By Arindam Nag
A DOW JONES NEWSWIRES COLUMN
LONDON (Dow Jones)--E.On's willingness to pay what it takes to buy Spanish utility Endesa might look rash.
But there is a strong business logic to the Germany utility's designs on Endesa, not least the attraction of profiting from likely rises in Spanish electricity tariffs.
And the German company could offset future risks by selling Endesa's Latin American assets.
The latest offer, 38% above E.On's original bid, values Endesa's equity at EUR38 billion, giving the Spanish company an enterprise value of EUR56 billion including all liabilities.
E.On had little choice but to sweeten its bid significantly, demonstrating the financial firepower it has at its disposal, after Acciona's surprise entry into the takeover battle.
But with a self-imposed target of achieving a 9% ROCE in 2008 and the importance of maintaining its credit rating, E.On is testing the commitment of its equity and bond holders to its expansion plan.
Those investors should urge the German utility to look for more non-core disposals, possibly even selling some of Endesa's Latin American assets, to ensure E.On covers its cost of capital.
Liberalization of Spain's energy market, even if it won't be fully implemented before 2010, does give investors in the sector greater visibility.
And as Spanish prices converge with the rest of Europe's owners of Spanish utilities like Endesa, Iberdrola and Union Fenosa stand to benefit. J.P. Morgan calculates that Spanish tariffs are on average EUR24/MWh or 30% below the E.U. average.
The expectation is that Spain's regulatory regime will become more British-like, with utilities allowed pricing power that would track a preset cost of capital, allowing moderate but steady returns. So, while investors have previously discounted Spanish utilities stocks because of a lack of regulatory clarity, E.On's new offer values Endesa at an 8.4X EV/Ebitda multiple that's not out of line with sector valuations.
But what should worry E.On investors and bond holders is how the German group is going to finance its Spanish acquisition.
E.On has indicated it wouldn't be shy in raising equity to pay for Endesa. But by offering to pay so much more than its original offer, it will have to raise some debt to keep its cost of capital down and avoid unnecessary earnings dilution.
But if E.On is to maintain its valuable 'A' credit rating - advisable given the industry's debt driven business model - it may have to think of selling Endesa's Latin American assets. They make up 31% of Endesa's total, contributing nearly a third of operating income in 2005.
But once part of E.On, Endesa's streamlined LatAm operations would amount to less than 9% of the combined group's assets. They might get attractive bids from U.S. utilities now that the sector's appetite for risk has finally improved after the collapse of Enron.
With Endesa saying in the past that it would approve an EUR35-a-share offer, it looks like the German utility might yet clinch the deal.
But the medium- and long-term value of doing so for E.On's investors will depend on shrewd management of the Germany company's balance sheet.
(Arindam Nag has covered business and finance for 15 years in Asia, Europe and the United States. He can be reached at +44 207-842-9289 or by e-mail: firstname.lastname@example.org)
(END) Dow Jones Newswires
September 27, 2006 09:59 ET (13:59 GMT)
Copyright (c) 2006 Dow Jones & Company, Inc.