Strategic Analysis and Valuation of

Master Thesis at CBS

Applied Economics and Finance

Thesis advisor: Henning Skov Jensen

Student: Niels Broholm

Number of characters: 143,666

Submitted: August 1, 2018

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Abstract This thesis investigates whether the shares of DONG Energy A/S were sold at a fair price during the

capital increase at the beginning of 2014. The equity of the company was valued at DKK 31.5bn at

the time of sale.

By conducting a disaggregated discounted cash flow valuation, the fair value of DONG Energy’s

equity is estimated to be DKK 51.4bn at the time of the sale. Since this valuation of the equity is

DKK 19.9bn, corresponding to 63%, higher than the valuation in the deal, the thesis concludes that

the Danish government did not sell the shares at a fair price in the capital increase of 2014.

The valuation in this thesis is based on strategic and financial analyses of DONG Energy’s four

business units: Exploration & Production, Wind Power, Thermal Power, and Customers & Markets.

Exploration & Production, which produces oil and natural gas, is in a risky business because its

profitability is highly dependent on the prices of oil and natural gas.

Wind Power is the global market leader within construction and operation of offshore wind farms.

This market is expected to continue its growth as the global energy mix is shifting towards more

renewable energy. Wind Power first mover advantage in the form of technological leadership serves

as a sustainable competitive advantage, and this makes it the most valuable of the business units.

Thermal Power, which generates electricity and district heating in Denmark, is the least valuable of

the four business units, because the business model is suffering due to low contribution margins, that

are expected to stay low in the foreseeable future.

Customers & Markets sells and distributes electricity and natural gas in Northern Europe. It also

hedges DONG Energy’s energy exposures. While the hedging activities are not assessed to

particularly valuable, the customer bases within natural gas and electricity sales are valuable, and

they serve as a sustainable competitive advantage.

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Tableofcontents

1.Introduction 4

2.ProblemStatement 5

3.Methodology 6

4.Companyprofile 15

5StrategicAnalysis 24

6.Valuation 55

7.Conclusion 74

8.Bibliography 75

9.Appendix 80

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1.Introduction

1.1 Introduction

Ørsted is a Danish power company. It was created in 2006, when state-owned DONG, which was

short for Danish Oil and Natural Gas, merged with five other Danish energy companies to become

DONG Energy (DONG Energy, 2017a). In 2016, it was listed on the Copenhagen stock exchange

(Bray, 2016). In 2017, DONG Energy sold off its upstream oil and gas business, and as a consequence

changed name to Ørsted (Orsted, 2017).

This thesis is about the most controversial episode in the history of the company; the capital increase

of 2014. In December 2013, the then Finance Minister of Denmark Bjarne Corydon sparked public

outrage and political turmoil, when he disclosed the government’s plan to sell about 20 percent of the

shares of DONG Energy to a group of investors led by American investment bank Goldman Sachs.

Earlier that year, when the Ministry of Finance announced that DONG Energy needed a capital

increase of DKK 6-8 bn, and that it would explore how to finance it, it was barely noticed by the

media. But when a deal was made with Goldman Sachs and the two largest Danish pension funds

ATP and PFA, the capital increase of DONG Energy became the most hotly debated issue in Danish

politics (Milne, 2014). The deal was criticized in a number of newspaper articles, opinion pieces and

TV debates. 200.000 Danes signed a petition protesting the deal (Christensen, 2014). On January 30th

2014, the deal was approved by the Finance Committee of the Danish parliament (Lund, 2014).

After having read most of the newspaper articles and watched the TV debates about the deal, I have

identified four main points of criticism about the deal.

The first point of criticism was the fact that the government was dealing with Goldman Sachs.

Goldman Sachs had a bad reputation as it was perceived to have played a major part in the global

financial crisis of 2008. Critics and protestors depicted Goldman Sachs as a vampire squid sucking

blood and money out of governments around the world and funneling that money to tax havens

(Milne, 2014).

Second, critics argued that the government should not sell off stakes in state-owned companies in the

first place. Former privatizations of infrastructure companies had been costly mistakes, and the

government should not give up any control over the energy supply, they said.

The third major point of criticism was that the political and financial process, that lead to the deal,

had been too secretive, non-transparent and unprofessional.

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The fourth point of criticism was that the terms of the deal were simply bad for the government, in

particular the valuation of the equity of DONG Energy. According to the critics, the share price was

too low, so the investors were allowed a big upside while taking just a small amount of risk (Kaufholz,

2014).

1.2 Motivation

In my view, the 2013-2014 debate about the capital increase of DONG Energy was dominated by the

first two points of criticism, which are largely political in nature. For the most part, the debate was a

reflection of the ideological worldviews and biases of the participants, rather than a debate about the

specific terms of the deal. Conservatives and libertarians, who generally favor privatizations, because

they believe the market is better at allocating resources efficiently than the government, had a

tendency to argue in favor of the selling of DONG Energy shares to Goldman Sachs. Socialists, who

generally oppose privatizations because they prefer full democratic control over the common goods

of society, tended to oppose the deal.

I would have preferred that the debate focused more on the financial aspects of the deal, because they

directly affect the state treasury and thereby the Danish taxpayers. While there were people who

voiced their criticism of the terms of the deal in early 2014 – chief among them former prime minister

Poul Nyrup Rasmussen – the public discussion about the valuation of the equity of DONG Energy

never elevated past the point of simple disagreement. The critics asserted that price was too low,

while the Ministry of Finance said that they accepted the best possible offer, and that the price was

fair.

Perhaps, detailed discussion about the terms of a complicated financial deal is simply beyond the

scope of public debate, and perhaps, it is just easier and good business for the media to focus on

political conflict and clear antagonists like Goldman Sachs. Either way, the lack of real debate about

the financial aspects of the capital increase of DONG Energy serves as my motivation to write this

thesis, where I will attempt to investigate the financial aspects of the deal as detailed in the problem

statement below.

2.ProblemStatement

The above considerations lead to the main research question:

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Did the Danish government sell the shares of DONG Energy at a fair price in the capital

increase of 2014?

In order to answer this question, the thesis answers the following sub-questions:

• What were the terms of the deal and the valuation of the equity in the deal?

• What was the fair value of the equity at the time of the sale?

3.Methodology

3.1 Introduction

In this chapter, I will explain how I am going to answer the problem statement. I will explain which

models I am going to use and how they compliment each other. I will outline their pros and cons and

explain why I chose those models over their alternatives.

The first subquestion to the problem statement does not require any models to answer as the terms of

the deal and the valuation of the equity in the deal are described in the legal document that was signed

by a majority of the Finance Committee on January 30th 2014 (Folketinget, 2013). Therefore, the

majority of this thesis will focus on answering the second subquestion: What was the fair value of the

equity of DONG Energy at the time of the sale?

3.2 Choosing Between the General Approaches to Valuation

There is a large number of methods for valuing companies, so choosing the right one can seem like a

difficult task. However, these methods can be grouped into four general approaches; discounted

cashflow valuation, relative valuation, liquidation value and contingent claim valuation. The last two

approaches are rarely used as they are mostly relevant under specific circumstances (Petersen &

Plenborg, 2012, p. 211). The liquidation approach assesses the net proceeds of the company if all of

the company’s assets are liquidated and its liabilities settled. This method is best suited for companies

that are about to go out of business, and since that is not the case for DONG Energy, I will not use

this model (Petersen & Plenborg, 2012, p. 235-236). The contingency claim approach uses option

pricing models to assess the value of an asset or company. This approach has the advantage of

capturing the value of flexibility under uncertain market conditions better than other valuation

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approaches. Despite that appealing characteristic, it is almost never used in practice as it is complex

to use and its inputs are difficult to estimate (Petersen & Plenborg, 2012, p. 211).

Relative valuation is commonly referred to as valuation using multiples, because practitioners of this

method use multiples of financial ratios to value companies. With relative valuation, you value a

company by comparing its earnings to those of similar companies. I will not use relative valuation

either, because even though it is easy to use, it does not account for the intrinsic differences between

the comparable companies.

This thesis will therefore be based on the discounted cash flow (DCF) valuation approach. DCF

valuation is also referred to as intrinsic valuation (Damodaran, 2010, p. 1) and present value (Petersen

& Plenborg, 2012, p. 210). It is widely used among finance professionals (Petersen & Plenborg, p.

211), and it is recommended by the most recognized books on valuation including “Valuation –

Measuring and Managing the Value of Companies” by Koller et al. (2015) and “Investment

Valuation” and “The Dark Side of Valuation” by Damodaran (2010).

The principle of DCF valuation is that the intrinsic value of any asset is equal to the present value of

all its future cash flows. The rate used to discount the cash flows back to the present, the discount

rate, is a reflection of the riskiness of the cash flows and the time value of money (Damodaran, 2010,

p. 1). Assets with a fixed cash flow, a bond for example, are relatively simple to value, because you

only have to determine the discount rate. Applying DCF analysis to a company is more complicated,

because you have to forecast cash flows from both existing assets and from future investments in cash

flow generating assets. You also have to take the mix of equity and debt used to financing the assets

and investments into account (Damodaran, 2010, p. 2). In theory, a well managed company can

generate cash flows forever, but since it is not feasible to forecast an infinite number of cash flows,

in practice, cash flows are forecast for a finite period. A terminal value capturing the value of the cash

flows after the finite period is then estimated and added to the present value of the finite period.

3.3 How to approach the valuation of DONG Energy?

As mentioned in the introduction, the equity of DONG was valued at DKK 31.5bn in the deal with

Goldman Sachs, ATP and PFA, but critics argued that it was worth much more than that. Former

prime minister Poul Nyrup Rasmussen said that according to his calculations the value was between

DKK 60bn and 80bn (TV2 News, 2014). The wide range of opinions about the valuation of DONG

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Energy indicates that it was a difficult company to value. A brief overview of the company confirms

this indication, as DONG Energy has many characteristics that make valuation difficult. These

characteristics are described in the aforementioned book “The Dark Side of Valuation – Valuing,

Young, Distressed and Complex businesses” by Damodaran (2010). Damodaran writes that if a

company falls into one the following categories, it is likely to be difficult to value (Damodaran, 2010,

p. viii):

• Cyclical and commodity companies

• Growth companies

• Financial services companies

• Companies that are heavily dependant on intangible assets

• Companies based in emerging countries

• Multibusiness and multinational companies

DONG Energy falls into three out of these six categories. First, it has multiple business units and it

operates in several countries. Second, it is a textbook example of a commodity company as it

produces, distributes and trades energy. And third, at least part of it can be considered a growth

company as DONG Energy is investing heavily in Wind Power, its offshore wind power business

unit, which is expected to grow in the next ten years (DONG Energy, 2014, p. 9).

