German Utility E. ON SE 'BBB/A-2' Ratings Affirmed Following Asset Swap Progress; Outlook Remains Stable

  • On March 25, E.ON presented its strategic and financial outlook for the combined group post-asset swap (New E.ON); in our view, the integration of innogy strengthens E.ON's business risk profile, as regulated earnings increases to above 70% of total EBITDA from about 55% previously.
  • We expect credit measures will weaken temporarily, but foresee that funds from operations (FFO) to debt will improve to about 14% within two years.
  • The combined group's regulatory asset base (RAB) increased to €33 billion from €20 billion pre-closing, and we expect it to further increase to €36 billion by 2022.
  • We are affirming our 'BBB/A-2' ratings on E.ON.
  • The stable outlook reflects our view that the innogy integration will support operating cash flow stability, and E.ON will be well-situated to weather current challenging market environment as well as for adjusted FFO-to-debt to improve to about 14% following a transitional period of 24 months; as well as some resilience to the economical consequence of COVID-19.
FRANKFURT (S&P Global Ratings) March 26, 2020—S&P Global Ratings today took the rating actions listed above.
E.ON is Europe's largest energy supplier, with a regulated asset base of about €33 billion generating above 70% of its EBITDA, and more than 50 million customers.
With assets predominantly in European countries with relatively high ratings, such as Germany and Sweden, and supportive regulatory frameworks, we consider the combined entity's business risk profile stronger than that of its predecessors, as well as those of large European peers. We expect annual compounded growth rate of 3%-4%, increasing RAB to about €36 billion over the coming three years and 80% of regulated EBIT contributions to stem from Germany and Sweden. We expect the largest part of capital expenditure (capex), 75%, will go to the distribution system operations segment. In our view, this should gradually strengthen the business mix, as revenue and cash flows streams become more stable on average. The group's customer solutions division services above 50 million customers in 13 countries, up from 31 million in eight countries before the asset swap. The market share is generally high and E.ON is typically among the top three players in its main markets. Next to supply, the segment offers various ancillary services such as onsite generation, efficiency, storage, and e-mobility solutions for households and businesses as well as local and district heating.
New E.ON's business mix still contains conventional generation, namely nuclear operations in Germany via its subsidiary PreussenElektra.
After E.ON transfered its minority stakes in Emsland and Gundremmingen C to RWE under the asset swap, the remaining plants Brokdorf, Grohnde, and Isar 2, are scheduled to go offline in 2021, 2021, and 2022, respectively. This follows the accelerated German nuclear exit decided in 2011 following the Fukushima nuclear accident in Japan in March that year. The plants' production rights deplete before their shut-down, missing about 45 terawatt-hours (TWh) to conclude. We expect no volume risk related to these as a closed nuclear power plant jointly owned by E.ON and Vattenfall (Krümmel1) still has about 88 TWh in rights remaining. The court dispute on how to settle the transfer is ongoing. However, we expect the maximum price to be €27.80 per megawatt-hour as charged for the recent transfer of 10 TWh by operator Vattenfall. 50% of the expenditure will flow back into E.ON's earnings as per its 50% ownership.
We expect E.ON's operating cash flow will show greater stability and lower profitability, while revising our rating thresholds.
We see the new entity as having a relatively stronger business risk profile than E.ON stand-alone due to higher stable cash flow contribution from regulated activities. We are therefore lowering our FFO-to-debt thresholds for the 'BBB' rating to 14%-16%, compared with rating thresholds of 16%-18% on a weighted average basis for E.ON before the transaction. Over the coming 24 months, we expect our ratio of adjusted FFO-to-debt to transition to the 14%-16% range.
E.ON's credit metrics are highly sensitive to changes in the pension discount rate.
In our base-case scenario, we assume a discount rate of 1.3% as per fiscal year-end 2019. Falling interest rates will have no impact on our calculation of adjusted debt due to asset retirement obligations as these are already reflected at the maximum value in our financial metrics.
Integration issues remain for a transition period of 24 months in a challenging market environment.
Integration risks, mainly delivering on synergies, and weathering imminent recession on the back of oil price and COVID-19 crisis (see "EMEA Utilities Should Withstand COVID-19 Better Than Most Sectors," published March 24, 2020, on RatingsDirect) will be crucial for E. ON throughout the transition period. We believe the company is better shielded to these market conditions than some peers because of its:
  • Smaller share of unregulated business and limited and fading merchant generation exposure;
  • Flexible capex program (about 50% noncommitted growth capex);
  • Dividend policy tied to deleveraging targets; and
  • Strong management commitment to rating and track record of implementing measures to protect metrics.
In the absence of meaningful political intervention, we view E.ON's regulated earnings --to be somewhat insulated to economic downturns.
Although, lower transport volumes can delay regulatory remuneration as measured by IFRS-accounted earnings. Furthermore, a delay in capex would slow RAB, and hence regulated earnings growth. However, in the near term, this should constitute a welcome additional liquidity buffer. In our base-case scenario, we do not foresee any disruption in the network operations or any risks related to continuity of supply as per a wide European political consent to protect critical infrastructure and as per E.ON's contingency plans to manage such a disruption.
We view the exposure to market downturn as more pronounced for the company's customer solutions (CS).
This is especially for its 10%-15% (of total CS earnings) business-to-business segment due to commercial counterparty risks and unwinding of volume contracts against falling wholesale power prices. We expect European power prices to come under pressure on the back of low commodity prices including low CO2 carbon dioxide allowance prices and lower demand during this recession.
Under the company's outright power generation with the three remaining German nuclear power plants, we expect low power prices to reduce earnings somewhat following hedge positions running out, mainly in 2021 and 2022.
That said, the overall contribution of E.ON's generation business to total EBITDA (starting point about 5%) is gradually decreasing anyway with the decommissioning schedule ending in 2022.
We consider management's commitment and track record a key force to move through the transition phase.
E.ON's history of rigorously steering the company's leverage and performance in line with the assigned rating is a positive credit factor. The company supported its credit metrics with measures throughout refocusing the business to a greener future and the spinoff from Uniper, as well as the recent wholesale power prices crises. We believe New E.ON's management is committing its dividend policy to a deleveraging target of about 5x by 2022.
The stable outlook reflects our expectation of stable earnings and cash flows from New E.ON's inherently low-risk, regulated electricity and gas distribution, combined with the company's prudent financial policy, which includes a commitment to a strong 'BBB' rating and a reduction of financial leverage toward 5x by 2022. Furthermore, we consider management's commitment and track record to maintain the rating, for instance by capex flexibility, dividend flexibility, disposals, and hybrid bond issuance. We consider FFO to debt of 14%-16% commensurate with the rating.
We could take a negative rating action if we see risks that E.ON's financial risk profile will not improve by year-end 2021, including FFO to debt reaching 14% and debt to EBITDA decreasing to close to 5x according to the company's deleveraging targets. We believe this could happen if the utility underdelivers on its synergy targets, for example due to less favorable economic and political environment; or if generation and supply businesses underperform, due to more challenging power price environment or widespread counterparty default in the customer solution segment; and if the company does not take any remedy measures to mitigate such downside risks. An increase in political intervention in light of the looming recession could impose meaningful constrains on customer solutions and regulated business alike, obstructing ability to cut costs or recover expenditure. This, however, does not constitute our base-case expectation.
We see rating upside primarily related to sustainably stronger-than-expected financial metrics, a supportive financial policy, integration of innogy, and stabilized market conditions.
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