Electricite de France (EDF) faces challenges and changes in Europe, especially in France following Francois Hollande's election to the presidency and increasing Socialist Party clout. EDF's French businesses constitute 60%-70% of earnings before interest, taxes, depreciation, and amortization, so political turnover could have a significant impact. Structural changes in France's heavily regulated electricity generation market--where EDF retains an effective monopoly--have been in the pipeline for years. EDF's huge nuclear fleet could require tens of billions of euros of investment, which may not be fully recovered. During his campaign, Hollande made anti-nuclear comments and threatened plant closures. EDF also could lose ownership of its hydro resources. In short, EDF's primary cash flow drivers could undergo radical change during the next three to five years--or not.
We think the uncertainty is reflected in EDF's flagging share price, trading at a 25% discount to our fair value estimate and at a discount to many of its European utility peers with a 5.5 times forward enterprise value/EBITDA multiple and 8.5 times forward P/E. We recognize the potential for a paradigm shift in the company's business model, but ultimately we believe EDF will retain ownership of France's nuclear fleet and much of its hydro fleet. These low-cost generation assets are the backbone of the company's narrow economic moat. Stormy seas in Europe may persist, and EDF's fundamentals could weaken in the near term, given its concentrated exposure relative to some of its peers. But we think EDF will continue to generate some of the strongest returns on invested capital in its peer group during the next five years.
Will France's Electricity Market Ever Be Liberalized?
Many members of the European Union have made great strides dismantling their national utilities' monopolies in response to EU liberalization initiatives, but France remains a stubborn holdout. Even though grid operator RTE is mostly independent, EDF controls almost all power generation, infrastructure, and retail supply market share. To a lesser extent, GDF Suez (GSZ) enjoys a similar monopoly with natural gas. On the generation side, EDF has had to make small concessions in recent years, like selling a fixed portion of nuclear output to rivals at a fixed price, and the previous government had begun the process of creating a staggered auction of hydro concessions within France. As it stands, however, EDF's generation business is effectively a hybrid that's not fully rate-regulated but not market-based, either.
This is where things have begun to get interesting. The Sarkozy government's NOME law was intended to pave the way toward eliminating regulated customer tariffs and introducing a "market" price that reflected EDF's operating and maintenance costs. The current ARENH price--at which EDF must make nuclear generation available to competitors--is EUR 42 per megawatt-hour for 2012 and is a good proxy for what the NOME rate might be. With the new Socialist government, we think NOME could be scrapped to score cheap public support. This could mean EDF remains protected from competition but must continue supplying power at lower profits while still funding investments in its reactors. French ministers' proposal in July to limit tariff increases to 2% for 2012 seems a step in the wrong direction, failing to cover EDF's cost and importantly making it all that much harder for alternative suppliers to supply profitable power. The Socialist government also could introduce a new framework that would allow a truly competitive electricity market to develop, unlike the NOME law, which we think would have stifled competition. Hollande promised during his campaign to drive France toward a "nuclear light" future, which could include forced nuclear plant retirements by 2025 and might not lead to compensation for EDF.
Whatever the outcome, EDF management believes the firm will be made whole for its past and future investments. Given that NOME, in our view, provided EDF with higher future profits without eroding significant market power, it seems the company might have reason to trust its political clout. With the state as the largest shareholder and beneficiary of dividends by far, it makes sense the government would let EDF benefit from its low-cost nuclear fleet, as we expected NOME would have done. The pressing issues EDF now faces are the level of new required safety maintenance capital investment at the reactors, the potential for forced closures, and how the group will be compensated for investments or plant closures.
EDF has estimated it will need to invest EUR 40 billion-50 billion to extend the lives of its existing nuclear fleet per new safety standards. This titanic sum surprised the market at the time and has a negative impact on our fair value estimate, given concerns about how EDF will be compensated. Alternatively, the Socialist/Green Opposition Energy Policy, which would close 21 gigawatts of nuclear power by 2025, could cost less but would require significant investment in new gas and renewable generation that might be more costly in the long run. We think the risks to EDF's profits are higher in the latter scenario, which could increase competition for new generation and erode the company's market share. EDF, however, does not believe that the new government intends to carry out the campaign policy. Hollande thus far has suggested he is committed to closing only one plant by the end of his term--the aging Fessenheim station. EDF likes the fact that Nicole Bricq--the new minister of environment, sustainable development, and energy--is a technician, and management is not unhappy to see former minister Eric Besson leave town. Pierre Moscovici, the new minister of economy, finance, and foreign trade, also will have influence crafting nuclear policy and is more of an unknown quantity.
