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By Jeremy Glaser | 03-21-2011 04:13 PM

German Utilities Oversold on Nuclear Fears

Concerns that Germany will permanently ban nuclear power have created two very attractive short-term dividend yield plays with a lot of long-term potential, according to Morningstar's Travis Miller.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. How will the European utilities ride out the nuclear disaster in Japan?

I am here with Travis Miller; he is the associate director of utilities for Morningstar, to take a look.

Travis, thanks for joining me.

Travis Miller: Thanks, Jeremy.

Glaser: What utilities have you been focused in the wake of the disaster?

Miller: Right now we are looking primarily at Germany. There has been a lot of debate around the future of nuclear in Germany. The governments there, successive numbers of governments there, have been anti-nuclear and the current government just enacted a much-debated extension for the lives of the nuclear plants there. It's very contentious, and there is still a large contingent of people who want to shut down the nuclear plants in Germany. However, the country gets about 20% of its power from nuclear. And the big leading nuclear operators such E.ON and RWE are taking the brunt of that popular movement against nuclear.

Glaser: Now do you think this is something that's going to succeed or will these reactors be allowed to keep operating even with heightened awareness of some of the risks?

Miller: The government came out recently, struck a deal with the nuclear operators in Germany that they could extend the lives of their plants by about 12 years on average. So for E.ON and RWE that was big win. The flip side of that is that nuclear operators now have to pay a substantial tax on the fuel that they buy for those plants and contribute to renewable energy and energy efficiency funds.

So, if you look at the impact from the tax, we think it takes anywhere from 15% to 20% off of E.ON's profits and 10 or so percent off of RWE's profits. So, these nuclear plants that are so low cost and so profitable before the tax now don't look quite as profitable, and the valuations for the companies, therefore, don't look quite as attractive.

Glaser: At the end of this 12-year period, though, are these plants most likely going to be shut down? How are these utilities going to cope with the loss of these assets?

Miller: We think the government will eventually decide that nuclear is still a good cost-benefit trade-off. It is the cheapest source of power right now. With coal plants facing a lot of environmental scrutiny, especially in Germany, the nuclear operators become the lowest cost option by far, if you are looking at natural gas generation or even renewable generation as an alternative.

So, we think that eventually the companies that own nuclear plants and the government will strike another deal that will prolong nuclear as a key source of power generation. Thus, when we are looking at our valuations for these nuclear operators, like E.ON and RWE, we think that the long-term outlook is much more positive than the market--which we think might be discounting the plants closing down in as soon as 12 years.

Glaser: So do those stocks look undervalued to you now, then?

Miller: Absolutely. And we think RWE is worth about 70 euro per share; we think E.ON is worth about 30 euro per share. We think the stock is trading at a 50% discount to our fair value estimates right now, and a lot of that is due to this uncertainty around nuclear. We think that, yes, even though the tax will take a significant amount of value out of the companies, that the long-term value of their assets, and even their assets outside of Germany across Europe, are still very valuable, and the market is not recognizing that.

Glaser: And you are still getting your margin of safety there with that 50% discount?

Miller: Absolutely. There is a wide margin of safety. You get the potential for any kind of inflation or energy price increases to benefit the stock, the companies. You could see as much as a 50% uptick in earnings over the next five years if you get a rebound in coal, gas, and power prices. You also, right now on E.ON, you get a 7% yield and a similar yield on RWE. So, this is a very attractive short-term dividend yield play, with a lot of long-term option upside.

Glaser: Travis, thanks for talking with me today.

Miller: Sure. Thanks, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.


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