David Einhorn: Nice Q4 letter but E.On as a long pick ? Really ? C’mon !!!
As this has turned out to be a very long post, a quick “Executive Summary”:
David Einhorn has published that German utility E.ON is one of his major new long positions. Based on what I have written in the past about E.On, I do think his summary investment rational has some serious flaws, mainly:
- buying management’s “spin” that the recent share price decline was only caused by uncertainties about nuclear provisions
- assuming a quick and very benefitial (for E.ON) solution for nuclear liabilities
To me it looks like that he tries to come up with some short term, rather risky “bets” in order to make good on his horrible 2015 performance as quickly as possible.
As a new shareholder in Greenlight Re I have to seriously rethink if I want to stay invested, however as a German tax payer I might also be biased in this case.
A few days ago, Greenlight Capital sent out their Q4 2015 letter to investors , explaining their catastrophic performance for 2015.
The letter itself is clearly a “Must read” as Einhorn adresses all the issues very openly. He even manages to make some pretty good jokes such as the investment advise of his children:
“Dad, why don’t you just short your longs and long your shorts?”
After critizing Einhorn a couple of times (Consol Energy, Aercap, SunEdison, Go Ups, Delta Lloyd), I actually invested into his abilities via Greenlight Re. My case is that good asset managers often come back strongly after a bad year (or three) if they stick to their strategy.
First the good news:
A few days ago, Greenlight Re came out with an 8-K saying the following:
On January 19, 2016, Mr. Einhorn spoke at a private investor conference and provided certain information relating to the client accounts that Greenlight Capital, Inc. and its affiliates manage, including ours. To comply with Regulation FD, the following information is hereby provided:The managed account of GLRE, for the period from January 1, 2016 through January 19, 2016, reported an estimated investment loss of 1.6% net of fees and expenses. As at December 31, 2015 the account managed by DME Advisors on behalf of GLRE had net invested assets of $1.1 billion.
Yes, he lost money again, but with the S&P being down aroun -7,9% and the Russel 2000 being down -12,3%, this is actually a pretty good number.
But then: E.On – C’mon !!!
However my positive mood darkened when I actually read about his first new long position was (highlights are mine)
We established several new longs during the quarter: E.ON (Germany: EOAN) is one of Europe’s largest utilities, owning power and gas grids, and power generation from renewable, fossil and nuclear sources. In 2011, the German government outlawed nuclear generation, creating political and market uncertainty about funding for the retirement of nuclear facilities and the storage of nuclear waste. Concerns on both fronts intensified in 2015 leaving EOAN down 35% for the year. We believe that much of the confusion around the company’s earnings power and nuclear disposals should be cleared up this year, most likely through the creation of a national foundation.
EOAN, alongside the other nuclear operators, would contribute their disposal liabilities and financial assets into a foundation to be administered by the state, at arm’s-length, with no future recourse to the utilities. This will eliminate uncertainty and increase reported earnings, allowing the market to once again appreciate the strong underlying businesses of EOAN. In the meantime, the company has split into two – future E.ON retaining high quality grid and renewables assets as well as the German nuclear liability; the other company (Uniper) with generation and trading assets. EOAN will spin off a majority stake in Uniper to shareholders in the summer, highlighting attractive earnings on the remaining assets. We purchased EOAN at an average price of €8.92, or about 9x earnings, which appears to be cheap for a high quality utility sporting a 6% dividend yield. The shares ended the quarter at €8.93.
In contrast to Consol Energy and SunEdison, I consider E.On to be at least somewhere near my circle of competence as I have written about them several times over the last few years and have followed the stock and the company at least for 15 years.
E.ON coverage at Value and Opportunity
I looked at E.On already 3 years ago and decided not to buy, which was a good decision because the stock lost ~30% (including dividends) since then, although the stock looked cheap back then as well at 9xP/E and a 7,6% dividend yield.
I did not buy at that time because I identified the following issues:
- nuclear exit risks
- screwed up German energy market
- bad capital allocation (instead of investing into renewables they bought stakes in Brazil and Turkey)
- other potential disasters like their 300 bn “fossil fuel purchase commitments”
E.On was also my prime example how managers of large companies set themselves easy to achieve targets (like total EBITDA) with no connection to shareholder value and earning nice bonuses while the shareholders lose out. In this regard, E.On is clearly among the worst companies in Germany, showing that you can easily earn record bonuses and in parallel destroying shareholder value on grand scale.
Next were the liabilities including the nuclear liabilities which I consider materially underreserved. Finally, I looked at E.On 1 year ago when they first announced their “spin off” plan. I was sceptical back then that the original plan would work:
There could be some roadblocks on the way. The current German energy minister Gabriel seems to like the transaction (or doesn’ understand it) but there could be more resistance building up if people understand that the nuclear liabilities are dramatically under reserved.
Back to Einhorn’s E.On case/arguments:
In 2011, the German government outlawed nuclear generation, creating political and market uncertainty about funding for the retirement of nuclear facilities and the storage of nuclear waste.