The first step in valuing a company with multiple businesses is deciding whether to estimate the

inputs to the valuation model separately for each business or for the company as a whole. Factors to

consider when making that decision include availability of information, the number of businesses and

regions and the differences between them (Damodaran, 2010, p. 543).

In this thesis, DONG Energy is valued on a disaggregated basis, because even though the information

available about each business unit is not as detailed as one could have hoped for, the number of

business units is small and there are large differences between them in terms of market risk and

growth prospects.

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3.4 Structure

Table 1 provides an overview of the structure of the thesis.

Table 1 – Thesis Structure

1.Introduction Introduction Motivation Problemstatement Methodology2.CompanyProfile HistoryofDONGEnergy FinancialPerformance FinancialActionPlan TheDeal BusinessUnits3.StrategicAnalysis MacroEnvironment IndustryLevelAnalyses CompanyLevelAnalyses4.Valuation FinancialStatementAnalysis Forecasting

WeightedAverageCostofCapital

DiscountedCashFlowValuation5.Conclusion Conclusion Perspective

3.5 Company Profile

The purpose of the Company Profile section is to provide background knowledge of DONG Energy.

The section will give an overview of the history of DONG Energy and its recent poor financial

performance, which lead to the financial action plan and the capital increase. The details of the deal

between the Danish government and the investors will be examined, and the business units will be

introduced.

3.6 Strategic Analysis

The purpose of the strategic analysis is to examine the resources and capabilities of each of DONG

Energy’s four business units and compare them to their industry environment. External and internal

factors likely to affect the businesses in the future are analyzed to assess the units’ abilities to create

value in the future and to assess the probability of them hitting their strategic targets. Together with

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financial statement analysis, the strategic analysis will be used to forecast the cash flows in the DCF

valuation.

The strategic analysis is done on three levels; the macro level, the industry level, and the company

level. I will begin the strategic analysis by analyzing the macro environment of DONG Energy. Then,

I will analyze the industry and company level of each business unit, one by one. In the following

paragraphs, I will describe the models chosen for each level of analysis and my reasons for choosing

them.

3.6.1 Macro Level Analysis

3.6.1.1 PESTEL

Analyzing the macro environment of a company or an industry can seem like an overwhelming task,

since there is an almost infinite amount of potential external influences. The PESTEL framework

provides a good starting point for collecting and analyzing such information, as it classifies the

information by category (Grant, 2010, p. 60-61). PESTEL is an acronym for political, economic,

socio-cultural, technological, environmental and legal factors. To avoid information overload, the

framework is often customized to focus on the key factors influencing the value creation of the

company and industry in question (Sørensen, 2012, p. 67). If a company has multiple business units

operating in widely different markets, there should be a PESTEL analysis for each business unit

(Sørensen, 2012, p. 67). Since all DONG Energy’s business units are subject to the same overall

macro environment; namely the Danish and North European energy markets, I decided to avoid

unnecessary repetition and make just one PESTEL analysis.

3.6.2 Industry Level Analysis

The industry level analyses will use two models for each of the four business units; Porter’s Five

Forces and Industry Structure and Environmental Opportunities.

3.6.2.1 Porter’s Five Forces

The classic framework for analyzing the competition intensity of an industry, Porter’s Five Forces,

will be used to analyze the industries of each of DONG Energy’s business units. The purpose of the

analyses is twofold. First, it will help gain an understanding of the important features of each industry.

This will be useful when analyzing each business unit at the company level to assess their

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competitiveness. Second, it will be used to analyze the overall attractiveness of each industry (Grant,

2010, p. 73).

Porter’s five forces include three horizontal forces of competition: the threat of substitution, the threat

of new entrants, and the industry rivalry of the established competitors. The framework includes two

sources of vertical competition: the bargaining power of suppliers and the bargaining power of buyers

(Grant, 2010, p. 65).

3.6.2.2 Industry Structure and Environmental Opportunities

While the Porter’s Five Forces framework focuses on environmental threats to analyze an industry

and its attractiveness, it does not offer much in terms of identifying and analyzing opportunities in a

given industry structure. Therefore, an opportunity analysis will be conducted for the industry of each

business unit. ”Opportunity analysis begins by identifying several generic industry structures and

then describing the strategic opportunities that are available in each of these kinds of industries”

(Barney, 2015, p. 69). Like Porter’s Five Forces Framework, this approach to opportunities was first

introduced by Michael Porter (Barney, 2015, p. 82).

Table 2 provides an overview of the four most common industry structures and the opportunities

associated with them. The contents of this table will serve as the starting point of each opportunity

analysis.

Table 2 – Industry Structure and Strategic Opportunities

IndustryStructure OpportunitiesFragmentedindustry ConsolidationEmergingindustry FirstmoveradvantagesMatureindustry Productrefinement

Investmentinservicequality

ProcessinnovationDecliningindustry Leadership Niche Harvest Divestment

Source: Barney et al., 2015, p. 70

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3.6.3 Company Level Analysis

At the company level, two tools of strategic analysis will be used; the VRIO framework and SWOT.

3.6.3.1 VRIO

The VRIO framework is an internal analysis of the company. It is employed to analyze the ability of

each business unit to create value in its environment.

VRIO, which was developed by Jay Barney, seeks to answer whether the resources and capabilities

of a company constitute a sustainable competitive advantage.

The first step in this process is identifying the resources and capabilities of the company. A way to

distinguish resources from capabilities is to think of resources as “the productive assets owned by the

firm” (Grant, 2010, p. 116) and capabilities as “a firm’s capacity to deploy resources for a desired

end result” (Grant, 2010, p. 121). Resources can be categorized in a couple of different ways. I have

chosen the approach recommended by Gamble et al. (2015) in their book “Essentials Of Strategic

Management”. They categorize resources into two groups; tangible and intangible resources (Gamble

et al., 2015, p. 71). Tangible resources are:

• Physical resources such as plants, equipment, real estate, and natural resources

• Financial resources such as cash, securities and other “financial assets such as a company’s

credit rating and borrowing capacity” (Gamble et al., 2015, p. 71)

• Technological assets such as patens, copyrights, and productions technology

• Organizational resources such as information systems, communication systems, quality

control systems, and distribution networks

Intangible resources are:

• Human resources, which include the training, experience, judgment, intelligence of individual

employees as well as the collective learning and managerial know-how embedded in the

organization

• Reputational assets, which includes brand names, image, customer loyalty, and reputation for

quality and service

• Relationships, which include alliances and joint ventures that provide access to desired

technologies, knowledge, or geographic markets

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• Company culture, which includes the relationships between groups of employees, the norms

of behavior, business principles, and beliefs within the company

VRIO is an acronym for value, rarity, imitability and organization. For each resource or capability

you ask a series of four questions, which Barney phrases in the following way:

1. “Value – Does the resource enable a firm to exploit an environmental opportunity and/or

neutralize an environmental threat?

2. Rarity – Is the resource currently owned by only a small number of competing firms?

3. Imitability – Do firms without a resource face a cost disadvantage in obtaining or developing

it?

4. Organization – Are a firm’s other policies and procedures organized to support the

exploitation of its valuable, rare, and costly-to-imitate resources?” (Barney, 2015, p. 90)

Table 3 shows the implications from asking and answering the four questions.

Table 3 – VRIO Framework

Source: Barney, 2015, p. 103.

3.6.3.2 SWOT

The results of all the other strategic analysis models will be summarized in a SWOT table for each of

the four business units. SWOT is an acronym for strengths, weaknesses, opportunities, and threats.

The SWOT framework is used to provide a holistic overview of the business units.

3.8 Data

The aim of the thesis is to answer whether the shares of DONG Energy were sold at fair price in the

capital increase of 2014. Both the seller, the Danish government, and the investors had access to

internal data from DONG Energy, before making their decisions. Unfortunately, I do not have access

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to internal data. Therefore, all analyses in this thesis are based on publicly available secondary data.

The main sources of data are DONG Energy’s annual reports, government document and websites,

and industry reports from the companies Frost & Sullivan and Marketline. I consider all the data

sources reliable.

3.9 Potential Bias

This thesis was written in the first part of 2018. Therefore, it is known what has happened to DONG

Energy since 2014. The value of the company has increased dramatically, and it got listed on the

Copenhagen Stock Exchange in 2016. Since the purpose of the thesis is to evaluate the capital increase

of 2014 by making a DCF valution based solely on information available at the time, having

knowledge about the company’s development since the cut-off date, gives me a potential hindsight

bias – even though I have not examined the financial statements from 2014 to 2018. In finance, using

data or information that was not available in the time period being analyzed is often referred to as

look-ahead bias (Investopedia, 2018). In both the strategic analysis and the valuation, I am carefully

avoiding look-ahead bias. However, there is no standardized formula for forecasting the inputs to the

DCF model, so, even though they are based on the strategic analysis and the financial statement

analysis, they are ultimately subjective and thus susceptible to my potential unconscious biases.

While all DCF valuations are susceptible to biased inputs, the potential for hindsight bias is a

particular weakness of this thesis.

3.10 Delimitations

The cut-off date for this thesis is set to February 5th 2014, because that was the day the annual report

for 2013 was published (Orsted, 2017). As mentioned in the introduction, the capital increase was

approved by the Finance Committee of the Danish parliament on January 30th 2014, six days earlier.

