RWE was a fat and happy German utility until deregulation forced it to compete at home and expand abroad. Now it’s a global player -- a sprawling multiutility with billions of debt and potential deal indigestion.
By Hugh Filman
August 2002
Institutional Investor Magazine
The letters R-W-E on the side of an office building or a power plant are a familiar sight to residents of Germany’s Rhineland. Their local utility is Germany’s top electricity producer and fifth-largest industrial enterprise. But this year the letters achieved international prominence when an estimated 1 billion television viewers worldwide tuned into the European Cup final in May and spotted RWE on the red-and-black jerseys of the Bayer Leverkusen football club.
RWE started sponsoring Leverkusen two years ago in the hopes of building brand awareness, and the club has fortuitously emerged as a world-class football power. RWE is just as determinedly making its own run at global recognition as a multiutility player, one that supplies gas, water and waste services as well as power.
RWE’s metamorphosis from a stolid regional power company into a dynamic private sector global player with a market cap of about E20 billion ($20 billion) in less than five years is in fact remarkable. Like other German utilities, RWE had to deal with sudden immersion in the free market after Berlin deregulated power in 1998. Shedding a slew of noncore assets, the company’s managers concentrated on cross-selling multiple utility services in markets around the world. Now, after a E40 billion shopping spree in which RWE paid what some say are premium prices for utilities in the U.S., the U.K. and Eastern Europe, the company needs to consolidate its far-flung operations while striving mightily for synergies to help cope with an impending E23 billion debt burden.
For CEO-designate Harry Roels the challenge -- and the opportunity -- are immense. Roels won’t get a chance to act, however, until next February, when he is due to succeed the principal architect of RWE’s transformation -- chief executive Dietmar Kuhnt, 64 -- who is retiring. The 54-year-old Roels is unusual for a CEO-to-be of a German utility in having been born in the Netherlands and in having never worked in the power generation industry. For more than 30 years he has been at Royal Dutch/Shell Group, where he began as a petroleum engineer and worked his way up, holding a variety of management posts in Malaysia, Norway, Turkey and the U.K., as well as the Netherlands, while overseeing specific operations in Latin America, the Middle East and Africa. Since 1999 Roels been managing director of Royal Dutch Petroleum Co. and a member of the management board of Royal Dutch/Shell, with responsibility for strategy and planning, most recently for the gas and power businesses.
Kuhnt says that it was Roels’s international experience that caught RWE’s eye. The appointment “demonstrates that RWE thinks and acts internationally,” he says. “It was really important to look for a new CEO who has international experience and who knows a lot of different cultures -- because we now have to integrate all the companies. I think he is the right man at the right time.”
Concurs Ralf Oberbannscheidt, the portfolio manager in charge of European utilities for asset management group Die Wertpapier Spezialisten (DWS), a major shareowner in RWE, who explains that investors like him are not looking for a visionary so much as a good operations person to fill the CEO post. “Now is probably the time they need to integrate their multiutility approach, and it’s probably more important to have stability than vision,” he explains.
It was back in April 1998 that Berlin, as if flipping a switch, threw the German electricity sector wide open to competition to comply with Brussels’ initiative to liberalize European Union energy markets. All of a sudden, RWE was no longer sitting comfortably atop a tightly regulated industry. Domestic utilities as well as new foreign competitors launched a no-holds-barred competition for market share, slashing prices -- and margins.
“Prices in the industrial sector dropped by 50 percent,” says Klaus Sturany, RWE’s chief financial officer. Soon the utility’s electricity costs exceeded the base rate it charged wholesale customers. Between July 1999 and March 2001, the company suffered seven straight quarters of declining earnings in its energy division. “We learned the hard way,” Sturany says. “We had to react quickly.”
