Dong Energy, Denmark's largest utility and power generation company, made its initial public offering Thursday in what was a highly anticipated IPO after the firm failed to go public in the years between 2006 to 2008.
Since then, the Danish utility has shifted its strategy away from oil & gas and power distribution towards offshore wind power.
Dong Energy is offering minimum 63,248,753 shares with an option of an additional 10,925,159 shares to the stabilisation manager Morgan Stanley & Co. International PLC. In addition to settle Dong Energy's obligations under the Employee Share Program and the Leader Share Program, another 2,686,884 bonus shares may be exercised which are expected to dilute shareholder value by 0.64%
The offer price per share is set to DKK 200-255 with a mid price at DKK 227.50 translating into a market value of around DKK 95.6 billion or $14.4 billion/€12.9 billion. This market value will make Dong Energy the 12th most-valuable publicly traded utility in Europe.
Based on the mid price, the total value of bonus shares is DKK 611.3 million. The Kingdom of Denmark will own 50.1% of the share capital post the IPO assuming full exercise of bonus shares.
The potential maximum free-float immediately after IPO is 18.3% but after long-term investors such as pension firms, long-only equity managers, insurance firms and ETFs have bought into the stock, the free-float could fall to half the initial level.
Dong Energy's offering is the largest European IPO so far this year. Photo: iStock
Dong Energy has four business segments: Wind Power, Danish Utility Business, Distribution & Customer Solutions and Oil & Gas. Dong Energy has shifted its strategy towards wind power with a focus on offshore; 75% of capital employed in FY 2015 was in wind power and 59% of long-term assets on the balance sheets are within the wind power segment.
In terms of revenue, the Wind Power segment generated around 31% of total revenue in Q1 2016. The vision is to lead the transformation to renewable energy.
According to Rambøll, there are plans to construct around 100 offshore wind farms to an approximate value of €150 billion helping Europe meeting its goal of 20% of all electricity production coming from renewable energy sources by 2020.
Dong Energy sees its competitive edge in offshore wind farms, but the main challenge is the unit cost of electricity remains twice the level of onshore wind farms. Production costs have gone up every single year since 2000, but are now expected to fall as new technology is being implemented to lower marginal costs of offshore wind energy.
The Danish utility business is a stable cash cow that will help Dong Energy fuel its investments into offshore wind power. The Oil & Gas one is more volatile, but from current low oil prices there some upside for the market value should oil prices go higher again.
Based on 12-month forward EBITDA (less hydrocarbon tax) of DKK 19.1 billion and an enterprise value of DKK 95.6bn, the forward EV/EBITDA is 5.1 compared to the median of 8.5 for the STOXX 600 Utilities Index (see table).
For European utilities with a market value above Dong Energy, the ratio is 7.5 translating into a discount of 32%
For those involved primarily in power generation the average forward EV/EBITDA is 8.2, so no matter what benchmark is used the valuation is set low.
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The low valuation is, of course, to entice investors to join Dong Energy's vision of offshore wind power – a vision that comes with a very high execution risk and large investments.
It is not unreasonable to assume that Dong Energy could tap into public equity markets and raise capital for its aggressive targets for installed capacity in offshore wind power.
Based on the free-float weighted forward EV/EBITDA on European utilities, the timing seems smart with the valuation back at levels observed back in 2006 when European utilities were very popular among portfolio managers due to high growth and returns on capital.
As previously stated, the relatively low valuation comes with higher risk. The largest is undoubtedly the risks relating to the Wind Power segment. All governments in jurisdictions where offshore wind power farms are built have national support schemes through tax or levy exemptions, feed-in premiums, feed-in tariffs, and/or tradable Green Certificates – 62% of revenue from operational offshore wind farms in FY 2015.
Although European governments have shown strong commitments towards renewable energy, these subsidies will fade over time. Beyond 2020 nobody knows how the political landscape will be oriented in terms of renewable energy.
Although only stated in a few lines, we believe the following is one of the biggest risks for Dong Energy.
"In particular, long-term power prices could decrease due to unforeseen increases in the
number of power producing wind farms, solar energy installations or other power producing technologies
with low marginal production cost."
Solar energy seems to have the technological trajectory to be the winning renewable energy source with very low marginal costs. Based on our research, we find it very unlikely that offshore wind power will be able to see marginal cost go below solar energy. Even more attractive for solar energy, it has the capability in the future to be a decentralised energy source incorporated into buildings etc.
Large write-downs on assets are also a key risk to balance sheet deterioration which has previously been the case and also the main driver behind the 2014 capital injection with Goldman Sachs and ATP (Denmark's largest pension firm).
While the valuation looks attractive on a relative basis against peers it comes with high risk. The return on capital employed will never be stellar in our view because of government intervention in power markets – consumers will never be let down by power distribution monopolies.
Return on capital employed will long-term be around 10% over a business cycle, which is enough to create shareholder value as the weighted average cost of capital (WACC) according to Dong Energy is around 3.1%
Taking the risks, business complexity, and valuation into account the stock is fairly valued at around DKK 230 per share. Given the big and stable power distribution business, the stock will have defensive characteristics, but the future certainty of subsidies to wind power will add as a discount factor on valuation.
As we see limited upside to ROCE the profit spread (ROCE minus WACC) will likely stay within a narrow band and as such the growth in capital employed will be a main driver of the share price.
We believe Dong Energy will not deliver excess return to shareholders over a business cycle and thus the main attractiveness lies in its diversification benefits in a portfolio.