2023-03-15 04:56:13 ET
Summary
- Fortum is a major European utility that has been dragged through the mud in 2022 as a result of the Russian Invasion.
- Their biggest problem has been resolved as Germany nationalized Uniper, but with 20% of their assets in Russia, the valuation is still stretched.
- Russian assets are currently valued at a P/E of 4.5x which is way too high.
- I present my thesis for the company and why I am not buying yet.
Dear readers/followers,
Following several articles on well-known utilities with heavy renewable exposure, today I want to present my analysis of a Scandinavian-based utility Fortum Oyj ( OTCPK:FOJCF ) that is somewhat undercover here on Seeking Alpha.
Note: As always the article will be based on the native EUR-denominated ticker FORTUM which trades on the Helsinki exchange in Finland. There is also an ADR available under the ticker FOJCY. Do your own research on tax implications.
Key Challenges for Fortum
Fortum has been dragged through the mud in 2022 with the share price dropping by 65% during the year. Let's first revisit the three main issues that caused this massive drop before we look at the business in more detail to see if an investment is viable at this time.
Russian exposure
In early 2000s the company made the strategic decision to expand into Russia and by 2022 about 20% of Fortum's assets were located in Russia. Obviously, when Russia invaded Ukrainian in early 2022 this became a major problem. Management has decided to dispose of all of their Russian assets, and has already recorder pre-tax impairments of EUR1.7 Billion in relation to these assets.
So far there has been little progress made on the disposal and management indicated in their Q4 2022 earnings call that the disposal will take a lot longer mainly due to the uncertainties related to regulatory approvals. Because of the decision to exit from Russia and because the company doesn't have access to the earnings and funds generated in Russia especially in relation to dividend distribution, all operating results below are reported excluding the Russian operation.
Effectively, given the uncertainties, we're going to assume that the Russian assets are written down to zero in our analysis going forward. If a disposal goes through and generates some cash that would be considered as additional upside.
Uniper
In late 2010s the company made another poor strategic decision. This time to allocate the large amounts of cash it received from the sale of their electrical grids in the Nordics into Uniper. The problem here also started with the Russian invasion. Simply put, Uniper's main division is in gas trading. This means that it buys natural gas in bulk (from Russia) and resells it at a slight premium (in Germany).
Normally this is not risky at all as the company has long term contracts to buy and sell the commodity and keeps the spread. However, when Russia stopped honoring their contract and stopped supplying natural gas, Uniper was in trouble. They basically had no choice but to buy gas at a very high price on the open market only to then resell it at a loss at the lower pre-agreed price to customers. This resulted in a massive EUR40 Billion loss until October 1, 2022 which is when the German government allowed the company to move most of the cost to end customers.
In the fall of 2022, the German state also entered into discussions with Fortum to nationalize Uniper. As of today the transaction has already been completed as Fortum sold Uniper to the German State for a fraction of the initial investment, recording an almost EUR6 Billion loss related to the divestment. But frankly things could have been a lot worse. Fortum received EUR500 Million for their shares of Uniper and the EUR4 Billion loan which Fortum issued to Uniper has been repaid in full in addition to the EUR4 Billion mother company guarantee being released. This allowed the company to deleverage its balance sheet significantly which will be important going forward.
Windfall tax
Finally, a third issue that the company faces is an extraordinary windfall tax that the Finnish government passed recently. Compared to the prior two risks, this one is minor and quite predictable, but still worth covering. In particular there should be an additional 30% tax on 2023 earnings, payable in early 2024. Initially the Finish government wanted to raise up to EUR1 Billion through this tax (from all companies, not just Fortum), but over time the Ministry of Finance lowered their target to now EUR 0.3-0.4 Billion. In their earnings call, management stated that they expect the impact of this to be around a 1.5 percentage point increase in effective income tax, which is quite minor.