While the members of the committee most likely did not have access to the financial results of the

last quarter of 2013 at the time of the vote, the Ministry of Finance most likely did, and thus they

could have halted the deal if they thought it was warranted by the financial results of 2013. Therefore,

I think it is most appropriate to include the annual report for 2013, rather than just the first three

quarterly reports, when analyzing whether the shares were sold at a fair price. The fact that February

5th 2014 is chosen as the cut-off date does not mean that I will not use data from sources that were

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published after that date. The critical point is whether or not DONG Energy and the Ministry of

Finance had access to the data on February 5th 2014.

There are two important aspects of the deal between the government and the investors, that I can not

conduct a proper valuations of, even though that would be desirable. First, the employee share scheme

that was introduced in the deal as requested by Goldman Sachs, is not possible to value, because the

details are not public. Second, the put option given to the investors as part of the deal is difficult to

value, because to value options, an estimate of the volatility of the underlying asset is needed, in this

case the equity value of DONG Energy. Since DONG Energy was not listed in 2014, such an estimate

would require a large amount of assumptions, that might not hold true. Therefore, I have decided not

to value the put option.

In case of discrepancies between numbers in annual reports the latest one is used.

The reader is assumed to be familiar with the most common terms of finance, economics, and

statistics.

4.Companyprofile

4.1 Introduction

The purpose of this section is to provide background knowledge of DONG Energy. The section will

give an overview of the history of DONG Energy, its recent poor financial performance, which lead

to the financial action plan and the capital increase. The details of the deal between the Danish

government and the investors will be examined, and the business units will be introduced.

4.2 History of DONG Energy

On March 27th 1972, the Danish Ministry of Commerce established Dansk Naturgas as a state-owned

company with the purpose of buying natural gas for the country. It was part of a long-term strategy

of improving the security of the national energy supply. However, the company was tiny and idle,

until the international oil crisis of 1973 exposed just how dependent Western Europe was on fossil

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fuel from the Middle East (Mathiasen, 2015, p. 22). Denmark was hit particularly hard as oil

comprised about 90% of its energy use in 1973 (Larsen, 2018).

On December 2nd 1973, Dansk Naturgas was renamed to Dansk Olie og Naturgas, which means

Danish Oil and Natural Gas – in short DONG (DONG Energy, 2017a). The government wanted

DONG to be a leading energy supplier in Denmark, and throughout the 1970s, a large majority of the

parliament voted to help DONG take control of the energy supply. DONG was designated to build a

distribution net of natural gas (Mathiasen, 2015, p. 23) and it was granted exclusive rights to import,

trade, transport and store natural gas in Denmark (DONG Energy, 2017a).

In the 80s, the natural gas distribution net was completed and DONG opened its first underground

natural gas storage facility. DONG started to distribute natural gas to Danish customers and it started

to export natural gas to Germany and Sweden (Naturgasfakta, 2017). The gas was extracted from the

North Sea by the Danish conglomerate A.P. Møller.

In the 90s, DONG expanded its activities significantly. In addition to being a distributor, DONG

became a manufacturer of oil and natural gas. In the European political and economic sphere, the free

trade area, known as the common market, was evolving. The European Union decided to liberalize

the energy markets, and as a member state Denmark had to be part of that liberalization. Until then,

the Danish energy sector had been a decentralized patchwork of small local power plants and

distributors. Many of which were controlled by local municipalities. The politicians of the Danish

parliament feared that many of the small energy companies would be acquired by foreign companies,

once the energy market was liberalized. In order to prevent that from happening, they decided to

consolidate as many Danish energy companies as possible under one big, state-owned, internationally

competitive company; DONG (Mathiasen, 2015, p. 24). After a long power struggle with some of the

biggest private competitors, the plan came to fruition. In 2006, the merger of the six Danish energy

companies DONG, Elsam, Energi E2, NESA, Københavns Energi og Frederiksberg Forsyning

created what was to become one of the leading energy groups of Northern Europe; DONG Energy

(DONG Energy, 2017a).

From the beginning, the plan was for DONG Energy to go public within a few years. However, that

did not happen due to the bad market conditions of the financial crisis in 2008 (Flensborg, 2008).

After the merger, the management headed by CEO Anders Eldrup focused on integrating the six

different companies and creating synergies between them. As the company had activities within all

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parts of the energy value chain, they implemented a reporting structure of four segments: Generation,

Exploration & Production, Distribution, and Markets (DONG Energy, 2007, p. 5).

Generation produced electricity and heat from conventional power plants and renewable energy

sources such as offshore wind farms and biomass fueled power plants (DONG Energy, 2007, p. 13).

Exploration & Production searched for and pumped oil and natural gas in the North Sea (DONG

Energy, 2007, p. 17). Markets sold electricity to about a million customers in the greater Copenhagen

area. They also sold natural gas to 116,000 customers in Southern Jutland and the southern and

western parts of Zealand. Distribution delivered the electricity and gas that Markets sold.

Over time, this reporting structure has changed a couple of times. Generation is now split into the

business units Wind Power and Thermal Power.

The units Markets and Distribution were first changed into the two new business units Energy

Markets and Sales & Distribution in 2008, as DONG Energy increased their international energy

trading. Energy Markets was buying and selling gas and electricity internationally; wholesale and on

energy trading hubs. The aim of Energy Markets was to optimise and hedge the company’s energy

portfolio (DONG Energy, 2009, p. 27). Sales & Distribution was selling and distributing gas and

electricity directly to end customers, primarily in Denmark, but also in other countries in Northern

Europe (DONG Energy, 2009, p. 33). In 2012, Energy Markets performed terribly and it reported a

large operating loss. This led to Energy Markets and Sales & Distribution being merged into the new

business unit Customers & Markets (Orsted, 2013). To sum up, the four business units of 2014 are:

Exploration & Production, Wind Power, Thermal Power and Customers & Markets.

Geographically, DONG Energy has always been focused on Northern Europe, selling off activities

in Spain and Portugal immediately after the merger in 2006 (DONG Energy, 2007, p. 2).

From the early years, DONG Energy’s investment strategy was focused on Exploration & Production

and renewable energy. The company wanted to increase its own production of gas, so that 30% of its

supplies were covered by it. It also wanted to continue investing in exploration for oil and gas in the

North Sea (DONG Energy, 2007, p. 4). The investments in renewable energy were focused on

building and operating offshore wind farms, particularly in the UK, but also in Denmark (DONG

Energy, 2009, p. 12).

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In addition to the offshore wind investments, they increasingly used biomass as fuel for their power

plants instead of fossil fuels such as coal, trying to lower CO2 emissions (DONG Energy, 2010, p.

8).

Table 4 shows DONG Energy’s gross investments by business unit from 2010 to 2013. The table

clearly shows the strategic focus on Exploration & Production and Wind Power.

Table 4 – Investments in Business Units as a Percentage of Total Investments

Grossinvestment 2010 2011 2012 2013Exploration&Production 26% 31% 28% 45%WindPower 41% 59% 62% 45%ThermalPower 25% 4% 2% 3%Customers&Markets 9% 6% 8% 7%

Source: Own creation based on DONG Energy’s annual reports

The focus on Wind Power has made DONG Energy the ”global market leader in the design,

construction and operation of offshore wind farms” (DONG Energy, 2012, p. 10). The investments

in Exploration & Production has given the company a ”strong regional position in North West

Europe” (DONG Energy, 2013, p. 5).

4.3 Financial Performance and the Need for a Capital Increase

4.3.1 Introduction

In this section, I will present a brief overview of DONG Energy’s financial performance from 2007

to 2011. Then I will explain what went wrong for them in 2012. Finally, I will describe how the

company dealt with the financial issues by devising a financial action plan, that included a capital

injection.

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4.3.2 The Period 2007-2011

Table 5 – Economic Performance from 2007 to 2013

Source: Own creation based on DONG Energy’s annual reports

Table 5 provides an overview of DONG Energy’ economic performance from 2007 to 2013. As can

be seen from the table, the overall economic performance of DONG Energy from 2007 to 2011 was

decent, but not impressive. Total revenue grew from DKK 41bn to DKK 57bn. EBITDA varied, but

trended upwards from DKK 9bn in 2007 to DKK 14bn in 2010 and 2011. Profits varied between

DKK 1.5bn and DKK 4.7bn. Profitability, which DONG Energy measures with the return on capital

employed ratio, ROCE, varied between 6.1% and 11.6%. The Ministry of Finance has conceded that

ROCE only surpassed the weighted average cost of capital in 2008 and 2010. However, it should be

noted that DONG Energy was investing heavily in offshore wind power and oil and gas exploration

and production in those years, and the proceeds from those investments had not yet been realized

(Rigsrevisionen, 2013, p. 19).

4.3.3 The Dreadful Year 2012

In 2012, a combination of negative events made for a very bad year for DONG Energy. The events

were:

• Lower coal prices made their natural gas power plants less competitive, and they, in turn, had

to write down the value of them.

• They had to make provisions for onerous gas storage contracts because smaller seasonal price

swings made gas storage less profitable (DONG Energy, 2013, p. 17).

• Reparations on the SIRI platform was a contributing factor to the oil production being lower

than usual. The costs of the reparations totaled DKK 3.5bn in 2012 (Rigsrevisionen, 2017, p.

13).

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• Due to mild weather, a declining economy and a large supply of cheap electricity from

Swedish and Norwegian hydropower, electricity prices were about 30% lower in 2012 than

in 2011.

• The prices on DONG Energy’s long-term gas buying contracts were oil-indexed, while their

gas sales depended on the spot prices for gas. A widening spread between oil and gas prices

cost the company money, even though a large proportion of this exposure had been hedged.

(Rigsrevisionen, 2017, p. 13) (DONG Energy, 2013, p. 25).

From 2007 to 2011, DONG Energy had financed its large investments in Exploration & Production

and Wind Power with operating profits, divestment and debt. In 2012, even with a normal economic

development, the borrowing associated with the continuation of the investment programme would

put pressure on key leverage ratios. With the bad economic performance of 2012, an even larger part

of the investments had to be financed with debt. The resulting higher leverage made the rating agency

Standard & Poor’s downgrade DONG Energy from A- to BBB+ with a negative outlook in October

2012. At the time, most European energy companies had a rating of A- with a few companies having

A+ and BBB+. While the bad market conditions also caused other energy companies to be

downgraded, DONG Energy was the only European energy company to have a BBB+ rating with a

negative outlook (Rigsrevisionen, 2017, p. 14-15).

