Why are shares of a huge, profitable energy company -- which currently yields 6.5% -- selling for the cheapest prices in a decade?
There must be a catch.
Well... yes and no.
To begin with, the company is based in Germany.
And since the Great Recession, the European Union has not recovered as well as U.S. markets. Demand for energy has declined. Bailouts in Greece and bank troubles in Spain have dominated headlines, driving share prices lower across the board.
However, there have been signs of a turnaround recently, and big-name investors have been snapping up bargains in Europe. In February, Warren Buffett's Berkshire Hathaway (NYSE: BRK) invested $1.9 billion in eight European stocks. Buffett said in a May interview with CNBC that Berkshire was continuing to invest in Europe.
In his typically understated fashion, Buffett said that Europe was still "going to be around." With that reassurance in mind, let's look at this bargain-priced European energy stock.
E.On (OTC: EONGY) is a highly diversified European energy company with a market cap of $29 billion. When I say "highly diversified," I mean it: The company's business activities include coal, natural gas and oil, nuclear, water, wind, solar and bioenergy, gas supply and production, and gas storage.
Basically, if something produces energy, E.On is involved with it. The company also operates in energy transportation and distribution.
E.On's unusual name comes from the Greek word "aeon," which means eternity. "Eternity" might be a somewhat lofty goal in terms of business longevity, but after being founded as Germany's national power company in the 1920s, E.On has been in business in its current form since 2000. It currently serves 26 million customers in over 20 countries in Europe and Scandinavia, and its exploration and production division operates in Russia, the North Sea, North Africa and Latin America.
E.On's share prices never really recovered after the crash of 2008. After hitting an all-time high over $70 in May of that year, share prices plummeted to $25, losing two-thirds of their value in nine months.
In fact, you'd have to go back to May 2003 to find shares trading for today's bargain price of around $15 per share.
So what's the upside? Why invest in a company with share prices in a slow decline for the past five years?
|Revenue is growing. The company reported total revenue of 93 billion euros (about $122 billion) in 2010, 113 billion euros in 2011, and 132 billion euros in 2012.|
|Much of the bad news is already baked into the stock price. The company took a big hit in 2011 when Germany announced it would phase out nuclear power after the Fukushima nuclear disaster in Japan. The company has already absorbed the loss from the forced shutdown of its nuclear plants, and further divestitures have helped to pay down its debt.|
|Free cash flow has risen from 394 million euros in 2010 to 4.6 billion over the past 12 months.|
The 6.5% yield is backed by a 63% payout ratio. Management has said in the past that its target payout ratio is between 50% and 60%, so there is a chance the dividend could be cut to keep the ratio below 60%.
While a 60% payout ratio might seem high in some industries, E.On operates as an energy utility in a tightly regulated European market. While this heavy regulation can hamper growth, on the upside it gives E.On a narrow economic moat because heavy regulation creates barriers to entry for other companies and discourages competition.
Risks to Consider: Slow growth in the EU would hurt energy demand and E.On's bottom line. Although the company has divested billions in non-core assets recently and the balance sheet looks better than it has in years, management has made some questionable acquisitions in the past.
Instead of monthly or quarterly payments, E.On only pays its dividend once a year (in the middle of May). As mentioned, the company's payout ratio is slightly over its target goal, meaning a slight dividend cut could be on the horizon.
Action to Take --> For contrarian investors who don't mind a bit of risk, E.On is an attractive buy at today's prices. Current book value per share stands at $27 during a trailing 12-month period, while today's share prices hover around $15. Set a price target of $25 a share over the next two years while bagging a nice 6% yield in the process.