Forced to rethink RWE’s whole approach in the face of mounting losses in its main business -- generating, distributing and retailing electricity -- Kuhnt undertook a strategy that would have been daring for any CEO but was positively audacious for one who had spent virtually his entire career in an industry insulated from market forces. Not only did he seek to radically remold RWE into a market-driven, price-conscious competitor in supplying electricity at home, but he also embarked on a quest to turn it into an international player in several utility businesses. “The liberalization, together with the internationalization [of the German market], put so much pressure on the company that we had to strengthen all our resources,” says Kuhnt. “So we decided to focus on four core businesses: electricity, water and wastewater, gas and environmental services.”
His close ally in this endeavor was Sturany, 55, who joined RWE in 1999 after a distinguished career in the chemicals industry, most recently, as the top executive of thermal engineering firm GEA. He has overseen RWE’s internal reorganization as well as helped to integrate multiple acquisitions.
Before deciding to remake itself into a jack-of-all-services, RWE had been a conglomerate with interests in gas, waste disposal, chemicals, telecommunications, printing machines, construction, real estate, cable TV and even car washes, along with power. The company has been shedding nonutility assets, such as its 30 percent stake in E-Plus Mobilfunk, Germany’s third-largest mobile phone operator, and its industrial chemicals division. So far RWE has sold nine of its 12 noncore subsidiaries, raising E9 billion. By the end of 2003, the company hopes to have taken in a further E5 billion from the disposal of majority stakes in a construction company, a printer and half of an oil joint venture with Royal Dutch/Shell.
Meanwhile, RWE has pushed into new markets, notably the U.K. and the U.S., while bolstering its German electricity holdings. It augmented its core domestic operations with the takeover in mid-2000 of VEW, Germany’s sixth-largest electricity producer and third-largest gas supplier, for E5 billion in cash and stock. And since 1999 it has acquired four other major utilities -- including Thames Water in the U.K. and American Water Works Co. in the U.S. -- along with a number of smaller firms.
Once the deals are fully absorbed, RWE’s debt will approach E23 billion, or roughly five times its cash flow and more than the company’s market capitalization. The debt is sizable even by utility standards, and in March Moody’s Investors Service dropped RWE’s credit rating from AA3 to A1.
Yet even as its ratings were going down, RWE’s profits were going up. Net income rose 9.1 percent year over year, to E693 million, on sales of E14.7 billion in the first quarter. For the whole of 2001, RWE earned E1.4 billion on sales of E52.8 billion. E.On, its great German rival, made E2.6 billion on E79.7 billion in revenues, or roughly the same margin as RWE.
To take an extreme example of a utility that changed its identity, French-water-company-turned-global-entertainment-conglomerate Vivendi Universal had a net loss of E13.6 billion on E57.4 billion in revenues in 2001, mainly reflecting one-time, noncash amortization charges from a flurry of acquisitions. Under Jean-Marie Messier, Vivendi -- the old Générale des Eaux, founded in 1863 by Napoleonic decree -- sought to aggressively transform itself into a media and telecommunications company while shedding most of its remaining interests in Vivendi Environment, the original water utility. The now-ousted Messier’s strategy, of course, has been a disaster.
In sharp contrast RWE decided to stick to its knitting and develop the four core utility businesses because of their potential for synergies. “They are the same customers, and the same cities with which we have to negotiate,” Kuhnt says. “Therefore, it makes sense.”
The U.K. has been the leading laboratory for testing this theory. A number of British utilities have aggressively taken up the multiutility strategy since the government began liberalizing the energy sector in the early 1990s. Mounting intensive advertising and sales campaigns, they have sought to persuade customers to buy both their gas and electricity. Some 37 percent of U.K. customers have proved willing to switch to another electricity or gas supplier to reap a discount.
But it could be a while before this approach begins to pay off in Germany: Just 3.7 percent of Germans have changed electricity suppliers since the market was liberalized three years ago. Most German consumers would wonder about a savings offer from a utility asking them to switch, says DWS portfolio manager Oberbannscheidt. “Germans are, in general, suspicious and very conservative,” he says. “They tend to stick with the company already serving them. We see this in the telecom sector as well.”
