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Electricite de France SA (EDF); Initiating Coverage – 11 November 2014

 

Company Overview:

Electricite de France (EDF) is a Paris based electrical energy company, in which the French Government holds an 85% stake. The group’s core operations are centered around the production, marketing and distribution of electricity. EDF generates electricity using a range of technologies, but most notably; through nuclear and hydroelectric means.

While the group supplies both business and private customers across the globe, its core operations are in France, the United Kingdom and Italy. The group is one of the “big six” energy suppliers in the UK and has recently won the tender offer to construct the UK’s first new nuclear reactors for over 20 years  

Electricite de France is listed in Paris and the shares are denominated in Euros.

Exchange Paris Ticker EDF.PA Latest Close 22.93
52 Week High 29.90 52 Week Low 21.21 P/E (H) 10.6
Dividend Yield % 5.4 Dividend Cover 1.6 CEO: Henri Proglio
CFO: Thomas Piquemal Price Target (Euros) 20.00

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The Electricite de France (EDF) story

EDF is Europe’s largest producer of electricity, with its nuclear reactors providing upwards of 75% of French electricity, 20% of the UK’s requirement and a substantial portion of Italy’s domestic energy. The key to EDF’s scale and reach as a utility provider are its expertise in both nuclear power and renewable energy (Hydro).

France’s substantial investment in civil nuclear power since the OPEC oil crisis of the 1970’s has made it a leading authority in this area, and the world’s largest net exporter of electricity. EDF is responsible for all 59 of the nation’s nuclear reactors as well as the construction of new plants for future years.

In addition to this, the group has a strong presence in the hydroelectric energy and alternative renewable energy fields.

EDF is 85% owned by the French government and as a result, is often criticised by analysts for placing the interests of everyday French citizens above that of its shareholders.

Most notably, under pressure from all sides over the economy, public spending, jobs, wages and living standards; the French government recently backed out of a planned 5% increase in electricity tariffs that was due to go ahead in August.

Instead of the planned increase, the national tariff was raised by just 2.5% on 01 November. This and EU meddling in the deal for EDF to build new reactors at the Hinkley Point nuclear plant in the UK have been significant contributors to the weakness seen in EDF shares so far into 2014.

While uncertainty over the Hinkley Point deal denotes the presence of a greater political risk to the group, the public pressure upon government and consequent uncertainty over French tariffs highlights just how the group’s ownership structure can sometimes be a disadvantage to ordinary shareholders.

However, we argue that the current ownership structure also provides benefits for EDF shareholders as its monopolistic position is partially protected, while the group enjoys stable revenues and returns on capital as a result of the French government’s regulation of energy tariffs.

EDF also benefits from lower financing costs relative to many of its international peers, given the implied guarantee provided by majority state ownership.

While the French government’s stake in the group may mean that double digit earnings increases are few and far between, it also means that substantial competition driven decreases are also rare too.

In addition to this, EDF’s focus on both nuclear and hydroelectric power enables it to avoid the pressures of commoditised pricing, which is positive for earnings stability. It also means that 85% of the group’s output is carbon free, something which stands it in good stead for future years given the European Union’s increasing desire to reduce Co2 emissions on the continent.

Further from here, EDF is also well positioned to benefit from the substantial nuclear and renewable investment required in countries such as the UK & France in future years, if the lights are to stay on once into the next decade.

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Electricite de France shares beginning to show signs of life

Recent years have proved a torrid time for EDF shareholders as the financial crisis, the Fukushima nuclear disaster in Japan and meddling by the EU’s competition authorities created significant uncertainties for the group.

Each of these were key drivers of the decline in EDF shares from 87.64 euros per share in 2007, down to 13.87 euros at the close of 2012. Fortunately, the latter stages of 2012 and the opening of 2013 saw the shares begin to bottom, while in the subsequent year they outperformed the market several times over.   

Despite this turn in fortunes for the group, the present day is not without headwinds as significant uncertainties still remain; most notably those concerning future increases to French electricity tariffs and the Hinkley Point reactors in the UK.

EDF SA Share Price //  8 Hour Intervals

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UK’s Hinkley Point C contract offers significant upside to EDF earnings over the longer term

The most significant event for EDF SA at the present time and in the immediate future is likely to be the development of the Hinkley Point C power station which will contain two new nuclear reactors.

The project received conditional approval from the European Commission in early October, with the final go ahead subject to approval of waste transfer arrangements by the EC, as well as an investment agreement between EDF and the UK government.

