EUR 850.00 For Business Accounts Only

Morningstar | Backdrop Improvement Should Drive a Reduction of Engie's Valuation Discount to the Sector

Engie is one of the three largest diversified international European utilities, along with Enel and Iberdrola. CEO Isabelle Kocher, who was appointed in 2016, has completed a EUR 15 billion asset-rotation program that drove the reduction of commodity-exposed activities--notably E&P, LNG, and coal plants--to focus on regulated, renewables, and client-facing businesses. This strategy has a sound strategic rationale, as it reduces earnings volatility and reduces commodity-exposed activities that are typically not moaty with low returns on capital. Still, the disposal of E&P and LNG in 2017 was not ideally timed, given the strong rebound of oil & gas prices ever since.The share of contracted or regulated activities has increased from 70% in 2015 to 90% in 2017. Regulated gas distribution and transmission networks, mostly in France, account for 36% of the group’s EBITDA. Contracted assets comprise thermal power plants in emerging markets with purchased power agreements, or PPAs, securing returns on capital. The group also develops solar and wind plants, notably through bolt-on acquisitions. Engie has a sizeable exposure to emerging markets, which account for around 30% of EBITDA, mostly in Latin America. The bulk of Engie's emerging-markets activities are part of its listed subsidiaries. Remaining merchant energy exposure is mostly made of thermal power plants in Europe, Belgian nuclear plants, and French hydro assets. Nuclear and hydro provide exposure to rising European power prices, which will support the group's earnings growth through 2022 as unfavorable hedging rolls off. With a net debt/EBITDA ratio of 2.2 times, Engie has among the lowest leverage in the sector. Hence, all eyes are on future capital allocation. We expect management to address this at its investor day in early 2019. We also expect the group to provide medium-term financial targets, in line with Enel's and Iberdrola's practices. After the surprise dividend increase in 2018, we believe that strong free cash flow will enable a 6.5% annual dividend increase through 2022 by assuming a 70% payout ratio. In all, we view Engie shares suitable for income-seekers and value investors.