The BBB+ rating itself was not catastrophic or even that costly for DONG Energy. It only entailed

an increase of the financing costs of about 0.06% per year, equivalent to DKK 9mn. The problem

was, that in addition to downgrading DONG Energy, Standard & Poor’s tightened the leverage ratio

requirements for the whole utility sector due to uncertain market conditions. Standard and Poor’s also

changed their weighting of the hybrid capital bonds issued by DONG Energy from 100% equity to

100% debt. The bonds had an outstanding value of DKK 5bn. Therefore, DONG Energy was likely

to be downgraded to BBB or even BBB-, if it did not improve its capital structure. DONG Energy

and the Ministry of Finance assessed that a rating of BBB would have a negative effect on the

company’s possibilities of entering into corporate partnerships in the offshore wind department. It

would also entail significantly larger financing costs. A rating of BBB- would be outright disastrous,

as it would lead to a full investment stop, which would have an extremely negative effect on the value

of the company (Rigsrevisionen, 2017, p. 15-17).

The management of DONG Energy, the Ministry of Finance and their financial advisor Danske Bank

considered and discussed a number of different ways to improve the capital structure. Among other

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things, they considered issuing new hybrid capital bonds, downsizing the investment programme,

spinning off the investment heavy business unit Wind Power into a stand alone company, a

government capital injection, and a capital increase with money from external investors

(Rigsrevisionen, 2017, p. 16-18). Ultimately, they decided that a capital increase of DKK 6-8bn

financed by external investors combined with a financial action plan was the best solution.

4.3.4 Financial action plan and strategy from 2013

On March 9th 2012, DONG Energy fired Anders Eldrup, the CEO responsible for the strategic focus

on Wind Power and Exploration & Production. (Damløv, 2012). The firing did not have anything to

do with the poor financial performance that would turn out later that year. Rather, it was a result of a

power struggle and a conflict about excessive remuneration of four key employees between Eldrup

and Chairman of the Board of Directors Fritz Schur (TV2, 2015) (Hjorth, 2013). However, when the

newly appointed CEO Henrik Poulsen assumed his position in September 2012 (Mathiasen, 2012),

the financial problems were mounting, giving him the chance to plan and execute a turnaround.

He did so by presenting a five-part financial action plan for 2013 and 2014 with the purpose of

restoring the company’s financial performance and capital structure. The five points were:

• ”Divestment of non-core assets for DKK 10bn

• Reduction of ownership interests in core activities

• Cost reductions with effect of DKK 1.2bn in 2013

• Restructuring of the loss-making gas business

• Injection of additional equity of at least DKK 6-8bn” (DONG Energy, 2013, p. 5)”

In addition to the plan, Poulsen stated that, from then on, the company would adopt ROCE, which is

short for return on capital employed, as its main financial target. ROCE had to be at least 10% from

2016 and onwards. He also reaffirmed the company’s strategic focus on offshore wind, exploration

and production, biomass-fueled power stations, and energy efficient customer solutions. He listed

four strategic benchmarks moving towards 2020 within these areas:

• ”Quadrupling installed offshore wind capacity

• Doubling oil and gas production

• Doubling the biomass share in generation from Danish power stations

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• Quadrupling energy savings among Danish customers” (DONG Energy, 2013, p. 5)”

In 2013 and January 2014, DONG Energy executed the first four parts of the plan. They sold off non-

core assets for DKK 14.4bn. They sold their stake in the London Array offshore wind farm, which

was a core activity, for DKK 5.8bn. They reduced costs for DKK 1.4bn. And they renegotiated a

number of gas contracts turning the 2012 loss into a small profit in 2013 (DONG Energy, 2014, p.

9). The financial action plan was completed on February 20th 2014, when the capital increase of

DKK 13bn was finally approved (Orsted, 2014b).

4.3.5 The Deal

In this section, I will describe the most important terms of the deal in which the Danish government

sold DONG Energy shares for DKK 11bn to the investors Goldman Sachs, ATP, and PFA.

4.3.5.1 Valuation

The pre-money valuation of the equity of DONG Energy was DKK 31.5bn. New Energy Investment,

which is a Luxembourg based shell company founded and controlled by Goldman Sachs, invested

DKK 8bn. The Danish pension funds ATP and PFA invested DKK 2.2bn and DKK 0.8bn,

respectively. To avoid getting their shares diluted, every existing minority shareholder were offered

to buy new stock under the same conditions as the new investors (Folketinget, 2013, p. 2). Four out

of five minority investors chose to do so (DONG Energy, 2014, p. 9).

4.3.5.2 Employee Share Scheme

Executives and employees were offered buy stock as part of an incentive programme designed to

keep key employees from leaving the company. 3,294 employees and managers chose to do so for a

total of DKK 222mn (Rigsrevisionen, 2017, p. 41).

4.3.5.3 Put Option

The new investors and DONG Energy agreed to pursue an IPO before 2018. After the IPO, the

government should still be the majority shareholder.

If DONG Energy was not publicly listed 45 days after the publication of the 2017 annual report, the

investors had the right to sell all of their shares to the government. 60% of the shares were to be

valued at the purchase price plus interest. The interest rate was set to be the Copenhagen Interbank

Tomorrow/Next Average, CITA, plus 2.25% per year. The remaining 40% were to be sold back at

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fair market value, defined as the average between the valuations of two independent investment banks

(Folketinget, 2013, p. 6).

4.3.5.4 Other Important Aspects of the Deal

• New Energy Investment got the right appoint one member of the board of directors and two

observers. ATP got the right to appoint one member of the board (Folketinget, 2013, p. 5).

• New Energy Investment got veto rights on virtually all major decisions, including significant

deviations from the current business plan, issuance of new hybrid capital, changes in the

management, and changes to the dividend policy.

• The investors were indemnified from potential losses resulting from a lower value of the

troublesome oil platform Siri.

4.4 Business Units

4.4.1 Introduction

As described in the section above, the corporation DONG Energy was created after the merger of six

Danish energy companies. As a result, it operates in a number of industries within the energy sector.

In this section I will give a brief description of the four main business units of DONG Energy.

4.4.2 Exploration & Production

Exploration & Production is the upstream part of DONG Energy’s oil and natural gas business. As

the name suggests, it explores and produces oil and natural gas.

4.4.3 Wind Power

”Wind Power develops, constructs and operates wind farms in Northern Europe. Wind Power

concentrates on the UK, Germany and Denmark as the largest growth markets” (DONG Energy,

2014, p. 28).

4.4.4 Thermal Power

Thermal Power generates electricity and district heating with conventional power stations. It

primarily operates in Denmark, where it has nine of the largest power stations. Most of the power

output comes from coal, gas, and biomass-fired combined heat and power plants.

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4.4.5 Customers & Markets

Customers & Markets sells electricity and gas on both wholesale and retail markets in Denmark,

Germany, Sweden, and the UK. Customers & Markets also handles the hedging of DONG Energy’s

energy exposures.

5StrategicAnalysis

5.1 Introduction

The purpose of the strategic analysis is to examine the resources and capabilities of each of DONG

Energy’s four business units and compare them to their industry environment. External and internal

factors likely to affect the businesses in the future are analyzed to assess the units’ abilities to create

value in the future and to assess the probability of them hitting their strategic targets.

5.2 Macro Environment

The macro environment will be analyzed with the PESTEL framework, which is short for political,

economic, socio-cultural, technological, environmental and legal factors. I have chosen to merge

the political and legal factors, because I think separating them would be artificial, given that the

subject is DONG Energy and the tightly regulated energy industry.

5.2.1 Political and Legal Factors

5.2.1.1 Government Ownership

The first political factor that must be considered is the fact that the Danish government is the majority

shareholder. Every action DONG Energy takes is ultimately subject to political control. If the Danish

politicians wanted to, they could engage in DONG Energy’s decision making process on a regular

basis. This might decrease the value of DONG Energy as politicians have other interests besides sheer

value creation, e.g. re-election, environmental concerns, and the interests of households and other

businesses not to spend too much money on energy. However, until now, the Danish government has

not exercised that kind of active ownership over DONG Energy. The political debate about DONG

Energy has been centered around the question of privatization and going public. In addition to that,

it should be mentioned that Transparency International ranked Denmark as the least corrupt country

in the world on in their Corruption Perceptions Index for 2013 (Transparency International, 2014).

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Therefore, I would argue that the risk of undue political interference is so small, that government

ownership of DONG Energy does not warrant a discount on the valuation of the company.

Nevertheless, as mentioned in the section about the terms of the deal, Goldman Sachs received veto

rights on all major strategic decisions as part of the deal, and thus eliminated any potential risk of

undue political interference.

One could also argue, that government ownership might increase the valuation of DONG Energy,

because it decreases the risk of bankruptcy, as the government is unlikely to let its own utility giant

fail. However, since the risk of bankruptcy is very small in the first place, I do not think that

government ownership increases the value of the company.

To summarize, I do not think the fact that the government is the majority shareholder affects the

valuation in a significant way. Therefore, potential future reductions in the government’s share of the

company will not affect the value of the DONG Energy.

5.2.1.2 European Focus on Lowering Greenhouse Gas Emissions

The international focus on combating climate change is particularly prominent in the EU. In 2005,

the EU set up the world’s first emissions trading system as a tool to lower the emission of greenhouse

gases (European Commission, 2018). The EU has an ambitious target that by 2050, total greenhouse

gas emissions must be lowered by 80-95% compared to 1990 (Regeringen, 2013, p. 10). For the

purpose of this analysis, the key questions are: how does the focus on reducing greenhouse gas

emissions translate to policy in DONG Energy’s markets? And how do these policies affect DONG

Energy?

In August 2013, the Danish government published its overall climate plan. Denmark wants to reduce

greenhouse gas emissions by 40% in 2020 compared to 1990. By 2030, oil for heating and coal must

be phased out. By 2035, the electricity and heat supply must be covered by renewable energy. In

2050, all of Denmark’s energy consumption must be covered by renewable energy (Regeringen,

2013, p. 14). These targets sound very ambitious, and indeed they are. But actually, they are similar

to the targets of the other countries of Northern Europe, DONG Energy’s geographic area of focus.

