Further structural gas price downside; EDP onto Conviction Sell List
* Significant further downside to gas/power prices creates risks
We believe the recent decline in European gas prices (down 26% over the
past three months) is structural and likely to persist owing to an
oversupplied global gas market (see our Commodities team’s report
Overpowered: Too much fuel is competing for the same fleet of power
plants, February 15, 2016). We cut our gas price assumptions and see 18%
further potential downside to market prices. Lower gas prices have several
negative implications for European utilities, namely: (1) lower power
generation profits; (2) lower E&P earnings; and (3) losses in gas/LNG trading.
* EDP added to Conviction Sell List: Unsustainable dividend, balance
sheet and valuation, as well as political intervention risks
We believe the expiry of fixed-price power generation contracts in Portugal
in July 2017 will lead to lower (7% negative EBITDA impact) and more
volatile earnings for EDP. We expect high leverage (2016E net debt/EBITDA
of 4.7x, well above management’s target) to compound these risks and
undermine the stock’s premium valuation (EDP currently trades at a 30%
EV/EBITDA premium to our coverage over 2016-18E). We expect the likely
extension of the energy tax in Portugal beyond 2016 to highlight dividend
risks (we estimate a payout ratio above 100% from 2017).
* Fortum, Verbund and EDPR valuations stretched: Down to Sell
We downgrade Fortum and Verbund to Sell from Neutral as we see their
premium valuations as unjustified following large cuts in our estimates and
price targets as a result of lower power prices. We also downgrade EDPR to
Sell as we see headwinds to its growth outlook from lower energy
commodities prices and from the need to carry out potentially dilutive
disposals to help its parent company EDP’s stretched balance sheet.
* Value in Gas Natural and A2A: Up to Buy from Neutral
While Gas Natural and A2A are negatively affected by lower gas prices, their
recent underperformance leaves both stocks offering deep value in our view
and we upgrade them to Buy. We believe the current valuation discount for
Gas Natural is excessive as we expect the earnings decline from the gas
supply/liberalised electricity business in Spain to be offset by growth from
regulated activities. We expect A2A to generate FCF equal to 38% of market
cap over the next four years and see material catalysts (increased cost cutting,
higher dividends, M&A). We remove Hera and Acciona from the Conviction
List (both remain Buys) and upgrade to Neutral from Sell Enel, CEZ (both
post underperformance) and Terna (on limited sector-relative downside).