Cause to Be Cautiously Bullish on EN

Italian utility Enel (EN - commentary - Cramer's Take) is the second-largest utility in Europe, after Electricite de France (ECIFF - commentary - Cramer's Take), and the third-largest utility in the world in terms of revenue. It certainly has an impressive market cap, at $75 billion.

The company is also giving me reason to be cautiously bullish on it, especially relative to its German competitor, E.On (EONAF - commentary - Cramer's Take). I say "cautiously" because of its heavy debt load and the likelihood of its making sizeable investments in its Russian operations. I say "bullish" because of its smart acquisition strategy and significant edge over its competition in renewable energy.

Changing Scene

The configuration of European energy is changing rapidly due to two main factors. The first is the push by the European Union to radically increase the share of renewable energy sources in electricity generation by 2010. The second is the growing presence of Russian energy sources as an alternative source of carbon-based fuels.

While the major oil and refining companies have had a major push to invest in Russia as a source of fuels, some major European utilities such as Enel and E.On are also entering the game of distributing electricity to Russia's power-hungry consumers.

The situation for these European powerhouses is much simplified by the recent decision of Russia's gigantic state-owned utility RAO Unified Energy Systems to unbundle its system of regional electricity operators and sell them off. E.On owns 70% of OGK-4 and Enel currently owns 37% of OGK-6. There's plenty to be done to revamp Russia's outmoded system of electricity generation and distribution.

At the same time, Enel has also outbid E.On over Spanish utility Endesa (ELE - commentary - Cramer's Take), in which Enel has a stake of 67%, along with its partner in the deal, Spanish infrastructure company Acciona.

The Endesa acquisition comes with considerable strings attached by the Spanish Ministry of Industry, including a pact to keep Endesa's structure intact and another to keep the company's debt-to-EBITDA ratio below certain levels.

But these investments are just part of a long list of Enel acquisitions. Over the past year, Enel has positioned itself in energy generation in Slovakia and Bulgaria, French wind-farm operator Erelis and projects in Panama and Brazil.

Given all these pressures, Enel has done fairly well over the last year, delivering fairly consistent stock returns of 30% and a dividend yield of 3.3%.

Source: Yahoo! Finance

Deepening of Assets -- And Liabilities

A potential Enel investor should consider that all of Enel's frenetic acquisition activities have come at considerable cost. The company's net debt-to-EBITDA ratio has increased by 156% to 11 over the third quarter of 2007. Most of this debt is in long-term bonds, whose face value is now at 15 billion euros out of a total net debt position of 24 billion euros.

The main items increasing this debt were 10.3 billion euros that increased Enel's Endesa stake, 1.3 billion euros for the acquisition of the 30% OGK-5 stake and 674 million euros to purchase Enel's 40% stake in Enineftegaz, a joint venture with Italian oil and gas distributor Eni (E - commentary - Cramer's Take) to control some of Russia's upstream gas assets.

I'm cautiously bullish on Enel given the consistent growth between 2006 and 2007 of the company's net asset positions in its different segments. It's especially impressive in domestic sales, but notable too in the company's international segment.

Enel increased its capital expenditures by 40% over the third quarter and increased cash by 473% to 15 billion euros. The table below shows the evolution of income and net assets for Enel's five main segments, with figures extracted from Enel's third-quarter results. (Revenue is gross of eliminations and adjustments.)

	Enel
% change in domestic sales operating income	300%
Domestic sales as a % of total revenues	42%
% change in net assets of domestic sales	107%
% change in domestic generation operating income	31%
Domestic generation as a % of total revenues	35%
% change in net assets of domestic generation	4%
% change in domestic infrastructure operating income	30%
Domestic infrastructure as a % of total revenues	11%
% change in net assets of domestic infrastructure	11%
% change in international operating income	-26%
International operations as a % of total revenues	8%
% change in net assets of international operations	40%
% change in services operating income	-17%
% change in services revenues	2%
% change in net assets of services	-35%

You can see that while Enel has increased its debt position, it has also invested heavily in its domestic and international sales.

Some of Enel's investments, especially in Russia electricity sales, might lead to unstable revenue generation in the future. But I also believe that the scope of Enel's acquisitions shows it's positioning itself to become the most important utility on the European scene, especially in renewable energy.

Renewable Promise

The Endesa move is also a play on renewable energy. I'd go so far as to say that taking a long position in Enel is the same as taking a long position in Endesa, which is the same as making a play on renewables.

It's also worth noting that Endesa has announced that its ADRs will be delisted from the New York Stock Exchange, probably on Dec. 5, consequent to the Enel-Acciona tender offer. As a result, the free float of Endesa stock has been reduced drastically.

Endesa has reported new initiatives in the Greek market and EBIT growth in Latin America. Overall, net income to the Spanish utility declined by 21% during the third quarter. But some segments performed well last year, especially Latin American distributions, where EBIT increased by 14%.

Wind remains one of Endesa's aces in the hole; electricity generation that was wind-originated increased by 582% in the third quarter (and hydrothermal derived electricity generation increased by 12%, and renewable generation by 25%).

A long position in Enel is not without its risks. The company is likely to make a substantial investment in its Russian operations, which it can ill afford to do now, given its heavy debt overhang. But the overall asset position of the Italian utility makes me cautiously bullish on it.

---

Vasu Vijayraghavan was an academic finance professor at the University of Paris who has now turned to a new career as a financial consultant. As an academic, she wrote on corporate governance issues, especially in the European context, and she believes in a long-run and balance sheet approach to stock picking.

Currently, Vasu is working as a consultant for lawyers, doing business valuation. She is a Level II CFA candidate and enjoys writing long/short and earnings calls pieces for TheStreet.Com.

Vasu holds a Ph.D. from the University of Michigan and a B.A. from Harvard University.