EDF, under the terms of the EC’s conditional approval, will also need to agree to increase the fee payable to the UK government in order for it to provide certain financial guarantees to the group.

In detail, the new reactors will cost £16 billion to complete and are expected to take at least 8 years. In addition to adding significant value to the local economy in Somerset, they will also see EDF lock in a sale price of £92.50 per mwhr for the electricity generated for at least a 35 year period; a level which is double the current market price.  

This pricing agreement is expected to guarantee EDF a 10% rate of return upon the electricity generated, while the UK government is also set to provide a guarantee for any debt that the group issues on financial markets in order to fund the project, therefore reducing the risk of the development to EDF shareholders.

As a result, the project helps to underline our attraction to EDF as it offers scope for both top and bottom line growth at the group over the long term.

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UK energy investment requirement offers scope for further long term growth

In the late 90’s nuclear power provided close to 25% of the UK’s electricity. Today it is just 13%, with this figure set to fall further over the next 10 years as all but one of the 16 remaining reactors are shut down for decommissioning.

This follows two decades of underinvestment and uncertainty over the future of civil nuclear energy as concerns from disasters in the US, Ukraine and Japan have repeatedly unnerved the electorates of nuclear powered states.

However, with doubts remaining over whether or not renewable sources are up to the job of making up the likely shortfall in UK electricity onward from 2023, the government confirmed plans in 2014 to complete an additional 16 new reactors before 2030.

With the planning and political approval minefield for Hinkley Point C now navigated, and acceptable levels of state assistance now established; it could be said that the most difficult part of the process to secure the national energy supply in future years is done with, and that precedents have now been set for further nuclear development projects in the UK.

In this regard, it is worthy of note that EDF bought British Energy in 2009 for £12.5 billion, formerly the UK’s largest producer of electricity. The purchase saw EDF assume control of eight nuclear sites in Britain, all of which hold approved land that is suitable for the development of additional reactors.

These assets and the existing contract at Hinkley Point lead us to believe that in regard to future developments of UK nuclear reactors, EDF has an attractive position from which to further expand its nuclear presence in the UK.  

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French tariff increases likely to remain low over the medium term; dividend is a redeeming feature

The current political and economic climate will mean that there is little appetite to raise French energy costs substantially ahead of the next presidential election in 2017.

This is negative for EDF shareholders who have hopes that tariff rises could offer scope for any form of significant earnings growth.

Despite that, the November rise of 2.5% demonstrates that some increases are likely and as a result, tariffs should not remain completely flat during the coming years.

As a result, some form of earnings growth should be forthcoming, albeit in the low single digits. In this regard, we note that the French government maintains a policy to ensure that EDF is able to make a return above that of its capital and equity costs,

The net effect of this is that the group is able to support a steady and sustainable dividend which, at current prices, provides a yield of 5.4%.  

This forms one of our key attractions to the shares as ultra low interest rates and the potential for further loose monetary policy measures on the continent are also likely to increase the appeal of EDF to other income investors, as well as the wider market in general.

Furthermore, we believe that the current fiscal position of the French government works in favour of income investors. This is because with the European Commission pressuring French policy makers to reduce the nation’s budget deficit, it is unlikely that politicians in Paris will welcome either a static or reducing dividend at any point in the immediate future.

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Balance sheet, dividend and valuation

EDF SA enjoys one of the stronger balance sheets of the industry. This is as recent years have seen the group’s gearing reduced steadily, as stable earnings growth and a disciplined approach to reducing leverage & balance sheet restructuring pushed net debt/Ebitda down from 2.6X in 2012, to 2.1X at the close of 2013.

Current consensus projections suggest that this multiple also fell further over the course of the year to date, down to 1.9X.

On this note, EDF also took advantage of favourable market condition this year to raise just over 2 billion euros in both pounds and dollars by issuing the first ever 100 year corporate bonds. The group achieved a yield of 6.1% on the bonds and used the funds raised to restructure its debt profile, extending the average time till maturity of its existing loans to just over 13 years.

In relation to dividends, the shareholder payout was cut substantially following the financial crisis although since this time it has crept back up to 1.25 euros per share, which equates to a yield of 5.4% at current prices. The group maintains a policy to pay out 55% of earnings to shareholders over the longer term.

This means that some years the group may only pay out 50% of earnings, whereas in other years it may pay out 60%. The 55% payout allows for a good level of dividend cover at nearly 2X DPS.

