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E.On adjusts to difficult times

E.On is weathering the economic storm, but uncertain German nuclear policy and high gas-procurement costs remain a threat to its bottom line, reports NJ Watson

HEADLINE results for the first half of 2010 exemplify the complexity and uncertainty of the power sector E.On operates in. But a glance at the operating results beneath shows how well Germany's largest utility company is coping with these tricky times.

The company's first-half net profit fell by 9%, to €3.91bn ($5bn), compared with €4.31bn in the year-earlier period, although revenue rose to €44.3bn, up by 6.7% from €41.5bn a year ago. The profit gauge E.On uses to calculate its dividend fell to €3.26bn in the first half of 2010 from €3.3bn a year earlier, which was worse than the €3.31bn average estimate from analysts surveyed by Bloomberg.

However, E.On adjusts its bottom line and earnings before interest and taxes (ebit) for gains or losses from asset disposals, the revaluation of energy derivatives and other so-called non-recurring items. As such, adjusted ebit, which the company calls its "main earnings metric", jumped by 11% to €6.08bn, although this was offset primarily by higher tax and interest expenses, resulting, on balance, in a slight decline in adjusted net-tax profit, which came in just 1.4% lower from first-half 2009 at €3.26bn.

The worse-than-expected headline numbers were blamed by the utility on higher interest payments and taxes – it recorded a tax expense of €1.8bn in the first half for its continuing operations, with its effective tax rate rising to 27% in the period from 25% a year ago – and it is the latter that is causing so much uncertainty in E.On's business. "In view of continued energy-policy uncertainty, particularly in view of the future earnings development in its gas business, E.On continues to expect full-year 2010 adjusted ebit to increase by between 0% and 3%, and adjusted net income to be at the prior-year level," the company said in a statement.

So while E.On's business performance may have been better than expected in the first half, "the issue of the German nuclear levy continues to overshadow the shares," says Ashley Thomas, an analyst at Daiwa Capital Markets.

Nuclear tax

In June, the German government said it plans to impose an extra tax on nuclear power stations as part of an attempt to reduce the country's debt levels, which caused E.On's shares to drop as low as €26.80 that month, compared with a level around €43.00 at which they were trading at the start of this year. In mid-August, the share price was around €30.00.

The nuclear levy will apply each time a reactor receives new fuel rods, which the government says will raise €2.3bn in fresh taxes a year – a total of €81.6bn between 2011 and 2014. E.On and its main rival RWE will bear the brunt of the levy – up to €1.5bn a year in adjusted ebit in E.On's case, which chief executive Johannes Teyssen said would "render the operation of nuclear power stations uneconomic".

Such fighting words are to be expected from the industry. But confusing the issue is a concurrent plan by the government to extend the lives of the country's 17 nuclear reactors to around 2022 to help it meet its carbon-emissions targets, a move backed by nuclear power generators such as E.On.

"The government made clear before the [May] elections that profits from extended nuclear plants would be taxed significantly, but back then there was no mention of the nuclear fuel tax, so maybe there's some leeway to net one tax off another," says Ingo Becker, head of utilities sector research at Kepler Capital Markets. Everything is under discussion, he points out. But it looks "unavoidable" that the utilities' nuclear plants will contribute significantly to the tax.

E.On expects clarification of the government's policy on the nuclear tax and extending the life of plants by September.

Tax issues aside, E.On appears to be handling the other issues that have hit its business reasonably well. Last year, was a terrible one for the gas division, a key revenue contributor to the group, as profits were crushed by high gas-procurement costs, mainly from Russia and Norway, while at the same time European spot-market prices plummeted in the wake of the global gas-supply glut.

In the first half of this year, however, E.On Ruhrgas, the lead company in the utility's European gas unit, saw sales rise by 22%, boosted by the cold weather snap, increased demand from industrial customers as the economic recovery took hold, and expansion beyond Germany. E.On Ruhrgas's adjusted ebit jumped by 17% to about €1.3bn.

The gas division says price negotiations begun last year with Russia's Gazprom – from which it bought 26% of its gas in 2009, second only to Norway with 27% – had helped it protect its profitability. E.On also cited positive effects from the upstream business, mainly the inclusion of the 25% stake in the Yuzhno Russkoye gasfield, which it received in exchange for a 3% stake it held in Gazprom. This helped lift gas production in the first half by over 400% year-on-year, although oil output fell by 7%.

Looking upstream

E.On says the remaining 3.5% stake it holds in the Russian gas firm is a financial, not strategic, investment, so few analysts were surprised at unconfirmed reports claiming the German utility was looking to swap the remaining stake for more Russian upstream assets. Gaining direct access to reserves is vital to removing some of the uncertainty from this part of its business. In 2009, E.On Ruhrgas purchased a total of 624.1 terawatt hours (TWh) of gas, only 3% of which was from its own sources.

In addition, 53% of procured gas came from Russia and Norway. So E.On is looking to diversify its supplies. This strategy took a step forward in July, when it completed the purchase of a 15% stake in the Trans Adriatic Pipeline (Tap) project, headed by Norway's Statoil and Switzerland's EGL. On completion, in 2016-17, Tap will carry 10bn-20bn cubic metres a year (cm/y) of Caspian and Middle Eastern gas through Greece and Albania and across the Adriatic Sea to Italy; and then on to western Europe. Tap hopes to source gas from phase two of Azerbaijan's Shah Deniz project – in which Statoil is a shareholder – which E.On says can meet the 4bn-6bn cm/y of demand from its Italian business.

In August, E.On Ruhrgas began production from the UK's offshore Babbage gasfield, which it operates with a 47% stake (its partners are Centrica Resources, 13%, and Dana Petroleum, 40%). The field is expected to produce more than 5bn cm over a field life of 20 years.

In the shorter term, the question for investors is whether E.On can maintain the strong first-half performance of its gas division. This is unlikely: Daiwa's Thomas says most of the sales contracts for the 2011 gas year (October-September) have already been signed at low or negative margins, meaning profits in fourth-quarter 2010 and in 2011 will be negatively affected unless E.On can renegotiate prices with its main suppliers. "If we assume around a quarter of our forecast 720 TWh of E.On Ruhrgas gas sales are renewed in 2011 at a negative oil-to-gas spread of €5 a megawatt hour, this suggests a potential ebit impact of around €0.9bn," she says.

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