Long gone are the days when the Czech utility CEZ was so important to the state and its politicians that the Central European country used to be nicknamed CEZ Republic. The company was, a long-term observer of Czech politics once noted drily, the “trough that feeds the elites”.
But since the middle of last year, CEZ’s bonds and stocks have taken a beating as investors punish the utility for a sharp deterioration in its finances on the back of record low electricity prices and a belated move to embrace renewable energy. Since hitting a high in May of 2012, the shares have fallen steadily, by around 50%, to trade around €14 in mid-March. Spreads on its bonds have widened from around 20 basis points to almost 80bp over the same period against the comparable sovereign issue, as investors demand extra yield for holding CEZ issues.
The rating agencies and investment banks have also had their say. On February 12, Moody's Investors Service put the company’s ‘A3’ rating on review for downgrade as a reflection of CEZ’s exposure to a weakening power price environment. “A prolonged period of low power prices will affect CEZ because market-exposed generation activities represent approximately 50% of its ebitda. As hedges roll off, lower power prices will likely result in a further reduction in the company's operating cash flow in the next two to three years. This pressure on profitability will be exacerbated by the predominantly fixed-cost nature of CEZ's generation fleet in the Czech Republic, with around 85% of total capacity represented by lignite, nuclear and hydro, thus making it particularly exposed to movements in wholesale power prices,” Moody’s said.
In September last year, Goldman Sachs recommended investors sell their CEZ shares because of a worsening earnings outlook though to 2018. On March 15, CEZ gave worse-than-expected guidance for 2016, predicting adjusted net income of CZK18.0bn, down 35% from last year. “Although CEZ should benefit over time from our view of gradually rising power prices, we do not expect earnings to improve until 2018 due to forward hedging and rising carbon costs,” Goldman analysts wrote.
Good old days
CEZ’s problems really date back to the big run-up in electricity prices from 2005 to 2008, when the company was coining it in and “everyone got used to the era of plenty very quickly and nobody was thinking about the rainy days", says Jan Ondrich, a Prague-based energy analyst. In 2007, CEZ’s net profit hit CZK42.8bn (€1.581bn), which was 49% up on the previous year.
However, the utility failed to invest significantly in renewables, instead relying on its nuclear and lignite cash-cows, and investing in gas-fired generation that is in today’s market unprofitable. “Due to the priority dispatch of renewable power, some thermal plants are called upon so infrequently that they are loss-making in terms of earnings – notably some gas-fired power plants in continental Europe,” notes Arkadiusz Wicik of Fitch ratings.
“CEZ has a higher exposure to the more volatile conventional power generation business compared with its European peers,” notes Wicik. “This business is under pressure from declining margins and a rising share of renewables supported by subsidies.”
This problem is only set to worsen over the coming years, as there is little sign of electricity prices bouncing back. During the big rise in electricity prices last decade, a lot of investment flowed into raising generating capacity, which is now coming online. “People were hedging power prices three to five years out so they are starting to feel the pain,” says one insider close to CEZ. “For utilities, it’s now about survivability. Those who didn’t take that big gamble on renewables will suffer.”
CEZ could, however, be in a stronger position than many of its competitors. Its financial leverage is low compared to that of its Western European peers, while it enjoys low generation costs from its nuclear plants.
CEZ has also put the years of its stewardship under the controversial Martin Roman behind it, when hardly a week went by without some scandal appearing in the press, whether overpriced nuclear fuel dumps or dodgy related-party procurement deals. “[CEO Daniel] Benes has been a benefit to the company because he’s business oriented,” says the industry source.
CEZ is also making a strong, if belated, move into renewable power in Germany. In January, CEZ announced it has mandated the German-based alternative asset manager Aquila Capital to facilitate its entry into the German market by building a wind portfolio in the country in the “triple-digit-million euro range” ahead of changes by the German government to make the subsidy system less generous.
“The CEZ portfolio is supposed to be a feed-in tariff portfolio and this is still manageable – we are confident that we will be able to source a sufficient number of attractive projects through our network for CEZ,” Susanne Wermter, head of the Special Infrastructure Team at Aquila Capital, has told bne IntelliNews.
Some are worried, though, about an attempt to ‘buy’ its way out of the problem. In December, CEZ submitted a non-binding offer to acquire Vattenfall’s German lignite mines, lignite-fired power plants and hydropower plants. Like its Czech peer Energetický a Průmyslový Holding (EPH), CEZ appears to be betting that lignite – ‘brown coal’ that has been the mainstay of Germany’s power generation for decades – will still be needed for some time in order to ensure a stable power supply because of the still intermittent nature of renewables.
CEZ and the other bidders like EPH are no doubt hoping for a knockdown price given the current low electricity prices, though Fitch warns that the acquisition of Vattenfall’s assets could be negative for CEZ's rating, depending on the price and details of the transaction. “We may tighten our leverage guidance for the rating if CEZ acquires Vattenfall’s German assets as it would increase the company’s business risk in our view,” says Wicik.
Goldman also noted in its report that its earnings projections don’t reflect the risk of CEZ undertaking “value-destructive acquisitions” – something it’s been guilty of in the past.
There is also the shadow of a new tender for nuclear power plants hanging over it. Last year, The Czech government officially designated nuclear power as the leading edge of its long-term energy strategy, which calls for as many as two new reactors at each of CEZ’s Dukovany and Temelin nuclear plants. Those two plants currently run a total of six reactors that generate a third of the country’s electricity; that share is to increase to at least 50% under the plan. However, the government provides no clear strategy to fund this expansion, which in this low power price environment remains a major stumbling block.
CEZ’s last nuclear tender was a fiasco. It was finally killed in 2014 after the politicians and other officials had so utterly mismanaged the process that one bidder, France’s Areva, was suing the Czech government and CEZ after it had been ejected from the tender, leaving just the US-based Westinghouse Electric and a consortium led by Russian state nuclear holding Rosatom in the race.
Ultimately, says Ondrich, CEZ remains a “not very sexy investment proposition” for the time being. “If you take away high power prices, you are left with an ailing, asset-stripped incumbent without direction,” he says.