Germany intends to reduce its greenhouse gas emissions by 40% in 2020 compared to the level of

1990. It also wants to phase out nuclear power. Norway wants to become greenhouse gas neutral by

2050. Sweden wants to reduce greenhouse gas emissions from the sectors, that are not covered by the

EU emissions trading system, by 40% in 2020 compared to the level of 1990. And the UK wants to

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reduce greenhouse gas emissions by 34% in 2020 compared to the level 1990, without buying foreign

emission credits (Regeringen, 2013, p. 17).

The countries have adopted different policies in order to achieve these climate targets. Norway and

Sweden produce a lot of hydropower because of the large differences in altitude afforded by

mountainous regions and the useful watercourses in their landscapes (Vattenfall, 2017).

Denmark, Germany and especially the UK are relying more on offshore wind power, which is DONG

Energy’s area of expertise. As of 2014, offshore wind farms are still relying on government subsidies

to be profitable. Therefore, changes to the national policies and subsidy schemes regarding offshore

wind farms and renewable energy in general can greatly influence the future value creation of DONG

Energy.

5.2.2 Economic Factors

As a producer of electricity, oil and gas, DONG Energy’s earnings and value are dependent on the

the prices of these commodities and the demand for them (Damodaran, 2010, p. 418). It is imperative

to examine the historical development of these variables, as this can contain valuable insights about

their volatility and thus their impact on the riskiness on DONG Energy’s future earnings.

It is a common pitfall for financial analysts to assume that commodity prices will stay at the current

level forever. This is called base year fixation. By doing so, one tends to overvalue companies, when

the base year is close to the peak of the cycle, and one tends to undervalue them, when it is close to

the bottom (Damodaran, 2010, p. 219-220). It is outside the scope of this thesis to attempt to predict

future prices, but I will describe how I handle the issue in the forecasting section.

On an general level, demand for electricity and gas is not considered cyclically sensitive. The primary

reason for this is that households and businesses need energy, irrespective of the state of the economy.

5.2.3 Socio-cultural Factors

The most important social factor influencing the energy markets and DONG Energy has the same

underlying cause as the political and environmental factors, namely, climate change. With regards to

socio-cultural factors, it is less important how and why the climate actually changes. What is

important is the public perception of climate change. If the public continues to worry increasingly

about climate change, DONG Energy benefits because of its green image strategic focus on Wind

Power.

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Socially responsible investing, SRI, is becoming increasingly popular. In the old form of SRI,

conscious investors screened for and excluded companies, they deemed unethical. Typically,

companies making unhealthy or damaging products like alcohol, tobacco or weapons were avoided.

Nowadays, socially responsible investors are increasingly investigating what companies they should

include in their portfolios. Their search is often focused on three criteria; environmental, social, and

governance. If SRI continues to gain influence on key institutional investors, that may have a positive

influence on the value of DONG Energy.

5.2.4 Technological Factors

There are a number of potential technological factors that may influence DONG Energy’s future

business. In a way, one might argue that the world is banking on technological advances in the field

of energy to save it from the gloomy scenarios of too much global warming. The energy efficiency

of machines such as cars is consistently increasing, and investments in renewable energy are being

made all over the world. DONG Energy’s strategic focus on offshore wind makes it one the European

leaders in the continuous effort to renew the energy supply.

However, the green transformation faces some tough challenges. If society is to run solely on

renewable energy, it must become possible to store electricity on a large scale efficiently. This is not

yet the case. And since one can not control when the sun shines or when the wind blows, one needs

reliable sources such as nuclear power or fossil fueled power plants, when the supply of renewable

energy is too low to cover the base load.

If battery technology takes a leap forward and makes storage of electricity on a large scale possible,

it could entail an enourmous boost for renewable energy and thus DONG Energy.

5.2.5 Environmental Factors

5.2.5.1 Climate Change

As mentioned, climate change and the scarcity of fossil fuels are the main reasons for the societal

shift towards more green energy. If global warming continues down the path projected by

climatologists, the demand for renewable energy is likely to increase. This would have a positive

effect on the value of DONG Energy. Should global warming halt og reverse, the effect on the value

of DONG Energy would be negative.

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5.2.5.2 Oil Spills

In 2010, the oil company BP experienced an industrial distaster, when a large marine oil spill polluted

the ocean outside the coast of Mexico. If such an event were to happen in the North Sea, it could have

devistating effects for all the exploration and production companies operating there.

5.3 Exploration & Production

5.3.1 Introduction

In this section, the business unit Exploration & Production is analyzed at the industry level with the

Porter’s Five Forces and Industry Opportunity frameworks. At the company level, it is analyzed with

VRIO. The results are summarized with a SWOT analysis.

5.3.2 Porter’s Five Forces

DONG Energy’s business unit Exploration & Production has 77 exploration licenses in the North

Sea; 2 in Greenland, 4 in the Faroe Islands, 14 in Denmark, 27 in the UK, and 30 in Norway (DONG

Energy, 2014, p. 27). However, their current production only comes from Scandinavian fields with

89% from Norway and 11% from Denmark. Therefore, I consider the Scandinavian oil and gas

industry the primary industry in this analysis.

5.3.2.1 Threat of New Entrants

The threat of new entrants to the exploration & production industry in the North Sea is very low.

There are a couple of reasons for that. First, it is a very capital intensive business. Exploring and

drilling for oil and natural gas requires huge investments in machinery, skilled labor, and platforms.

Second, both exploration and production require licenses issued by national governments. Licenses

are distributed via tenders for periods of up to 20 years. This makes it difficult for new entrants to get

access to the good areas. Third, it takes time to realize economies of scale. This also serves as a barrier

to entry.

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5.3.2.2 Threat of Substitution

Oil and gas are standardized products, that are not directly substitutable. In theory, all other energy

sources, that can be used to generate electricity and heat, are potential threats of substitution; nuclear

power, hydropower, wind power, coal-fuel thermal power, solar power etc. However, the threat of

substitution of crude oil is low, because it is used to produce gasoline, diesel fuel, heating oil, and

plastic. As of 2014, oil is still irreplacable in the transportation and manufacturing sectors. While

electric cars are a potential threat of substitution for conventional cars and in turn crude oil, the

replacement of the car fleet is progressing so slowly, that even if electric cars may impact the oil price

significantly some time in the distant future, the oil reserves of the North Sea will probably have dried

up by then.

For natural gas extracted from the North Sea, the threat of substitution is high for more than one

reason. First, European natural gas is primarily used for electricity generation and for heating and

cooking in residential areas. The fact, that you can you use other sources of energy for these purposes,

makes natural gas replacable – even if initial installation costs of other energy systems are significant.

Second, the discovery of shale gas in Norway, France, and Poland has the potential of decreasing

European gas prices. However, for the short to medium term, this risk is assessed to be low due to

the nascent state of the European shale gas industry and large environmental concerns with regards

to shale gas extraction (Frost & Sullivan, 2012, p. 47-48). Third, the installation of more pipelines

from Russia, where natural gas is abundant, to Central Europe, has the potential of decreasing natural

gas prices significantly (MarketLine, 2012, p. 21).

5.3.2.3 Bargaining Power of Buyers

Oil is traded on a global market, while natural gas is traded regionally via pipelines (DONG Energy,

2009, p. 6). The bargaining power of buyers of crude oil is low, because the price is determined by

global supply and demand on exchanges in New York, London and Dubai (MarketLine, 2017, p. 17).

The usual buyers include oil refineries, national oil companies, large manufacturing companies and

national governments.

The bargaining power of buyers of natural gas is also assessed as low, as it is traded on regional

virtual trading hubs.

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5.3.2.4 Bargaining Power of Suppliers

For the purpose of this analysis, there are two categories of suppliers; national governments, and

equipment and service providers. The bargaining power of the national governments that license the

exploration and production in the North Sea is assessed as moderate. This may seem counterintuitive,

as the licences are issued via strict tender procedures regulated by EU law, which would make one

think their bargaining power was low. However, there are often tough negotiations between

governments and oil and gas companies about taxation schemes. This gives them some bargaining

power. The reason it is not assessed as high, is that, irrespective of environmental concerns, it is

always in the governments’ interest to extract the oil and gas, rather than leaving it underground and

getting nothing out of it.

The oil and gas equipment and service providers are typically large, diversified companies like GE,

Schlumberger, Halliburton, and Danfoss (Marketline, 2016, p. 18). Their size gives them a moderate

bargaining power.

5.3.2.5 Industry Rivalry

The industry rivalry is assessed as strong. The exploration and production in the North Sea is

dominated by large, multinational oil companies such as Royal Dutch Shell, Maersk, Statoil, and

DONG Energy. Some of them are vertically integrated with operations in transportation, wholesale

marketing, refining, and retail marketing, while others focus solely on upstream. On the global oil

market, the competition is even stronger with the Middle East having much larger reserves and lower

production costs than anywhere else in the world. Their transnational Organization of Petroleum

Exporting Countries, OPEC, acts as a cartel, seaking to control prices by increasing and decreasing

production to control demand (MarketLine, 2018, p. 11). However, their ability to control prices has

been reduced with non-members such as Canada, USA, Russia, and China increasing their

production.

The competition on the European natural gas market is also strong with Russia having large reserves.

Gazprom, which is owned by the Russian state, has a market share of 30% (MarketLine, 2017, p. 15).

In addition to that, the regional gas markets of Europe are expected to integrate further, as there are

more pipelines in the pipeline. This will further increase competition.

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5.3.3 Industry Structure and Environmental Opportunities

In my view, the industry structure of exploration and production in the North Sea has the

characteristics of a mature industry. The total volume of production has stabilized around 400mn

barrels of oil equivalents in the past couple of years (MarketLine, 2016, p. 11), and investments are

mainly focused on ensuring a reliable supply from existing oil fields, rather than exploring for new

fields, as they are becoming more difficult to find (Frost & Sullivan, 2015, p. 68).