Portfolio
So now that we have the main issues out of the way, let's have a look at their portfolio. Fortum is a major European power company with 9 GW of installed capacity located mainly in Sweden and Finland. In 2022 they generated 44 TWh of power and 5.3 TWh of heat. This makes them a top 10 largest green energy producer in Europe (notice Enel and Iberdrola in the chart below, both of which I've covered in my recent articles). They are also a major player in the highly fragmented Nordic market - in particular they are the 3rd biggest energy producers and the number one provider of electricity to retail customers. Excluding Russian operations, their energy is almost exclusively clean with 53% of power generated by Nuclear, 43% by Hydro and only 3% by Coal.
The company is well positioned to grow domestically thanks to electrification and decarbonization as well as internationally thanks to the growing interconnectivity between the Nordics and the rest of Europe. This is mostly driven by the fact that the Nordics have the cheapest and cleanest energy in Europe which makes a great export commodity. New interconnections are expected to increase the Nordic export capacity by 3 GW in the next three years to 13 GW.
Financials
In 2022 continuing operations EBITDA (excl. Russia and Uniper) increased by 25% to EUR 2 Billion, driven primarily by a 40% YoY increase in energy prices. Continuing operations earnings per share reached EUR 1.21 (up 26% YoY). If we take the whole group, including the negative one-offs of Russia and Uniper, earnings per share were negative at EUR (2.72). Management did not provide any guidance on future earnings, because energy prices are inherently volatile, but with 75% of 2023 energy production fixed at EUR 58 per MWh (on par with 2022 prices), the visibility is quite good and I expect earnings to be roughly flat.
Fortum has a BBB-rated balance sheet with EUR6.5 Billion in debt and management has stated that keeping this rating is their top priority. In February, they repaid a significant portion of bonds due in 2023 (from proceeds received as repayment of their loan to Uniper) and have an option to extend their EUR1.6 Billion loan by an extra year to 2024. As such they will still have relatively large maturities of EUR1.5-2 Billion in 2023 and 2024, but with EUR2.5 Billion in cash and EUR7.2 Billion in undrawn credit facilities the company should have enough liquidity to cover this. Their average interest rate including hedging stands at 3.7%.
The dividend has been slashed as a result of discontinuing some operations from EUR 1.14 per share to EUR 0.91 per share going forward. Still at the current price of EUR 14.50 this represents a solid dividend yield 6.3% , that's reasonably well covered by earnings of EUR1.21 per share. This is in line with the company's payout guideline of 60-90% of EPS. I don't expect the dividend to grow much going forward, unless the company can miraculously sell their Russian assets.
Valuation
If we exclude Russian operations all together, the company is actually in a pretty decent shape. The Uniper transaction has been finalized and the one-off impact of 2023 windfall tax won't be that significant. As such Fortum currently trades at a P/E of 12x. That's above most of the peers. I think a fair multiple for the sector right now is 10x which implies that Fortum is still about 20% overvalued here.
Company | P/E |
Enel | 9.0x |
Iberdrola | 16.0x |
Engie | 9.6x |
E.ON | 10.5x |
RWE | 9.4x |
Of course that's saying that the Russian operations are worth zero, in reality they generate additional EPS of EUR0.53 per share so if one was to include 50% of this in the calculation, we would get the company as a whole at a P/E of 10x which would be fair.
Another way of looking at this is to value the non-Russian operations at a fair multiple of 10x which would give a fair share price of EUR12.10. The difference to the current market price of EUR 14.50 per share then implies that the market is valuing the Russian operations at a P/E of roughly 4.5x. That's still way too high for me as I strongly believe that the business should be written down to zero and any proceeds from the exit should be considered as additional upside and not relied upon to make the valuation work.
Given the uncertainties, Fortum is a " HOLD " for me here at EUR 14.50 per share. I will revisit this if management makes significant progress on the Russia exit or if the stock price drops by 20% or so. Until then I see safer alternatives in the market with better total return potential, namely my favorites in European utilities - Enel ( article here ) and Iberdrola ( article here ).
For further details see:
Fortum Oyj: Russian Assets Still Overvalued At 4.5x Earnings