For RWE, which still depends on selling electricity for half of its operating results worldwide, cross-selling services to retail customers at home is critical. Although Kuhnt concedes that getting Germans to accept the multiutility concept -- even with discounts on electricity, gas and water bills -- will be a struggle, he maintains that it is perfectly feasible.
“Cross-selling is not a business model that has worked effectively in Germany up until now,” he grants. “But there is a high potential. It works with some industrial customers, for example. They want to be served by one company with electricity, water and waste management services.”
The trick, Kuhnt says, is to offer consumers better prices by achieving lower costs through common billing platforms, call centers and service systems. “We have to work on it,” he admits. “We have to create synergies.”
RWE’S FIRST BIG SPLASH IN THE INTERNATIONAL utility market came with its acquisition of Thames Water in September 2000 for £6.8 billion ($9.6 billion) including the assumption of £2.5 billion in debt. The leading water utility in the U.K., with £1.4 billion in revenues at the time, Thames has more than 12 million domestic customers and an additional 11 million in the Asia-Pacific, the Americas and the Mediterranean. It was in the process of taking over E’town Corp. for $1 billion, so in acquiring the British utility, RWE also gained the Westfield, New Jerseybased water company, with its 1 million U.S. customers and $163 million in revenues.
The Thames deal covered a gap in RWE’s core operations, and it also transformed the company into an international player. “At the beginning, everyone was saying, ‘Thames Water? What is that all about?’ And then it got more clear that they want to focus more on water and the multiutility approach,” says DWS’s Oberbannscheidt. Adds Merrill Lynch European utilities analyst Chris Rogers, “There’s a lot more opportunity in water because you’ve only got roughly 5 percent penetration of private capital into the global water industry.”
The water business gave RWE’s profits an instant boost, just as it was struggling to put its electricity operations in the black. Thames contributed 5 percent of sales but 22 percent of operating results in 2001.
Venturing into the water market separated RWE from Germany’s other utility giant -- E.On -- which has remained focused on power and gas. “We feel our strategy is more balanced,” says RWE CFO Sturany. “It’s less volatile with water in there. Water, in fact, is the fastest-growing and most profitable area.”
Nevertheless, some are skeptical. Julian Sinclair, the portfolio manager in charge of global equities for Gartmore Investment Management in London, prefers E.On to RWE precisely because it is not in the water business. “I’m not that keen on water, and certainly not that keen on water in the U.S., principally because it’s such a fragmented market,” he says.
The Thames takeover did indisputably address a shortfall in RWE’s management expertise. “We don’t have, yet, internationally experienced management in the core businesses, so we are buying good management and then keeping it,” confides Sturany. “We have achieved that with Thames Water.”
RWE gathered all of its water businesses -- it owns stakes in several municipal utilities, including Berliner Wasserbetriebe -- under Thames chief executive Bill Alexander. And it gave him and his utility’s other seasoned senior executives -- most of whom elected to stay on -- considerable leeway and support to broaden Thames’s purview. “We had lots of growth opportunities, and they’ve helped us take those, and not just by providing the financial support,” Alexander says. “We’ve worked together with their M&A people and other teams at the corporate center of RWE in doing some joint acquisitions and projects, the biggest of which is American Water Works.”
Thames’s September 2001 bid for American Water in Voorhees, New Jersey -- one of the first U.S. deals after September 11 -- brought the largest publicly traded water services company in the U.S. into the RWE fold. The $7.6 billion takeover has already been blessed by American Water’s shareholders but still needs approval from regulatory authorities in 13 of the 23 states where the utility serves 16 million water and wastewater customers. That isn’t expected before mid-2003.
Counting American Water, RWE’s water operations would encompass more than 44 countries and 60 million customers. Only Suez and Vivendi Environment serve larger populations. “You need to get scale in the water business,” contends one institutional investor. “Thames Water obviously is too small a player, and now RWE can transfer the knowledge gained there to the U.S.”