Companies in mature industries usually focus on product refinement, customer service, and process

innovation (Barney, 2015, p. 74). Since, in the oil and gas business, product refinement happens

downstream, it is not really possible in the upstream part of the industry. Customer service is not very

important, because oil and gas are commodities. That leaves process innovation as the best strategy

to pursue.

However, investments in exploration are highly dependent on the prices of oil and gas: If prices go

up, investments in exploration go up. If prices go down, investments in exploration go down. Should

prices fall below a certain point, investments in exploration may stop altogether.

5.3.4 Company Level Analysis

I will begin the company level analysis by examining the highlights of Exploration & Production’s

recent performance and their strategy going forward. Then, I will analyze the business unit with the

VRIO and SWOT frameworks.

5.3.4.1 Performance

Exploration & Production has gradually increased its production of natural gas from 2mn BOE in

2007 to 23mn BOE in 2013. The annual oil production has been between 8.2mn BOE and 10mn BOE

in every year of the same period. Table 6 provides an overview of Exploration & Production’s

production and financial results from 2007 to 2013.

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Table 6 – Exploration & Production’s Performance

Exploration&Production 2007 2008 2009 2010 2011 2012 2013Revenue,mnDKK 4486 7322 6416 8264 10469 11871 12344Growthrate 63% -12% 29% 27% 13% 4%

EBITDA,mnDKK 2366 4261 3264 5051 5684 6550 7324Growthrate 80% -23% 55% 13% 15% 12%

Oilproduction,mnBOE 9,2 10,0 8,5 9,0 9,3 10,0 8,2Growthrate 9% -15% 6% 3% 8% -18%

Gasproduction,mnBOE 2,1 8,5 15,5 15,4 17,1 18,5 23,5Growthrate 296% 82% -1% 11% 8% 27%

Source: Own creation based on DONG Energy’s annual reports

5.3.4.2 Strategy

Exploration & Production has two types of strategic targets: annual oil and gas production; and total

reserves divided by annual oil and gas production, which is known as the R/P ratio. R/P is a rough

measure of the number of years of production left in the current reserves. The targets of annual oil

and gas production are 47.5mn BOE and 55mn BOE for 2016 and 2020, respectively. In other words,

they aim to increase production from 2013 to 2016 by 50%. Meanwhile, R/P must be equal to or

above 10 in both 2016 and 2020. Put differently, at all times reserves should be large enough to be

able to continue production for at least 10 years with the current year’s volume (DONG Energy, 2014,

p. 14). From 2010 to 2013, R/P has gradually fallen from 18 to 15.

DONG Energy believes that three new fields, that are currently under development, will make it

possible to hit the target of 130,000mn BOE per day, corresponding to 47.5mn BOE per year, in 2016

(DONG Energy, 2014, p. 14).

In order to also hit the 2020 production and R/P targets, they have to find new reserves. Therefore, in

2012 they decided to increase investments in exploration significantly for the period 2012-2014

compared with 2009-2011 (DONG Energy, 2013, p. 7).

DONG Energy has also set a financial target of 20% ROCE in 2016 and 2020 for Exploration &

Production. As the profitability of this business is entirely dependent on oil and gas prices, which are

outside of DONG Energy’s control, their ability to hit this target will not be discussed in the strategic

analysis. The financial details of Exploration & Production will be discussed in the forecasting

section.

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5.3.4.3 VRIO

The purpose of the VRIO analysis is to assess whether the resources of Exploration & Production are

valuable, rare, costly to imitate, and exploited by the organization. Rather than examining all

resources of the business unit, the analysis focuses on the most important ones.

5.3.4.3.1 Tangible Assets

Producing Fields

Exploration & Production has shares in 13 producing oil and gas fields in Norway and Denmark

(DONG Energy, 2014, p. 13). Their ownership percentages vary from field to field. In some of them,

they are the license operator, but in most of them, they are license partner (DONG Energy, 2014, p.

130). They do not disclose the reserves and production of each field. However, they do state that gas

production comes primarily from the Ormen Lange field in Norway (DONG Energy, 2014, p. 27).

This field is assessed to be particularly important, as the company’s natural gas production is

increasing, while its oil production declined by 18% from 2012 to 2013 (DONG Energy, 2014, p.

27).

DONG Energy’s stakes in producing oil and gas fields are assessed to be valuable, rare, difficult to

imitate, and exploited by the organization. However, it is important to note that this assessment is

based on the current oil and gas prices. If prices fall like they did in 2008, it is possibble that the very

high costs of decommissioning the fields as they dry up, will surpass the value of the oil and gas that

is left in them (Oudenot, 2017).

Fields Under Development

As mentioned earlier, Dong Energy is expecting three new fields to allow the company to increase

the annual production of oil and gas from 31.7mn BOE in 2013 to 47.5mn BOE in 2016. More

specifically, they are banking on the Danish field Syd Arne, which produced its first oil in November

2013, the UK gas fields Laggan-Tormore, which is expecting to start production in late 2014, and the

Danish field Hejre, which is expected to start production in 2016, to enable Exploration & Production

to hit the 2016 target.

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While I do think these three fields will make the company increase its production, it is not possible

for me to accurately assess the chances of them hitting their 2016 and 2020 targets. In any case, the

fields under development are assessed to be valuable, rare, costly to imitate. They are not yet exploited

by the organization, but they most likely will be in the near future.

Exploration Licenses and Exploration Activities

DONG Energy has a total of 77 licenses. With 13 producing fields and three fields under

development, it can be deduced that they have 61 exploration licenses. About three of them have led

to discoveries. DONG Energy and their partners are still in the process of drilling and analyzing

results in order to assess, whether these discoveries are commercially viable (DONG Energy, 2014,

p. 14).

In 2013, gross investments in Exploration & Production was DKK 9.6bn, which is almost double the

amount invested in 2012. DONG Energy does not disclose how much of the DKK 9.6bn that went

into exploration, but it is reasonable to assume that a large part of it did, because in their 2012 annual

report, they wrote that the company planned to ”significantly increase its investments in exploration

in the period 2012-2014 compared with 2009-2011” (DONG, 2013, p. 7).

The exploration licenses certainly do represent som value, they are not rare, as there are many

exploration licenses in the North Sea.

Financial Resources

DONG Energy’s need for a capital increase is clear evidence that the company does not have strong

financial resources. Compared to the supermajors ExxonMobil, Royal Dutch Shell, BP, Chevron,

ConocoPhillips, and Total, Dong Energy is a tiny company. Being relatively small in a risky business

environment is a weakness, as the ability to withstand potential losses is smaller. In terms of the

VRIO framework, the financial resources of DONG Energy, or rather their lack of financial resources,

is assessed as being not valuable for the Exploration & Production business unit.

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5.3.4.3.2 Intangible Assets

Technical know-how

As an outsider without technical knowledge about exploration and production, it is difficult for me to

assess the value of DONG Energy’s technical expertise within the field. It is clear that exploration

and production in the North Sea does indeed require a significant level of know-how, as the license

areas differ in terms of water depth, weather conditions, transportation possibilities etc. (DONG

Energy, 2011, p. 27). It is also evident that DONG Energy does have this know-how, as they have

been operating oil and gas fields for more than a decade. However, their expertise is probably not

greater than that of other Scandinavian operators like Statoil and Maersk or international giants such

as Royal Dutch Shell, ExxonMobil, BP, and Chevron. The fact that DONG Energy has had rather

large problems with the repairment of the underground structure of the one field they own 100%, Siri,

is an indication that they are not leaders with regards to technology. All things considered, DONG

Energy’s technical know-how within exploration and production is assessed to be valuable, somewhat

rare, costly to imitate, and exploited by the organization.

5.3.4.3.3 Sub-conclusion

Table 7 – Exploration & Production VRIO

Source: Own creation

Table 7 provides an overview of the assessed resources within the VRIO framework.

The most valuable resources of Exploration & Production are the shares in the producing fields and

the fields under development. These resources give Exploration & Production an opportunity to earn

economic returns that are above normal. Their exploration licenses have the potential to become

valuable, but they are not rare and thus they do not constitute a competitive advantage. DONG Energy

has a relative lack of financial resources, which is a competitive disadvantage.

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5.3.4.4 SWOT

The purpose of this section is to synthesize the macro, industry, and company level analyses using

the SWOT framework. The most important findings are summarized in Table 8 to give a holistic

overview of Exploration & Production’s strengths, weaknesses, opportunities, and threats.

Table 8 – Exploration & Production SWOT

Source: Own creation.

The most important strength of Exploration & Production is its shares in producing oil and gas fields.

These shares give the business unit the chance to earn economic profits that are above average.

However, the economic performance is entirely dependent on the level of oil and gas prices, which

are affected by a number of factors, all of which are out of the company’s control. In addition to the

oil and gas price risk, the business is subject to exchange rate risk, and the risk of not finding new

fields, that are commercially viable. These threats make Exploration & Production a high-risk, high-

reward business. If the oil price remains above USD 100 per barrel, or if it breaks USD 140 like it

did in 2008, the business will be very profitable. If it tumbles back down to USD 40, like it did in

2009, the value of the business might turn negative as decommissioning costs for offshore oil and gas

fields are high. In such a risky industry environment, companies with large financial resources have

a competitive advantage, as they can withstand losses for a longer period of time. Unfortunately,

DONG Energy is a tiny company compared with international oil and gas companies like Royal

Dutch Shell, Exxon Mobil, BP, and Total. The expressed need for a capital increase demonstrates

that DONG Energy does not have the financial buffer to withstand potential losses. This is a

significant weakness.

In general, it is my assessment that the competitive advantages of Exploration & Production are the

result of acquiring scarce assets at opportune moment. This can be thought of as a first mover

37

advantage (Lieberman et al., 1988, p. 44). Their capacity to achieve an economic performance, that

is above normal, is a consequence of the historical circumstances that allowed the company to buy

valuable natural resources, rather than a consequence of resources and capabilities that are inherent

to the company. In economics, this kind of profit is referred to as economic rent.

5.4 Wind Power

5.4.1 Introduction

In this section, the business unit Wind Power is analyzed at the industry level with the Porter’s Five

Forces and Industry Opportunity frameworks. At the company level, it is analyzed with VRIO. The

results are summarized with a SWOT analysis.

