesses. They may have lots of customers but these businesses will be under pressure for years to come to reduce costs. Further restructuring is inevitable. They need to invest in modern IT systems and most importantly they have to reduce their cost of serving these customers so that they can compete with low cost digital players such as Sonnen who are using low cost IT platforms and digital channels as well as the internet and apps to interact with their clients. In contrast, both RWE and Uniper do not have these legacy retail businesses anymore, which frees them up to develop their own energy services business or to make acquisitions. And let’s be clear they will do so as not having customers for your commodity power is a very risky game….

The conclusion has to be that neither E.ON, RWE, Innogy or Uniper are fit for the future. The good news however is that they do have some stability in their businesses, and there is increasing investor interest, which means that management, can devote themselves to the positioning of those companies and in particular to necessary M&A work.