As the quarterly reporting season draws to a close, around two-thirds of the S&P 500 has either met, or beaten, targets. However, much of that outperformance has been due to companies pushing through price hikes, rather than stronger sales volumes. That means disposable incomes are being squeezed, putting pressure on the ailing consumer. That’s why it is time to load up on cheap defensives whose revenues are more resilient in a downturn.
1. E.ON AG (Xetra: EOAN), rated a BUY by Raymond James
E.ON is one of the world’s largest utilities, operating in North America, Russia, Germany and throughout Europe. The firm not only owns coal, nuclear and gas-fired power stations, but is also a leader in renewables, investing heavily in solar, biomass, hydro and wind.
Here, despite reductions in government subsidies, profits are soaring. In the first quarter its renewables division (13% of profits) delivered earnings before interest, tax, depreciation and amortisation (EBITDA), up by 28%, of €396m. That was on a significant increase in capacity, along with higher hydro feed-in-tariffs and carbon credits. Yet this is just a drop in the ocean. In 2010 the firm invested €1bn in green technologies, and is ploughing in another €2.6bn by 2013. It already operates 84 wind farms globally and recently broke ground on its landmark London Array offshore venture. Once fully constructed, this project should generate 1,000MW of electricity, making it the world’s largest facility.
So why have the shares fared badly of late? Well, the biggest threat facing the group and its peers is that the industry is being held hostage to the politicians. After the Fukushima disaster in Japan, the German chancellor, Angela Merkel, made an about-turn in her pro-nuclear stance by idling seven of Germany’s 17 reactors for a three-month safety check. This temporary shutdown will whack E.ON’s profits by at least €250m, even assuming its two affected plants are brought back on stream in July. Worse, there are rumours the government may backtrack on its decision to extend the useful lives of the facilities by a further ten years.
However, this seems far too pessimistic and explains the rock-bottom valuation.To me the three-month review was just a political stunt to garner votes ahead of important regional elections. And once the public’s fears die down, the status quo will be restored; 25% of Germany’s electricity comes from nuclear power. If everything were prematurely mothballed in 2020, it would blow a massive hole in the country’s aim of achieving energy security.
In terms of the figures, the City is predicting 2011 revenues, underlying earnings per share (EPS) and the dividend to be €87.4bn, €1.87 and €1.30 respectively. That puts the shares on a frugal price/earnings (p/e) ratio of 10.8 alongside a generous 6.4% yield. Better still, future profits should accelerate – current performance is being artificially depressed by a legacy contract with Russian outfit Gazprom, forcing it to buy gas above market rates. This agreement is in the process of being renegotiated.
I would rate the firm on a 2011 EBITDA multiple of 7.5. Adjusting for €18.5bn of non-interest-bearing liabilities and pro forma net debt of €13bn, that delivers an intrinsic worth of roughly €27 per share. First-half results are scheduled for 10 August, and financial adviser Raymond James has a price target of €28.
Recommendation: BUY at €20.36
2. Centrica (LSE: CNA), rated a BUY by Investec
Centrica’s British Gas unit is often wrongly blamed for hiking prices at the expense of its 16 million customers. In fact, many of the rises are sanctioned by the industry’s watchdog. Ofgem has warned that the UK faces power blackouts as early as 2015 unless urgent investments are made in dilapidated infrastructure.
What’s more, at this month’s trading update Centrica pointed out that it “is currently the cheapest supplier of electricity at average consumption of any major supplier in every region of Great Britain”. And it is adding to its already impressive market share in domestic gas (42%) and electricity (25%). Centrica is not just a UK supplier of power (50% of profits) – it owns oil/gas and electricity generation assets (32%), along with storage facilities (8%) and a North American division (10%). This matters because, by having a presence in all parts of the supply chain, it can remove a great deal of the inherent volatility in its energy markets.
Its biggest production source comes from the mature Morecambe Bay field, which supplies about 6% of Britain’s gas needs. And although output is set to gradually tail off, it should remain an important resource for much of the next decade.
Elsewhere, Centrica also owns a 20% stake in British Energy, giving it exposure to both the next generation of atomic power stations and an expanding low-carbon business. Additionally, over the past year it has beefed up its upstream assets by shelling out £1.3m for Venture Oil, £144m to double its stake in Norway’s Stratfjord field and stumped up a further £259m to beef up its gas interests in Canada.
Altogether, this equates to 434 million barrels of oil equivalent (mboe) in proven reserves, and represents over eight years output. As for gas, these assets supply the group with a third of its North American and UK requirements. The remainder typically comes from long-term contracts. An example is February’s £2bn deal to buy liquefied natural gas (LNG) from Qatar for the next three years. That should provide enough fuel for 10% of the nation’s residential demand.
Like E.ON, however, Centrica is also at the mercy of political show-boating. In March the government slapped another 12% tax on North Sea production, which will hit profits this year. But I am forecasting 2011 turnover and underlying earnings per share of £21.5bn and 25.5p respectively, rising to £22.5bn and 28p a year later. As such the shares trade on undemanding p/e ratios of less than 13 and offer a hefty 4.5% dividend yield. Net debt is a comfortable £3.3bn. I would value the group on a 2012 earnings multiple of 14, which suggests a fair value of about 390p per share.
A further bonus is City chatter that the Qataris may be interested in Centrica, with whispers of a 450p price-tag. This may be wide of the mark, yet a tie up could make strategic sense. Adding Qatar’s vast gas reserves and LNG-export capability to Centrica’s huge customer base would improve profitability. Investec has a target price of 424p.
Recommendation: BUY at 318p