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Confidence in Iberdrola

There's nothing Quixotic about Iberdrola's assault on wind power, writes Tom Nicholls

Don Quijote attacked windmills in La Mancha, mistaking them for giants. Wind power's detractors claim intermittency and high costs make it impractical at scale and that those that believe otherwise are also deluded.

But there is no doubting the value of wind power to Iberdrola. It has helped transform the company from Spanish utility to global energy company in under a decade: in 2000, Spain accounted for 99% of the company's core earnings (earnings before interest, taxes, depreciation and amortisation – ebitda). Last year, traditional Spanish generation activities – those that predate the expansion into renewables – contributed just 37% to ebitda, with 57% coming from renewable energy and international businesses.

Growth in the wind sector has made for a more balanced generation portfolio: in 2008, renewables accounted for over a fifth (21.5%) of Iberdrola's installed capacity, the remainder being divided among combined-cycle gas (30.4%), hydro-electricity (22.7%), thermal (10.9%), nuclear (7.7%), fuel oil (4.1%) and cogeneration (2.7%).

Green investments have made Iberdrola the biggest wind-generation company in the world by capacity, it says. Its renewables arm, Iberdrola Renovables – which trades on the Madrid stock exchange but is 80% owned by Iberdrola – claims to be the world's largest wind-power company by capacity. Its portfolio is dominated by wind, accounting for nearly 97% of electricity the unit produced between January and March.

Given that renewables – and wind in particular – are likely to be the utilities sector's principal source of growth in the next five years, this should translate into superior top-line growth, says Fernando García, an analyst at Espírito Santo bank in Madrid.

And Iberdrola Renovables is expanding at an impressive rate: in the first quarter, despite a weak market, it produced 5.4 gigawatt hours (GWh) of electricity – 20% more than in the same period of 2008. Between January and March, the firm added 323 megawatts (MW) of wind capacity, bringing its world total to 9.6 GW – up by 27.3% on the year.

Green and the US go together

Spain accounts for nearly half of Iberdrola's wind-power production, but its presence in the US – an attractive market for wind because of strong government support for the technology – is expanding rapidly. The most rapid growth in the first-quarter capacity increase was achieved in the US, with 155 MW installed, bringing the total there to over 3 GW. Its growing US position – enhanced by its $8.8bn acquisition of Energy East, a Maine-based electricity company with 1.7 million customers, in September – has also made it less dependent on its Spanish businesses, affording it greater protection from adverse regulatory decisions in any one market.

Its other big acquisition, in 2007, was the £12bn ($18bn) purchase of the UK's Scottish Power: the company beat off competition from French and German rivals with a more established international presence to become, it claims, the world's fifth-largest power company. More than half of the 141.27 GWh of electricity it generated in 2008 came from overseas operations.

Diversification notwithstanding, however, the company continues to derive a large proportion of its income from regulated businesses, implying stability of income and cash flow – a significant source of comfort for investors. Yet its strategy is not flawless, say analysts. It is highly exposed to fixed-cost generation capacity – nuclear power and hydropower, which, along with wind, form the backbone of its growth strategy.

In addition, the UK and US power markets are mature. While both countries may offer the comforts of solvency and stability, growth opportunities, outside the renewables sector, are likely to be limited, says an analyst at the Madrid branch of a US bank. And the prices paid for Scottish Power and Energy East are – in view of the rising cost of capital because of the credit crunch – starting to look expensive. Management of the company's €30bn ($40bn) of debt, accumulated to finance its global expansion, has been identified as a priority by chairman and chief executive Ignacio Galán.

There are other potential pitfalls. Iberdrola faces an element of regulatory uncertainty in the US, where it wants to invest in upgrades to electricity networks; the success of that plan, however, depends largely on the expectation that the US authorities will allow higher rates of return to incentivise such investments. While incentives may be made available in the short term, it is "doubtful" whether they will be maintained, says the analyst at the US bank.

At home, meanwhile, there is the unsavoury problem of the tariff deficit: power firms, including Iberdrola, must sell electricity in Spain at regulated prices, which do not cover costs. Regulated prices need to increase to cover the shortfall; in the meantime, the companies are allowed to defer the deficit, but must finance this steadily mounting debt.

Not surprisingly, Iberdrola and other Spanish utilities would like to see this issue resolved as soon as possible, particularly given that Iberdrola's immediate problem – one that it shares with most power suppliers – is protecting its revenues in a shrinking market. Spanish electricity demand fell by around 10% on the year in March. And, following substantial rainfall, the availability of hydropower in Spain – Iberdrola's core market – has put further pressure on domestic wholesale electricity prices.

Favourable outlook

On balance, however, the outlook for Iberdrola is favourable. Ebitda in 2008 fell short of market forecasts, largely because of negative currency and accounting effects at Scottish Power. But, in general, the company has a reputation for meeting the market's expectations. And that disappointment was at least partly offset by the firm's attractive dividend policy: dividends for 2008 rose by 20%. In a difficult market, the company achieved a robust 21.3% increase in net profit, to €2.86bn. It expects a similar result in 2009 and is still targeting a net profit of €3.5bn in 2010.

The capital markets seem to have confidence in Galán. While some companies have struggled to obtain credit, Iberdrola has freely tapped the markets this year, accumulating some €9bn in funds – enough to cover its financial requirements for nearly two years.

And there is no faulting its ambition: promising investments of €4.2bn in 2009 as part of a four-year, €25bn investment plan, it has even styled itself as an engine for economic recovery – a knight errant with a mission to slay the monsters of the recession.

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