Hydro concession auctions are slated to take place by 2013 at the EU's request. EDF's management told us that the new government thus far didn't seem keen on opening up the concessions, given the chance that foreign companies, likely Nordic hydro operators, could bid and acquire French assets--a prickly subject in France.
Despite Nuclear Uncertainty, EDF Has Other Near-Term Priorities in France
The health of and remuneration for its nuclear fleet is EDF's key performance driver, but management is also focused on resolving other key issues in France. Foremost is addressing the CSPE mechanism, which forces EDF and other suppliers to buy renewable power at high feed-in tariffs while restraining the companies' ability to pass costs on to end users. Does this predicament sound familiar? Spain chalked up a renewable tariff deficit for its power suppliers of more than EUR 20 billion in exactly this way as huge amounts of renewables came on line and the government attempted to hide their cost from end customers. This created giant holes in suppliers' balance sheets that remain today. EDF, which would shoulder most of the burden, given its dominant retail market share, is hoping to avoid this situation. In 2011, it supplied 94% of households and 78% of businesses. At the end of 2011, EDF's receivable was roughly EUR 3.8 billion. The government-mandated tariff that EDF collects to make it whole has increased steadily but continues to be insufficient. We don't believe the situation will get as crazy as it did in Spain, but EDF is working on spreading the costs to other energy-intensive industries and cutting the lag between purchasing the expensive power and receiving remuneration.
EDF is also trying to improve accounting for some of its distribution assets and nuclear fleet to match provisions with depreciable lives. For example, French regulation requires EDF to book negative revenue for any third-party investment on its networks. This depresses EBITDA and earnings. It is meant to offset the benefit EDF gets from having assets that it didn't finance in its regulated asset base, but there is no impact on free cash flows. Altering the treatment for this capital expenditure would help tidy up the income statement and could be addressed as part of the distribution review by year-end 2012. EDF would like more control of these expenditures, since local municipalities frequently overinvest or invest without regard for economic returns. Also, EDF believes the accounting provisions it has taken to cover future distribution capex are higher than the amount it would need to maintain the assets through the end of its legal concessions. Ceasing to book new concessions, which are amortized through a charge on the income statement, could tidy up the book further. These changes could come late this year and could boost accounting earnings, but we don't expect them to affect the value of the company since they will not change cash flows.
Nuclear New Build in the U.K.: Waiting for Clarity?
When we met with management, EDF was still officially silent on whether it intended to develop the proposed 3.3 GW Hinkley C nuclear station in the United Kingdom. The new plant would be a significant earnings driver for EDF, which already generates 10%-15% of consolidated EBITDA in the U.K. However, management told us its U.K. nuclear operations would never reach the efficiency levels of its fleet in France, where it can optimize its operations and costs as a result of the size of its fleet and its long operating tenure.
Today, EDF is still awaiting details from the government on "contract for difference"--which would guarantee set payments for output--before it decides whether to invest. EDF would like at least a 20-year payment contract to provide transparency on returns. The company announced June 19 that it had selected a contractor to begin site development, and management indicated it was close to a final investment decision. Management has since indicated a willingness to bring in more partners to ease the capital requirement for new construction. The company maintains that its final decision will not come until it has finalized the legal framework for the guaranteed payments, though the U.K. nuclear regulator has announced that the Hinkley site is nearing licensing approval Other large utilities such as Scottish and Southern (SSE), RWE (RWE), and E.ON (EOAN) have withdrawn from U.K. nuclear development recently, but EDF remains committed. Chinese companies and U.S. nuclear giant Exelon (EXC) are also considering moving into development should the final framework be attractive. We believe contract approval would be a significant positive, even though we expect it will face legal attack and could end up significantly different in its final form.