Well, as a starter that is not the complete story. What actually happened is the following:
- Germany decided in 2000/2001 under Schroeder that they want to exit nuclear energy with a clear plan until when Nuclear energy has to be phased out over a ~20 year period
- 2010, after intensive lobbying form E.On,RWE &Co, the Merkel Gevernment extended the deadline by a further ~10 years on average
- 2011 after Fukushima then Merkel thought that it is maybe not such a good idea to run those old reactors and switched back (more or less) to the original plan with some additional direct close downs of really old reactors
So 2011 we basically had the same situation as one year ago with regard to provisions. One side remark: Over the first 10 years, the utilities were not yet able to come up with a solution where nuclear waste shall be finally deposited. In Germany, only intermediate deposits exist, ususally on the site of the reactor. This is important to keep in mind when we talk about costs later. In my opinion, the German utilities assumed that they will continue to mae easy profits with their old reactors and therefore missed out completely on the “renewable energy” bonanza in Germany.
Concerns on both fronts intensified in 2015 leaving EOAN down 35% for the year.
Uhm no, E.On was not down -35% because of those discussions. The major reason for the drop in 2015 however was an -8 bn EUR “impairment” in the “non-nuclear” segments in Q3 2015. Losing 4 EUR per share or 1/4 of your equity in a quarter is in my opinion the more likely explanation for the drop in 2015 than the Nuclear issue.
E.On is very cryptic about this 8 bn loss but I assume that most of it has to do with E.ON’s fixed price Nat gas contracts with the Russians. With sinking spot prics everywhere you are pretty much screwed if you negotiated 20-30 year contracts with the Russians at much higher fixed prices. As I have written, this is a 300 bn (yes three-hundred billion) EUR problem and it didn’t get better since then.
My personal take is that that E.ON’s management wants investors to believe that the Nuclear issue is the main reason for E.On’s problems and not the many bad decisions by E.On in the past (investing in Russia and Brazil instead of renewables, negotiating long term fixed contratcs with the Russians etc.).
Now to Einhorn’s key point:
We believe that much of the confusion around the company’s earnings power and nuclear disposals should be cleared up this year, most likely through the creation of a national foundation.
EOAN, alongside the other nuclear operators, would contribute their disposal liabilities and financial assets into a foundation to be administered by the state, at arm’s-length, with no future recourse to the utilities.
Now this is interesting. Yes, it is public knowledge that the German utilities want to get rid of their Nuclear liabilites. But I found it quite surprising that Einhorn assumes two things here:
- Timing: Something will happen in 2016
- ALL Nuclear liabilities will be taken over by the Governement
With regard to timing, I am very surprised because I found nothing in the German press which would indicate a solution in the near term. Clearly at federal level, the priorities are now very differerent with the big discussions about the refugees. Plus there are a couple of important elections on the state level in March and September this year where such a controversial issue could be used by the opposition to hurt the “big coalition” even more.
The recently formed “Atomkommission” has the task to come up with a proposal by February 2016 (see below). However this is also the timing for Merkel to report on what she plans to do about the refugee issue before the elections in March.
Personally, I highly doubt that something will be actually decided in February or this year. In 2017 then there are the general elections and I guess if it drags on until then, the chance is even lower to get a decision. If you have watched the current German Government, especially Ms. Merkel, their main strategy is not to make any fast decisions but to wait as long as they can until there is only one “inevitable” outcome. I would be very surprised if they would change their strategy now.
Now to the second part: Assuming ALL Nuclear liabilities will be transferred to the Government. As I had written before, in 2014 E.On first attempted to spin-off the Nuclear liabilities into the bad ship (Uniper).
Triggered by this attempt, the German Ministry of Economy then comissioned an official study on what to do with this and how to proceed. This study can be downloaded (in German, 150 pages) directly on the Minsitry’s web site and is most likely the basis for any decision that will be taken.
The study then led E.On to abandon the spin-off of the Nuclear liabilities into Uniper in September 2015 because Minister Gabriel threatened to change the laws in order to keep E.On “new” as liable entity.
After this failed attempt, E.On and RWE now with the help of Boston Consulting (BCG) tried to start the discussion to establish a “foundation” sponsored by the Governement similar to RAG which then would take over the liabilities. According to the WiWo article, the recipients of the “Atomkommission” were not amused. I guess because although being polititians they are not completely stupid. The article mentions also the “Swiss solution”, where in Switzerland the utilities could buy themselves out by transferring their liabilites plus 30% “top up” for future price risk.
It seems to be that the Atomkommision has to come up with a recommendation in February 2016. I found an interesting interview with one of the leaders here.
It is pretty clear at least to me that there will not be a complete transfer of all liabilities from utilities to the Government. In typical German fashion, I guess there will be a “compromise” solution.
This is also the solution which was favoured in the above mentioned study: There will be an external fund assuming some of the liabilities, most likely those for the final deposits but not for the more shorter term expenses for dismantling the reactors.
According to the report to the Ministry, reserves for final deposits at E.On are only ~5 bn EUR or 1/3 of the liabilities. I think this is actually the best case for the utilities that they maybe can bring those liabilities into a foundation with a 30% surcharge like in Switzerland.