5.4.2 Porter’s Five Forces

5.4.2.1 Threat of New Entrants

The threat of new entrants to the offshore wind industry is very low. First, it is a very capital intensive

business, requiring large upfront investments with repayment only beginning after a couple of years.

Second, as a relatively young, advanced, and quickly developing technology, participating in it

requires a vast amount of knowledge and expertise. The incumbent businesses have already

developed and are still developing that expertise. If a newcomer wants to enter the industry, he would

have to outbid the incumbents to win projects, accepting large losses, just to get the expertise that

would allow him to become competitive some time in the future. In my opinion, that is an unlikely

scenario.

5.4.2.2 Threat of Substitution

The increasing political awareness regarding climate change is moving the European energy mix

towards more renewable energy (European Commission, 2018). Therefore, the threat of substitution

from conventional energy sources is very low. The threat of substitution from other renewable energy

sources is high, particularly in Scandinavia where generation from wind power is dwarfed by

hydropower (MarketLine, 2016b, p. 15). However, in Europe as a whole, the wind power share of

the renewable energy mix is projected to increase towards 2020, while the hydropower share is

projected to decrease, even though it will also grow in the overall European energy mix. Put in another

way, wind power is projected to grow faster towards 2020 than hydropower (Frost & Sullivan, 2013,

p. 9).

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5.4.2.3 Bargaining Power of Buyers

As of 2014, it is not yet profitable to build and operate offshore wind farms without subsidies.

Therefore, it is difficult to assess the bargaining power of buyers as being low, moderate, or high in

a meaningful way. The building process involves national governments offering offshore wind farm

projects on specific locations via tender. Whoever offers to construct and operate the wind farm

project at the specified capacity for the lowest price, wins the tender. In recent years, the subsidies

have decreased from significantly, and that trend is expected to continue as production cost come

down.

5.4.2.4 Bargaining Power of Suppliers

The most important suppliers for offshore wind farms are the wind turbine manufacturers. This

market is dominated by two companies, Vestas and Siemens Wind Power. GE also produces offshore

wind turbines, but as of 2014, the offshore wind turbine market in Europe is practically a duopoly,

since Vestas and Siemens offer the best quality. They are both based in Denmark, even though the

Siemens conglomerate is German. The low number of suppliers gives them a high bargaining power.

Other suppliers include companies specializing in molding foundations, installation, and service.

Their bargaining power is assessed as moderate, because these companies are typically relatively

small and not well diversified. Therefore, they are very much dependent on getting individual orders

from the wind farm developers.

5.4.2.5 Industry Rivalry

The rivalry in the offshore wind power industry is assessed as moderate. Since electricity generated

from wind power is a commoditized product, there is no differentiation of the end product. Thus, the

competition revolves around offering the lowest prices. As of 2014, offering the lowest prices means

offering the national governments who tender for offshore wind farms, the cheapest subsidy scheme

for the electricity being produced. In order to be able to do that, you need to build and subsequently

operate the wind farms more efficiently than your competitors. This kind of price competition usually

entails a high level of industry rivalry, but since offshore wind power is such a young and

technologically advanved industry, it is still dominated by relatively few large energy companies,

namely DONG Energy.

DONG Energy is the leading developer of offshore wind farms. In 2013, they were responsible for

48% of total installations (EWEA, 2014, p. 6). In terms of cumulative market share, they are also the

39

largest owner of offshore wind capacity in Europe, with 26% in 2013 (EWEA, 2014, p. 13). Their

closest rivals are Vattenfall, E.ON, Centrica, SSE, RWE, and EDF.

Since offshore wind is an growing market, competition and industry rivalry is expected to increase in

the future.

5.4.3 Industry Structure and Environmental Opportunities

The European offshore wind power industry ticks all the boxes of an emerging industry. It is newly

created and formed by technological innovation, changes in demand, and new customer needs

(Barney, 2015, p. 71).

Figure 1 – Cumulative and Annual Offshore Wind Installation in Europe

Source: EWEA, 2014, p. 10.

Figure 1 shows how the annual and cumulative offshore wind installations in Europe have taken off

since the turn of the millennium.

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Most of the opportunies in an emerging industry fall in the broad category of first mover advantages

(Barney, 2015, p. 71). In this particular industry, the first-mover advantage is technological

leadership, more specifically advantages derived from the learning curve ”where costs fall with

cumulative output” (Lieberman et al., 1988, p. 42). As mentioned earlier, within each branch of

renewable electricity generation, be it solar power, hydropower, or offshore wind power, the product

is exactly the same. Therefore, competition revolves around offering the lowest prices by being able

to produce at the lowest costs.

In the past decade, the costs of offshore wind power have come down significantly, so the strategic

opportunities for first movers revolve around whether the ”learning can be kept proprietary”

(Lieberman et al., 1988, p. 42-43) for an extended period of time. If first movers are able to do that,

the learning curve may continue to serve as barrier of entry, keeping competition low and profits

high.

5.4.4 Company Level Analysis

I will begin the company level analysis by examining Wind Power’s stated strategy. Then, I will

analyze the business unit with the VRIO and SWOT frameworks.

5.4.4.2 Strategy

Wind Power is the fastest growing business unit of DONG Energy. Revenue has increased from DKK

1.6bn in 2009 to DKK 12bn in 2013 (DONG Energy, 2014, p. 20). As of 2013, DONG Energy has

built 35% of the total European offshore wind capacity.

Wind Power has two types of strategic targets, gross installed offshore wind capacity and societal

cost of offshore wind electricity. As of 2013, gross installed offshore wind capacity is 2.1GW. The

targets are 3.5GW in 2016 and 6.5 GW in 2020. The societal cost of electricity generated by offshore

wind is EUR 160 per MWh in 2013. The target is EUR 100 per MWh in 2020 (DONG Energy, 2014,

p. 10). “This corresponds to a reduction of approximately 30% compared with 2011” (DONG Energy,

2012, p. 8), and it would bring the cost of wind power down to a competitive level with electricity

generated with conventional methods.

In addition to the strategic targets, Wind Power has a ROCE target of 6-8% in 2016 and 12-14% in

2020 (DONG Energy, 2014, p. 2). In 2013, ROCE was 4.6%.

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Figure 2 - DONG Energy’s Expected Development in Installed Wind Capacity, GW

Source: DONG Energy, 2014, p. 13)

Figure 2 shows DONG Energy’s expectations to its gross installed offshore wind power. They expect

projects, that are already under construction, to enable them to reach 3.6GW in 2016, hitting the target

of 3.5GW. They expect to fullfil the 2020 target of 6.5GW with wind farm projects that are in the

pipeline, but where the final investment decision has not been made yet.

Wind Power’s strategy to grow and reduce costs includes partnerships with industrial and financial

investors, a framework agreement with theOff leading wind turbine supplier Siemens, and the

execution of current investment projects. These will be analyzed within the VRIO framework in the

next section.

5.4.4.3 VRIO

The purpose of the VRIO analysis is to assess whether the resources of Wind Power are valuable,

rare, costly to imitate, and exploited by the organization. Rather than examining all resources of the

business unit, the analysis focuses on the most important ones.

5.4.4.3.1 Tangible Assets

Offshore Wind Farms

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At the end of 2013, Wind Power had built a total offshore wind capacity of 2.1GW, corresponding to

a European market share of 35%. 1.4GW of the 2.1GW is owned by the company. Part of Wind

Power’s business model is to regularly divest some of their shares in offshore wind farms to free up

capital to invest in building new ones.

The shares in offshore wind farms are a stable source of income because of the subsidy schemes

under which they were built (DONG Energy, 2012, p. 14). The offshore wind farms are assessed as

valuable, somewhat rare, costly to imitate, and exploited by the organization.

Offshore Wind Farms Under Construction

Wind Power has a number of offshore wind farms under construction. If these are completed on time,

and there is nothing to suggest that they will not, they will also be a valuable, somewhat rare, costly

to imitate, and exploited by the organisation, resource.

Financial Resources

As mentioned several times, DONG Energy’s financial resources are limited. In fact, the large

investment programme within offshore wind was a major reason, why the company needed to launch

the financial action plan that included a capital increase. Even with the financial action plan

completed, DONG Energy still has considerably smaller financial resources than their closest rivals

within offshore wind power. Therefore, in terms of the VRIO framework, the fact that the financial

resources available to Wind Power are not as large a those of their competitors, serves as a weakness,

not a valuable resource.

5.4.4.3.2 Intangible Assets

Technical know-how

Wind Power has a unique experience in developing, constructing, and operating offshore wind farms.

The technical expertise they have developed from being the first mover within offshore wind power

has made them global market leader (DONG Energy, 2014, p. 13).

As mentioned earlier, competition now revolves around cost reduction. Until 2013, offshore wind

farms have been built with few standardized components. Most of the components have been

customized to the specific location, which has been expensive. Wind Power’s vast experience has let

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them to begin standardizing different elements of the value chain to reduce costs, while at the same

time improving effiency. In the future, the company will primarily choose projects with locations that

are compatible with the standardized solutions (DONG Energy, 2013, p. 15).

Wind Power’s technological leadership gives the company a cost advantage. If they are able to keep

the learning propritary and sustain the cost advantage, as Lieberman et al. phrase it in their definitive

text about first-mover advantages (Lieberman et al., 1988, p. 42), this can serve as a barrier to entry

and help them maintain their position as market leader.

Wind Power’s technical know-how is assessed as their most valuable resource. It is very rare, very

costly to imitate, and exploited by the organisation.

Financial Partnership Model

In order to mitigate their relative lack of financial resources, Wind Power has developed a financial

partnership model with other energy companies, private companies, and institutonal investors,

particularly Danish pension funds (DONG Energy, 2013, p. 8). The company co-funds the

construction of a wind farm with the investors. This also serves to diversy some of the risk associated

with each project. Upon completion, DONG Energy sometimes sell their share or part of it to free up

capital for new investments (DONG Energy, 2014, p. 99). Other times, they choose to keep their

share.