RWE’s multiutility strategy, however, has required it to shop around. In January it paid E4.1 billion for 97 percent of onetime state-owned natural gas distribution utility Transgas in the Czech Republic along with dominant stakes in eight regional gas utilities in that country. The deal essentially gives RWE control of the Czech natural gas industry as well as a pipeline extending from Russia that provides roughly one fifth of Western Europe’s natural gas. “Being close to Germany, Transgas does have cross-border synergies,” notes Sturany.
The acquisition gives RWE a springboard for further expansion into Eastern Europe, identified by Kuhnt as the company’s fourth-biggest target market, after Germany, the U.K. and the U.S. RWE already has significant electricity holdings in Hungary and footholds in Slovakia and Poland, and the CEO hopes the company can take advantage of future privatizations in the region.
RWE struck a deal in March to buy Innogy Holdings, a British electricity and gas utility, for £3.1 billion plus £2.1 billion in assumed debt. Innogy, with its 6.1 million electricity customers and 1.8 million gas customers in the U.K., balances Thames and should make for ample cross-selling opportunities. Swindon-based Innogy has itself been extremely adept at peddling multiple services -- 80 percent of its new customers sign up for both gas and electricity -- and RWE hopes to apply the company’s unified information technology platform and single-billing system to its home market. The deal should thus provide synergies not only with Thames but also with RWE’s German energy operations, says Patrick Kohlmann, the fund manager in charge of utility bonds at Frankfurt-based Union Investment Privatfonds.
Skeptics who don’t dispute RWE’s strategy still question the execution, especially the sums that the company has shelled out for acquisitions -- as much as 12 times earnings before interest, taxes, depreciation and amortization. Dumping extraneous assets and enlarging core operations is “the only viable strategy for utilities these days, and this has certainly been applauded by investors,” acknowledges Lueder Schumacher, until recently a utilities analyst for Deutsche Bank in London. “The only problem was that in this whole process of trying to reposition themselves, they’ve made a number of acquisitions, and they paid what has frequently been described as pretty full prices. So you have to really rely on RWE delivering a lot of synergies on these acquisitions.”
Sturany rejects outright the notion that RWE has overpaid for acquisitions. He is adamant that the company would never buy at any cost simply to amass size or to beat a rival to the punch. “We are really risk averse and profit driven, so if in a negotiated contract or an acquisition we have reached the walk-away limit, we just walk away,” the CFO says. He adds that the company sets clear financial criteria for each deal: The internal rate of return has to be greater than the aftertax weighted average cost of capital and, most important, the projected return on capital employed (including goodwill) has to be in excess of the pretax cost of capital in two to four years.
RWE will find out soon enough how U.S. bond investors feel about its acquisition binge. The company intends to go to the U.S. fixed-income market to raise the $7.6 billion it needs for the American Water purchase. “We will be approaching the U.S. debt capital market at the end of this year or early next,” says Georg Lambertz, the company’s vice president of finance. “What is crucial is that we enlarge our investor base.”
Portfolio manager Kohlmann endorses this approach, saying that drawing on a fresh source of capital for RWE could be a smart move; the company has after all hit the European bond markets two years in a row. That program brought in E11.5 billion, including E6.5 billion this April from an issue with euro and sterling tranches that had been slated to raise E5 billion. “We didn’t expect the overwhelming success, particularly in the sterling market,” says Lambertz.
But as RWE’s debt load has grown, Moody’s has dropped its credit rating and given the company a negative outlook. Although its Standard & Poor’s rating has remained AA-, a downgrade is expected once all of RWE’s acquisitions are completed. Sturany and Kuhnt maintain that through the sale of RWE’s remaining noncore assets and with a strong single-A credit rating, the company will nonetheless still have the capacity to raise a further E10 billion if necessary. “There are still major chances for them to raise debt,” Kohlmann concurs. “They have strong cash flow and revenues.”