The leader of the Atomkommission, Jürgen Trittin, the former Minister of Environment from the Green Party made it relatively clear in interview last year that a full non-recourse solution is not part of the possible outcomes. There are many other articles in the press that he is not exactly a big friend of German utilities and is not willing to accept the full liability from teh Government’s side. If I would need to bet on Trittin vs. Einhorn, I would prefer Trittin in this case…..
What amounts are we talking about at E.On ?
Let’s look at how E.on presents this issue:
What stands out is of course the discount rate they use (4,7%), the inflation rate and the argument that this is “adequat”.
As I have written before, the discount rate looks very high. Similar long term pension liabilities for instance have to be discounted with 2,25% p.a. Of course, inflation expectations are also lower for pension liabilities, normally around 1,5% or so.
So in theory now E.On can claim that the “real” discount rate is very similar.
This argument sounds clever but has one major logical error:
German pension plans actually are directly linked to CPI with a minimum of 1% increase. The nuclear liabilites however will be subject to the actual inflation of the actual costs to retire those facilties. If history is any guide and if you look at other large sacel constrution projects, cost inflation is always the main problem. So I think it is pretty fair to assume that the inflation assumption is for real.
However if we would for instance use the same assumtions for the discount rate as for pensions, we can easily calculate the “hole” in the reserves assuming a 15 year duration:
(4,7%-2,25%)*15*16,6 bn ~ 5,5 bn EUR
Depending at the actual cashflow profile, the value of the liability needs to be upward adjusted for the non-linear effect of lower rates which is called convexity.
Overall I guess we can assume that the real “arm’s length” value of the liabilities are at least 6 bn EUR higher.
The question is of course what is already implied in E.On’s stock price, but even if no transfer is implied, the “upside” is most likely + 2bn EUR as a maximum.
A short look at the “spin-off”
This is the proposed split between “new E.On” and the bad ship Uniper:
So clearly all the bad stuff goes into Uniper. As a side remark, it will be interesting to see how long Uniper survives and what the Russians will say to this….
However as I mentioned in my earlier post on the spin-off: It is not a real spin-off. E.On plans to keep a stake (less than 50%). Why ? Well, my guess is that they need the money from the sale of the rest at “E.On new”.
Of course this also makes the spin-off case a lot more risky than a clean cut: If Uniper shares fall very quickly, this could mean that E.On new has to get new capital from somewehere else.
We should also not forget, that the management who made all those mistakes in the past will stay at E.On new, so in my opinion there is little hope that E.On will change much in the future. I guess EBITDA will remain their main KPI because it is so easy to beat.
For me, Unier will be in big trouble very soon if the current environment (low energy prices persist. If, for some reason the spin-off wouldn’t work, E.On would be at risk either for a massive capital increase or worse…….
Obviously, EInhorn’s major new long position is more a short term event driven “special situation” investment than a long term value play.
Based on how he explains his investment; I do think there are major flaws in his case:
- The bad performance of E.On in the past is not driven by the nuclear issue as Einhorn claims, but caused by decade long bad capital allocation plus losses from Nat Gas purchase contracts due to low oil and gas market prices
- It is highly unrealistic that E.On will ever get fully releaved (non recourse) from their Nuclear libailities. The best case is more likely a fund for 1/3 of those liabilities. Also the timing (somthing being decided in 2016) looks optimistic
- Finally I do think there is still a lot of potential downside in the stock, among others they are relying on selling part of the “bad ship” for cash which might turn out very difficult
Overall, for me the E.On case is more a high risk gamble than a value investment. Yes, it can work out well short term but there is a big downside potential in my opinion and little “Margin of Safety”. Maybe he has much better research than I assume, but looking at his recent investments in his home market the US, I am somehow sceptical.
I don’t know if Einhorn feels pressured to come up with some quick wins in order to compensate for his -20% in 2015. As a Greenlight Re Investor, I am not happy with such a “bet” and need to rethink this seriously.
On a personal side, I need to acknowledge that I am maybe biased in that case. If E.On would be really successful, as a German Tax payer I would be suddenly liable for everything. So it could easily be that I maybe see don’t see this totally objective and my analyis is biased.
Funnily enough, just today BofA released a “research” report arguing similar to David Einhorn which boosted the share price almost +4%. Again, I am not sure how much of this is “wishful thinking”.
EON, RWE Rise; BofA Confident on Nuclear Liabilities SolutionBy Naomi Christie(Bloomberg) — BofA confident there will be a “pragmatic solution” to nuclear liabilities following meeting with policymakers in Berlin.
- EON +3.4%, RWE +3.7%; lead Stoxx 600 Utilities index
- German govt could offer to underwrite risk of changes in nuclear waste storage in return for insurance premium: BofA
- Nuclear operators could settle premium by ceding court cases
- German nuclear commission recommendation report expected at end of Feb.: BofA
Interestingly enough in this case, US based researchers/investors seem to be much more optimistic than local ones.