On a valuation basis, the group currently trades on a multiple of just over 11 X 2015 projected earnings, which compares favourably to the sector average of 16.8X.

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Risks

While we are attracted to EDF as a long term play on both energy demand growth, as well as the desire of many nations to become energy independent; there are a number of risks facing the group in both the near-medium term, as well as the longer term.

In the short-medium term, energy tariffs in France could remain static for longer than currently anticipated. This could constrain near term earnings growth at the group therefore making the shares less attractive.

In addition to this, EDF may decide that it is not able to meet the more costly terms of the hinkley point agreement, which would be a negative event for the shares given the potential contribution to earnings of an increased energy position in the UK.

The European Commission, for a number of reasons, could also decide to make further stipulations that could again increase the cost of the project to EDF. This would also be a negative event for the shares.

Furthermore, shareholders are indirectly exposed to the financial position of the French government as it has previously committed to balancing its books through limited sales of state assets, which will likely include a partial EDF sell off. Any expectations of a large sale could weigh on the shares for some time, thus hindering further gains.  

Given its dominant position in France the group also runs the risk of incurring further scrutiny from European competition authorities in future years. A worst case scenario outcome here could see the group undergo either a forced break-up, or come onto the receiving end of further legislation which sees it bullied into selling more of its output on wholesale markets to competitors at trade prices.

Such moves could further constrain the group’s ability to grow earnings in what is already a challenging environment.

In addition to the above, it is also possible that given EDF’s own substantial investment requirement for future years, dividend growth may not be forthcoming at times. This could reduce the attraction of new or continued investment in the group, thus creating a further headwind for the shares.

While limited, there are risks to be found in the succession of current management. This is as CEO Henry Proglio is due to step down on 22 November, to be replaced by Thales CEO Jean Bernard-Levy.

The exact reason behind the move is unclear although, some have voiced concern that it could have resulted from President Francois Hollande’s 2012 pledge to reduce the nation’s dependence upon nuclear energy, in favour of a greater move toward renewable sources such a hydro-power.

Although EDF already holds a strong position in hydroelectric, and invests heavily into alternative renewable R&D; a marked shift away from nuclear power could create further uncertainty for the shares.

Further from here, and more in relation to the longer term; blowback from the Fukushima nuclear disaster in Japan has left many governments, in both Europe and elsewhere, reluctant to further develop their civil nuclear capability. It has also led some to make commitments to phase out nuclear energy altogether over the coming years.

Although this is highly unlikely to signal the beginning of the end for nuclear energy, public concerns over safety could lead to slower development of energy infrastructure in some states over the coming years. This would be a negative outcome for both the countries in question as well as for companies such as EDF.

All in all, and despite the positive investment case for EDF shares over the longer term, we feel the risks associated with them are above average. This is given the heavily regulated nature of the group’s core businesses and political risks surrounding competition issues as well as the subject of nuclear power.

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Summary

Overall, we like Electricite de France over the longer term for its attractive and sustainable dividend, as well as the growth potential offered by the need for substantial investment into energy infrastructure across the UK.

EDF’s strong position in both hydroelectric & nuclear power, as well as its existing nuclear infrastructure in the UK, place it well to exploit the trend of underinvestment which has prevailed in Britain over the last twenty years.

An increasing focus of governments upon reducing Co2 emissions, combined with the difficulties inherent in implementing new renewable energy projects, also adds to our belief that EDF will benefit from such an investment requirement.

This is as nuclear power is carbon free and new projects in the UK are able to be built upon sites which already contain existing reactors, thus avoiding the lengthy process of consultation and planning with locals.

As a result, we believe that nuclear projects will be preferred to substantial wind, solar and hydro projects in the UK. This will again, be likely to benefit EDF.

While investment in EDF shares is not without risks throughout the near, medium and long term; we believe that the dividend, stable earnings and the oversight of the French state are sufficient enough to offset these.

In relation to price targets, EDF shares have weakened throughout 2014 following a rapid recovery during the twelve months previous. With the investors still smarting from the reduction to French energy tariffs, and a small number of uncertainties remaining over the proposed reactor development at Hinkley Point in the UK, we see no immediate catalyst for a reversal in the shares.

On the contrary, we feel that the current weakness has further to run given the implications for energy demand of a long summer and what has so far been, a mild winter.

For this reason, while we remain convinced that EDF shares offer scope for outperformance over the longer term, our initial price target for the shares implies a further leg downwards from the current level (23.00), to 20.00 euros per share.

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