Lueder Schumacher

Lueder Schumacher

Lueder Schumacher is Co-Head of the European utilities team at Deutsche Bank, with a particular focus on German and Austrian utilities.

He joined NatWest Markets in 1996 having previously worked with Kleinwort Benson. Following the takeover of Bankers Trust, the utilities team, which has consistently ranked in the top three of all major investor polls over the past several years , has now become part of Deutsche Bank.

The utilities sector

Introduction

Utilities are generally valued just like other stocks, that is multiples such as EV/EBITDA, P/CF or a DCF provide a fair value range which can be broken on either side by certain overruling investment themes. For example during the TMT bubble the global utilities sector showed almost a perfect negative correlation to NASDAQ as funds were withdrawn from defensive funds. However, utilities have a few distinguishing characteristics that make the valuation a bit more complicated.

1. Watch the use of cash.

   Because utilities operate in a mature industry, they often have more money available than they can reasonably expect to invest in their core business. This leads to either diversification or re-investment risk, as utilities start to acquire other companies to put their cash to use.

2. Discounted cash flow valuations can give inflated numbers .

   Further problems could arise from political or regulatory pressures, as utilities try to avoid showing an 'embarrassing richness', which could draw attention to their cash piles. The need to invest their cash flow irrespective of the availability of attractive opportunities means that utilities often struggle to invest their free cash flow at a NPV (net present value) larger than zero. In turn this means that a DCF (discounted cash flow) valuation can give inflated results. A DDM model (dividend discount model) therefore provides a more conservative approach.

3. Utilities require a higher equity risk premium.

   The uncertainties of regulation also mean that utilities usually require a bigger equity risk premium to allow for the added uncertainty - a fact that contradicts the supposed predictability and associated safety of the cash flows.

4. Utilities can behave like bonds .

   If regulation is very tight, utilities can become bond proxies, with a safe and predictable dividend flow, but little incentive to create extra value.

5. Watch out for the conglomerate discount.

   Sometimes the urge to invest the free cash flow creates conglomerate structures, which result in a conglomerate discount being applied to the sum-of-the- parts of the Group. The reversal of this process, the focus on the core business and disposal of, usually non-profitable, non-core activities, then leads to additional performance as the conglomerate discount disappears.

6. Invest in companies that are restructuring.

   • First, invest in utilities that are restructuring (for example E.ON and RWE in Germany).

   • Second, invest in utilities that can re-invest their free cash flow in their core business (e.g. Edison in Italy).

   • Third, invest in utilities that have accepted the difficulty of re-investing their free cash flow and opt instead to return cash to shareholders via special dividends and/or share buy backs (e.g. UK utilities in the past).