Merrill analysts suggest capital structure trades in five European utilities

By Ronda Fears

Nashville, Aug. 7 - Massive restructuring in European utilities has created complicated capital structures with interesting investment opportunities, and Merrill Lynch analysts suggest several capital structure trade ideas in a report Thursday.

Specific recommendations are made for sterling bond issuers E.ON AG, RWE AG, National Grid Transco plc, AWG plc and Glas Cymru.

Convertible analyst Jeremy Wyett, credit analysts Jón G. Jónsson and Olek Keenan, structured credit analyst Jenna Collins, equity derivative analyst Giovanni Amanti, equity sales specialist Richard Alderman and stock analysts Robert Miller-Bakewell, Philip Green and Chris Rogers contributed to the report.

Several of those analysts will host a conference call on the report Monday, Aug. 11, at 10.00 a.m. ET.

A capital structure approach to investment in European utilities is appropriate, specifically for sterling bond issuers, following a dynamic three-year period has transformed the European utility landscape.

"Ownership [in European utilities] has consolidated and markets have opened up to competition, albeit on an uneven basis," the analysts said in the report.

"Significant incremental debt has been issued as a direct consequence of this M&A splurge. This period of change has been different to the parallel turmoil experienced by U.S. utilities, and generally has been less traumatic for debt and equity investors alike."

Many utility stocks pay high dividends, so a significant correlation between stock and bond returns has been established.

"The sterling debt market is a deep, broad and innovative source of financing for European utilities," the analysts said.

"In particular, structured debt financings and regulatory ring-fencing have altered the risk and reward profiles of utilities investors, both in debt and equity."

The analysts said they expect credit trends for the European utilities sector to continue to be modestly negative for the next 18 months. That could make capital structure trades more important to moderate risk.

Principal utility issuers of sterling bonds include RWE, National Grid Transco, E.ON, AWG, Electricite de France, United Utilities plc and Glas Cymru.

The analysts presented capital structure trade ideas on RWE, National Grid Transco, E.ON, AWG and Glas Cymru.

E.ON

E.ON is the group of analysts' top pick. They suggest: buy the stock; buy an at-the-money call option on the stock; buy the E.ON 5.75% euro bonds due 2009 and 6.375% sterling bonds due 2032; buy Powergen bonds.

In early 2003, E.ON completed the acquisition of Ruhrgas to become the biggest player in both the gas and electric markets in Germany, and the analysts expect E.ON to remain active. Down the road, they see a further U.S. investment and/or a share buy-back as strategic options.

There are risks from ongoing regulatory developments, price movements in U.K., German and U.S. wholesale energy markets, proceeds from the Ruhrgas asset disposal program and potential tax changes in Germany, the anlaysts noted.

RWE

Key investment suggestions on RWE are: buy the stock; buy an at-the-money call option on the stock; write a covered call on the 5.375% euro bonds due 2008.

Having invested a total of €52 billion over the past three years, in both acquisitions and capital expenditures, RWE is now one of the big three global multi-utilities. The next stage will revolve around restructuring these assets to both cut costs and boost revenue growth.

"In our opinion, management has so far met the challenge," the analysts said, noting the recent integration of its electric and gas business units. "However, the share price suggests the market has yet to be convinced."

National Grid Transco

For National Grid Transco, the analysts suggest a long position in the stock, parent company bonds and operating company bonds. They noted strong covenants in the bonds and upside potential in the stock.

"It has a stated ambition to acquire another U.S. utility, most likely in the north east," the analysts said. "While this is logical given the consolidation potential, shareholder sentiment is currently erring on 'sweating' the merger, and we believe that the timescales to the next deal have lengthened."

Natinoal Grid Transco, the analysts said, should be a core utility holding because of its defensive characteristics, combined with a strong merger platform to drive cost savings and business restructuring. Key risks are regulatory reviews, although none are pending, and the pensions deficit.

AWG

Ideas for AWG include its ring-fenced subsidiary, Anglian Water Services. The analysts suggest: buy the stock; buy the 6.875% sterling bonds due 2023.

Based on a 12-month price objective of 650p, there is 21% upside. But the stock price would need to rise by 35% to bring its dividend yield in line with its bond yield. The analysts expect the bonds to continue to tighten, however.

Glas Cymru (Mutual)

With regard to Glas Cymru, the analysts recommend switching into the triple-B rated bonds and out of the single-A rated sterling bonds.

Established in second quarter 2001 as the new mutual owner of Dwr Cymru, the regulated water utility for Wales, Glas Cymru financed the purchase with debt but has since embraced deleveraging. There are tighter debt covenants at the triple-B level in the capital structure, the analysts pointed out.

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