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Summary Engie’s share price has under-performed EDF despite its much stronger positioning in terms of strategy and financials. EDF is exposed to materially higher political risk than Engie and the Areva deal is does not mean an end to it. There is now increased execution risk for EDF, while recent short term headwinds should reverse for Engie. EDF (OTC: ECIFF ) and Engie (OTCPK: GDFZY ) are both major French energy companies with global operations. A short EDF / long Engie trade is based on political risk, balance sheet strength, growth prospects and corporate strategy. Some key points are: chosen (Engie) vs. forced acquisitions ; commodities exposure with reasonable hedge (Engie) vs. capped tariffs ; balance sheet strength (Engie) vs financial strain ; earnings growth (Engie) vs. flat earnings . EDF has outperformed Engie by 300bps year to date, even when including the period during which one of the arguably worst news flow for EDF has come into the market. Engie’s under-performance is largely due to commodity weakness. I expect relative performance to revert strongly. Key catalysts Potential catalysts for a reversal of performance are plentiful: · Any indication of a turn in commodities prices. Failing that, improvement in the LNG to oil spread would have the same result, even though it will take longer to feed into the share price. · News flow on a re-start of the Belgian nuclear reactors Tihange and Doel should remove an overhang for Engie and lead to out-performance. · Over the summer, there will be abundant news flow and uncertainty with regards to EDF’s regulated retail tariffs. · EDF will soon give an update on its investment decision with regards to the nuclear new build project at Hinkley Point in the UK. There is a high chance for a negative reaction either way: Either, EDF will proceed – then there may be concerns over financing, the company’s ability to source enough partners and long term cash generation and profitability of the project. Or, it does not go ahead. That would lead to a very negative reaction on the loss of a long term opportunity. Another possibility still, would be further delay, again likely to lead to EDF underperforming. · Engie management has communicated it is in acquisition mode. Judging by the company’s track record, a growth acquisition would likely lead to outperformance. EDF EDF is the dominant French power utility. It controls the country’s nuclear power plant base of 63 GW and has an 85% supply market share. It also runs 9GW of nuclear capacity in the UK and is engaged in the UK’s nuclear new build programme, by far the largest in Europe. In France, there is limited competition, with the most important competitors being Energie Direct (an independent supplier with very little vertical integration) and Engie (a global integrated energy company and the dominant national gas supplier). The French government owns 85% of EDF. Key bear points: · Political intervention. There is consistent intervention by the French government into electricity markets, regulation as well as the company’s strategy. The CEO is government appointed. The company is seen as a public good as well as political vehicle by the government. It is questionable to what degree minority shareholders are relevant for the crucial decisions by the government. This has been illustrated very strongly by the government orchestrated acquisition of Areva’s (OTCPK: ARVCY ) nuclear reactor business by EDF. The French government has decided, not surprisingly, to execute its plan A, EDF acquiring Areva’s entire nuclear reactor business. EDF’s offer stands at Eur 2.7bn, or 0.74x book. EDF will acquire a majority and Areva retain a minority stake in the business. The potential for the business to be structured in a joint venture, but with the same majority EDF/minority shareholding structure. Areva itself will become a front end and nuclear fuels company. The take out multiple is expensive for a business with large unknown liabilities. The most important liability is the Finnish project, but there are others, too. As I have previously argued, reactor construction and export is outside of EDF’s core competencies. EDF will further strain its balance sheet. In addition to the straight outlay for the deal, it will have to take on provisions. The benefit for EDF, streamlining of its own reactor build and maintenance will be marginal when compared to the risk and financial strain. · A very large part of the company’s revenues are conditioned on government regulated tariffs that are not reflective of EDF’s true cost base. There is little prospect for tariffs reaching a level that reflects costs any time soon. Rather, the prospect for any significant tariff increase has been pushed away further than ever. EDF is currently asking the government for a 2.5% increase to regulated tariffs over three years. It is the time of the year where the negotiations for the annual tariff increase begin, to be confirmed in August. This increase is particularly sensitive, because it comes after the Energy Minister froze tariffs, and now because of the Areva deal. There are suggestions that a stronger tariff increase might be a reward for EDF’s offer for Areva’s reactor business. The government will tread very carefully, in order to avoid any negative interpretation on the Areva re-capitalisation vs consumer vs taxpayer interests. Also, the new formula fixed by the government gives some framework for tariff increases. The government had just devised that formula last year, in order to reduce tariffs, and asked EDF to reduce costs. A u-turn would be difficult. Investors should keep in mind that nuclear energy is seen as a public good, the profits of which are not due alone to EDF shareholders. That opens the way for redistribution · EDF is very strained on capex and the balance sheet. Net debt exceeds 4.4x Ebitda. EDF needs to finance over Eur 60bn capex over the next five years, out of annual operating cash flow of Eur 12bn. The company has reported negative free cash flow before dividends for 2014. All of that is before the significant impact of nuclear new build capex yet to come. The company is engaged in the very sizeable nuclear new build programme in the UK. · The French government has just approved a bill that foresees the reduction of nuclear in the country’s power mix from 75% to 50%. That will likely mean early closures of EDF plant, even if only over a longer term horizon. Engie (GSZFP) Engie is a global integrated energy company. It is dominant in the French gas downstream market. It has a globally diversified portfolio of power generation assets and is one of the largest global LNG operators. The company owns a large energy services business. Key bull points: · The recent share price under-performance reflects pressure on global LNG margins as a result of weak pricing. That is now a consensus view. Meanwhile, Engie benefits from an LNG/oil price hedge that shelters its margins to a degree. Despite short term commodity headwinds, the company’s vertical integration gives it a very good hedge and margin protection. Its positioning across the energy value chain is second to none. · The company has the best positioned power generation portfolio in Europe, if not globally. It is the largest global IPP with a well-diversified portfolio. Its generation business is amongst the most profitable in the European sector. It benefits from the growth trend in renewables through well diversified assets. It globally has over 10GW of power generation assets of various kinds under construction. It proactively captures the renewables trend with a deep and diversified pipeline across the mature technologies. · Engie is largely deprived of political risk, contrary to EDF. Its regulated gas tariffs are governed by a transparent formula and are not high up on the current political agenda. It comes from a background as a fully private company and has never seen the same kind of intervention as EDF has. Even though there is now a state participation of 30% that is unlikely to change. The state has been almost completely hands off. There was no suggestion of Engie having to participate in the Areva restructuring, for example. · Engie’s balance sheet is amongst the strongest in the sector. Net debt stands at 2.4x Ebitda. Capex of Eur 6bn is well covered by operational cash flow of Eur 8bn. Along with portfolio rotation, the company will have Eur 6-7bn of growth capex pa available. Given its very strong asset base, opportunities with synergies and/or acquisitions with a fast impact are plentiful. · Engie’s energy services business captures the most important new growth trends in the energy sector: Energy efficiency, new capacity build and optimisation. The company’s market leadership is getting built out further and gains further speed. As an additional benefit, the business is characterised by high and stable margins, which compensates for current volatility in the commodity exposed businesses. EDF trades on a P/E of 9.6x, Engie on 13.7x 2016E. Engie’s P/E is in line with the sector, whereas I believe it merits a premium. Further, the difference reflects stronger earnings growth: Engie’s EPS are likely to growth 6% pa compound 2015-17, whereas EDF’s are flat over the same period. EDF has historically traded on a discount to the sector. Engie trades on a 2016E EV/Ebitda of 16.2x, EDF on. Engie’s 5.7% yield is much better underpinned than that of EDF of 5.8%. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks. Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.