Some companies’ stock values have fallen but not their earnings – buy them (1)

I always remember a Warren Buffet interview where he commented on his Wells Fargo (US bank) holding throughout the financial crisis. To him, it made perfect sense to keep adding to the position as while the stock price fell, the earnings generation was stable. He made the point that the perception of the value of the company had changed (due to external factors) but not the actual cash generation.

Therefore today, I think one should look at those beaten down sectors where stock prices may have collapsed and where value can be found.

First, one must remember that stocks are lowly valued for good reasons. However, in the downtrend, we can go to stupid extremes. 

I am looking currently at the European utility sector for such a call. This sector is back in relative terms to the levels of 2002. The bull market between 2003 and 2008 has been completely erased.

There have been good reasons: over investments, subsidies to renewables, falling demand, regulation changes to name a few. 

EDF (EDF FP) is a stock I knew well, having traded in and out in the past. At its peak, stock analysts gave it at €120 per share price target. Today, it is struggling to go above €14 and it is nearly €20 below its €33 IPO price. One of Peter Lynch’s key investment tips was to buy IPOs of public companies. This would have cost you dear if you held the stock until then.

Today, EDF’s market cap is a mere €25bn. 

Market value vs. replacement cost

EDF has around 135GW of capacity, of which 75GW is nuclear.

The new Flamanville nuclear reactor will have a power of 1.5GW and will cost €8bn to build. Arguably, the overrun is probably due to the French government forcing the Areva design onto EDF (a few press articles in the French press hint at that precisely).

EDF claim they can probably build something less powerful (say 1GW) for €4bn. Let’s assume that 1GW costs €4bn thereafter.

The average age of the nuclear fleet is 26years for a service life of at least 40, if not 60. Let’s assume a service life of 40years here. Assuming a 40 year depreciation schedule, at current construction costs, this fleet of 75GW is worth €300bn at today’s costs.

Adding the depreciation, this asset base is still worth €105bn.

Let’s not forget the decommissioning provision, estimated around €1bn per reactor by the European commission. Since EDF has 58 reactors, with a 26y average life, there is still €20.3bn of provisions to substract.

In total, we reach a value near €85bn having been cautious on estimates.

This is just for the nuclear side, 55% of the overall capacity!

In the balance sheet, non-current assets are reported above €160bn!

Earnings power

The replacement value of the asset base is much higher than the current share price. But what about the earnings power?

Ebitda generation has disappointed since the IPO but growing feebly. But it has remained globally positive.

I saw negative analysts still looking at a floor for EPS around €2 per share. This implies a PE of 7x on the worst of the regulation, power price outlook, etc.

The dividend history has not been fabulous but there seems to be a floor at €1.1, a 8% yield.  

Valuation

EV/Ebitda is around 4x, suggesting that the Ebitda is not sustainable.

A PE ratio of 7x while the dividend yield is 8% also suggests a dividend cut.

I would think the French state cannot cut its dividend supply but even if the yield was cut in half, this would still yield some support.

The ratio of the market cap to the replacement cost of the asset base is at least 5x.

This is a great margin of safety to me.

Newsflow

It has been dire and still looks unfavourable.

When I look at analysts forecasts, they seem to factor in no rise in earnings until 2016. But no fall either.

Despite the negative news, EDF can maintain its earnings over the forecast period, which means that a bit of optimism could bring upgrades.

Catalysts to unlock the value

This is the hardest point. No big hope on cost-cutting in France of the French gvt not interfering.

It has to come from several directions:

-          EDF cutting its capex programme so its net debt starts to fall rather than stabilise

-          Power prices recovering somewhat or expectations of that phenomenon in Europe

-          New energy policy

-          End to subsidies on renewables which should raise somewhat margins and lower costs

-          Higher allowed returns for regulated assets

-          Etc.

Conclusion

Overall, I think over 5 years, there is little capital risk in EDF if you accept some volatility.

In the worst case scenario, the dividend should pay back more than 40% of the investment.

I would set a price target of 13x the expected earnings to reflect the earnings stability over time. This is 100% upside is a largecap, which is becoming rare.

There is value and once the catalysts occur, the stock appreciation should surprise more than one observer.