We downgrade our ratings for RWE (from Neutral to Underperform) and
for E.ON (from Outperform to Neutral). While we maintain a strong
valuation preference for E.ON over RWE, we expect short-term
headwinds from clean spread contraction to create increasing investor
concern over medium-term earnings growth. Following E.ON’s share
price recovery post 10 March 2009, we also remove E.ON from the
Credit Suisse Focus List.
Who needs earnings guidance? Mind the gap in 2013E earnings. With this
report, we aim to improve visibility on sustainability of earnings growth. In
addition, in analysing E.ON’s and RWE’s management guidance—based on
divergent commodity, macro and regulatory scenarios—we aim to provide key
earnings sensitivities. We also view full CO2 auctioning in 2013E as the only
relevant timeframe to indicate sustainable earnings levels—opening up a
significant organic earnings gap, as 2013E EBITDA is 7% above 2008A for
E.ON and 8% below 2008A for RWE.
Wholesale review of our financial models results in further cuts. We have
investigated four specific sources of earnings and valuation risk: demand
destruction, value destruction from acquisition forays into new markets,
currency depreciation and regulatory vulnerability. As a result, we cut our
earnings estimates for 2009E by c20% and by c10% beyond. Nevertheless, our
estimates end above E.ON’s 2010E earnings target but below RWE’s 2012E
outlook range.
Contraction of clean spreads overdue. We expect to see unprecedented
levels of demand destruction across Europe in 2009E; our base case of a 5%
fall in total consumption in Germany would be twice as severe as the demand
contraction seen in the recession following German reunification. This will
loosen reserve margins further and in our view result in markedly lower
generation spreads—possibly helped by Germany’s latest anti-trust
investigations. While UK and Nordic clean spreads have declined by c30%
since the start of 2008, German clean dark spreads have actually increased by
40%—in our view, implying c20% downside to current forward-power price
levels. With c50% of RWE’s EBITDA (versus c30% for E.ON) derived from
German power generation and trading, we are particularly concerned that
continuous forward hedging throughout 2009E will inevitably lock in 2011E and
2012E margins below market expectations.
Our DCF valuation for E.ON gives upside potential, but multiples reveal
real opportunity. We see E.ON’s and RWE’s relative share price valuations
today (at 2010E P/E of 7.0x for RWE and 7.2x for E.ON) unjustifiably close
despite their diverging earnings growth paths into ETS III. In other words, we
suggest E.ON will close its >20% valuation gap based on 2013E P/E at 7.2x
versus 8.7x for RWE. This is also borne out by our DCF valuations, giving us
target prices of .