Stock investors, of course, are preoccupied with earnings, so RWE has taken drastic steps to improve profitability, mainly in its troubled German electricity group, and also get out its message (see box, page 26). In January 2000 the company initiated a program to cut E2.6 billion in costs by 2005. Almost all the reductions are coming from the electricity group: 12,500 jobs are to be eliminated, roughly 30 percent of the group’s workforce. So far RWE has scrapped 6,200 positions, chiefly through retirement and voluntary leave packages.
After initially battling for new electricity customers, RWE concluded that going for market share domestically was a game it couldn’t afford to win. “We have, in fact, stopped going for individual private household customers outside of our traditional region [the Rhine and Ruhr valleys] because it’s too expensive,” says Sturany. “We are not going for market share in Germany -- we are going for margins.” In any event, the German cartel office’s strict enforcement of monopoly rules makes it difficult for RWE or for rival E.On -- which between them control 60 percent of the domestic electricity market -- to expand much more.
RWE’s domestic electricity business is now emerging from the red. In the first quarter its operating results from its core businesses were up 11 percent compared with the same period last year. Electricity generating worldwide supplied most of the growth, with a 50 percent surge. In all, electricity accounted for 47 percent of RWE’s revenues and 46 percent of its total operating results. The comparable figures for gas were 11 percent and 22 percent; water, 5 percent and 20 percent; and environmental services, 3 percent and 2 percent. (The remaining revenues and operating results come from noncore businesses.)
To help RWE managers focus on profits, Kuhnt and Sturany broke the company up into smaller operating units, each accountable for its performance, and set up a results-based incentive scheme. “That’s a management philosophy: Pass on the pressure of the financial markets to our operational people as well,” says Sturany.
More controversially, RWE has also sought to augment profits through energy trading, employing some Enron Corp. veterans, though not the Enron model (see box, above).
To be sure, RWE is not entirely the free spirit that deregulation might imply. German municipalities continue to own about 35 percent of the company, versus 49 percent for institutional investors (counting German insurer Allianz’s 12 percent stake), 13 percent for individual investors and 3 percent for employees. The 130 municipalities hold five seats on RWE’s 20-member supervisory board.
Nevertheless, Kuhnt maintains that “the municipalities are not organized in a company and don’t act in a bloc.” He notes that they “never intervened when we planned our acquisitions, and they gave their approval to the new structure of RWE.” What’s more, Kuhnt points out, cash-strapped local governments are now as profit-driven as any other shareholders.
The municipalities have had to accept that RWE must operate in a new competitive environment, adds former utilities analyst Schumacher. “The influence the municipalities can have on the running of the business is much less than it used to be,” he says. “In the past they could determine where you spent your money, what projects you should do, what you think is socially acceptable -- but they can’t do this any more. If you’re not completely ruthless and efficient in your core business, you don’t have a chance of survival.”
RWE is largely done with major acquisitions for the time being, Kuhnt insists. The task at hand is to absorb the five companies that RWE stuffed into its shopping bag during its 48-month global shopping spree. But he concedes that there may be just one last reason to keep the credit card close at hand: RWE is looking to move into the U.S. electricity business by building on its 68 percent stake in Consol Energy, whose coal mines and gas fields make an ideal foundation for a fossil fuel power generation business. But antitrust restrictions would confine RWE to nonregulated wholesale power generation.
Ironically, the European Commission, having sparked tumultuous electricity deregulation in Germany, has yet to truly liberalize energy markets across Europe. Kuhnt was sharply disappointed this spring when France -- the main opponent of dropping barriers between European energy markets -- reluctantly agreed to allow business customers but not home consumers to choose cross-border power suppliers by 2004. Says Kuhnt, “It is progress, but only very, very little.”
For the time being, however, Western European markets are not a pressing issue for RWE. It first must integrate its dozens of operations and thousands of employees in the U.K., the U.S. and Eastern Europe. Much as the idea appeals to RWE, conquering the continent on a level playing field will have to wait -- just as it will for Bayer Leverkusen, which lost in the cup final.