Wind Power’s financial partnership model is assessed as valuable and rare. The setup of the model is

not particularly costly or difficult to imitate, but the willingness of institutional investors, who are

often quite conservative, to invest in emerging industries, is contingent on the reputation of the

company. Wind Power’s proven track record within offshore wind is what makes the partnership

model attractive. Therefore, it is also assessed as somewhat difficult to imitate and exploited by the

organization.

Relationship with Siemens

In 2012, Wind Power made a framework agreement with leading wind turbine supplier Siemens.

Siemens are going to supply 300 of the new, large wind 6.0 MW wind turbines. In 2013, Wind Power

successfully introduced the wind turbine type in a test project. The large turbines are expected to help

44

reduce costs per energy unit. However, more technological progress is needed to reach the strategic

target of EUR 100 per MWh in 2020 (DONG Energy, 2014, p. 15).

Wind Power’s relationship with leading supplier Siemens is assessed as valuable, rare, difficult to

imitate, and exploited by the organization.

5.4.4.3.3 Sub-conclusion

Table 9 – Wind Power VRIO

Source: Own creation

5.4.4.4 SWOT

The purpose of this section is to synthesize the macro, industry, and company level analyses using

the SWOT framework. The most important findings are summarized in Table 10 to give an overview

of Wind Power’s strengths, weaknesses, opportunities, and threats.

Table 10 – Wind Power SWOT

Source: Own creation

The offshore wind power industry is newly created and formed by technological innovation, changes

in demand, and new customer needs. It is expected to continue growing for the foreseeable future.

Therefore, it is a textbook example of en emerging industry, which typically presents early entrants

the strategic opportunity of exploiting first mover advantages. This is exactly what Wind Power is

45

doing. As DONG Energy was a first mover in the industry, they are taking advantage of their

technological leadership. The learning curve serves as a barrier to entry, as the company is able to

construct offshore wind farms at a lower cost than their competitors. This is a sustainable competitive

advantage for as long as the company is able to keep the learning propriety and keep reducing costs.

Falling energy prices as a result of cheap hydropower is not a threat in the short term, because most

of the subsidy schemes of the wind farms that are already constructed or under construction for the

most part provide for a guaranteed price per energy unit. However, in the long term, the potential

growth of cheap hydropower is a threat of substitution.

5.5 Thermal Power

5.5.1 Introduction

In this section, the business unit Thermal Power is analyzed at the industry level with the Porter’s

Five Forces and Industry Opportunity frameworks. At the company level, it is analyzed with VRIO.

The results are summarized with a SWOT analysis.

5.5.2 Porter’s Five Forces

5.5.2.1 Threat of New Entrants

The threat of new entrants to the Danish thermal power industry is very low. It is capital intensive,

and building new thermal power plants requires permission from the government as well as technical

expertise.

5.5.2.2 Threat of Substitution

The threat of substition for district heating is very low, because changing a home heating system is

inconvenient and expensive. In many areas, homes with district heating are obligated to be connected

to it. This creates a monopoly and eliminates the threat of substitution. Nevertheless, despite large

regional price differences, district heating is almost always cheaper than the alternatives (Frederiksen,

2016).

46

For electricity production, the threat of substitution is high. The main substitutes are solar power,

nuclear power, hydropower, and wind power.

5.5.2.3 Bargaining Power of Buyers

For district heating, the bargaining power of buyers is very low, because, as mentioned, it is a

monopoly in many cases. In regions, where it is not a monopoly, it is still expensive to change heating

system.

For electricity, prices are determined by supply and demand on the North European energy exchange,

Nord Pool (Energitilsynet, 2018). Factors influencing prices include fuel prices, prices for CO2

emissions allowances, and weather conditions (DONG Energy, 2014, p. 38).

5.5.2.4 Bargaining Power of Suppliers

The main suppliers of thermal power plants are the suppliers of fuel. The fuel is mostly coal, gas,

biomass, and waste (DONG Energy, 2014, p. 29). As these are commodities, with many, relatively

small suppliers and buyers, the bargaining power of suppliers is low. Some power plants can run on

different fuels, further weakening the bargaining power of suppliers.

5.5.2.5 Industry Rivalry

The industry rivalry is assessed as low for the thermal power industry. In Denmark, each region has

a fixed number of power plants. Historically, these have been operated by utility companies owned

and run by the local municipalites. Even now, when the local companies have consolidated into larger

companies, they are still regional monopolies. DONG Energy is the largest energy company in

Denmark. It owns 44% of the available thermal generation capacity and generate about one third of

the district heating in the country.

Because the Danish heating supply is provided by a number of regional, natural monopolies, the

sector is tightly regulated. Local areas are either covered by district heating or the natural gas network.

A few places are covered by both networks. Prices are set to cover costs, and this is controlled by the

47

government. Therefore, district heating is not a particularly profitable industry, even though

competition is low or non-existent (Energistyrelsen, 2018).

The electricity generation side of the thermal power industry is very different from district heating,

because the liberalization and continuous integration of the European electricity markets have

challenged the old monopolies of power generation. As mentioned in the section about the threat of

substition, renewable energy, particularly cheap Scandinavian hydropower, is a big threat to the

profitability of thermal electricity generation (DONG Energy, 2014, p. 42).

5.5.3 Industry Structure and Environmental Opportunities

Classifying the generic industry structure of thermal power is not straight forward. In my assessment

it is best thought of as a mature industry. However, an argument could be made that it is a declining

industry, because renewable energy sources are gradually replacing it. At least that is the political

goal in Europe.

In mature industries, the most common strategic opportunities are product refinement, emphasis on

service quality, and process innovation. In declining industries, strategic opportunities include market

leadership to facilitate the exit of other firms, focusing on a market niche, harvesting as much value

as possible while scaling down operations, and simply divesting at once.

In my opinion, the most appealing strategic opportunity in the thermal power industry is the gradual

replacement of coal with renewable energy sources like biomass and waste. This can be categorized

as product refinement. I also think that focusing on district heating, rather than electricity production,

is a good strategy, since that is not going to be replaced in the foreseeable future.

5.5.4 Company Level Analysis

The company level analysis will begin by examining the stated strategy of Thermal Power. Since

Thermal Power is a no longer part of DONG Energy’s core business, the VRIO analysis will be

very short.

5.5.4.1 Strategy

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Table 11 – Gross Investment by Business Unit

Source: Own creation based on DONG Energy’s annual reports

Table 11 shows DONG Energy’s gross investments by business unit. From 2008 to 2010, the

company invested more than DKK 10bn in Thermal Power. From 2011 to 2013, they only invested

DKK 1.7bn, corresponding to 3% of total gross investments. This shows DONG Energy’s strategic

shift away from Thermal Power, and towards Exploration & Production and Wind Power.

The lessening importance of Thermal Power is also expressed in the modest financial and strategic

targets, DONG Energy has set for the business unit. The other three business units have ROCE targets.

Thermal Power’s financial target is to “deliver annual operating cash flows of DKK 600-800 million

from Danish power stations” (DONG Energy, 2013, p. 3), which is another indication that the

company does not believe in the business. Thermal Power is regarded as a non-core activity. The

strategic targets of Thermal Power are that the biomass share of electricity and heat generation in

Denmark is at least 50% in 2020, and that they among the best in Europe in terms of flexible and

efficient operation of power stations. Divesting the worst performing power stations of Thermal

Power seems reasonable given the poor economic performance it has had.

5.5.4.2 VRIO

Danish Power Stations

Thermal Power’s most valuable assets used to be the Danish power stations. Unfortunately,

contributions margins for conventional electricity productions have decreased in recent years, and

they are not expected to rise again in the foreseeable future. Therefore, the power stations are no

longer valuable.

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Customer Base

Thermal Power provides district heating a large number of Danish households. Even though this

customer base is valuable, it is difficult to exploit that value to its full potential as the sector is

comprised of regional monopolies and thus heavily regulated.

5.5.4.2.1 Sub-conclusion

Table 12 – Thermal Power VRIO

Source: Own creation

5.5.4.3 SWOT

The purpose of this section is to synthesize the macro, industry, and company level analyses using

the SWOT framework. The most important findings are summarized in Table 13 to give an

overview of Thermal Power’s strengths, weaknesses, opportunities, and threats.

Table 13 – Thermal Power SWOT

Source: Own creation

Thermal Power is DONG Energy’s least important important business unit. It is operating in a

mature or even slightly declining industry, and therefore its only strategic opportunity is to increase

its share of biomass fuel. The business model of conventional power plants is not as profitable as it

used to be due to a lowering of contributions margins of coal-fired power plants.

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5.6 Customers & Markets

5.6.1 Introduction

In this section, Customers & Markets is analyzed at the industry level with the Porter’s Five Forces

and Industry Opportunity frameworks. At the company level, it is analyzed with VRIO. The results

are summarized with a SWOT analysis.

5.6.2 Porter’s Five Forces

Customers & Markets consists of the two former business units Sales & Distribution and Energy

Markets. Sales & Distribution sells electricity and gas in Denmark, Germany, the UK, Sweden, and

the Netherlands (DONG Energy, 2014, p. 30). It also distributes gas and electricity in Denmark. The

distribution of both gas and electricity are natural monopolies, where prices and conditions are

regulated by law (Energistyrelsen, 2018). Therefore, it does not make sense to analyze those parts of

the business with Porter’s Five Forces. Therefore, this analysis is only about the wholesale and retail

sale of electricity and gas.

5.6.2.1 Threat of New Entrants

The threat of new entrants to the electricity and gas market is assessed as moderate. New energy

companies do not have to produce energy themselves. Therefore, the barriers to entry are significantly

lower than for the other three business units. The main challenge for new entrants is to win market

shares, so they use call centers to get new customers (Mosskov, 2016). The reason, I do not assess

the threat as high, is that since the liberalization of the energy markets, a number of new energy

companies have emerged, and thus the market seems saturated already.

5.6.2.2 Threat of Substitution

In modern society, electricity is indispensable, so there is no threat of substitution for it. Natural gas

is used to fuel thermal power plants generating electricity and heat, and it is distributed directly to

homes for heating and cooking purposes. For both of these uses there is a long term threat of

substitution. Thermal power plants can use other sources of fuel such as biomass such as wood pallets

as fuel, which emits less CO2 than gas. For heating and cooking, one can use other energy sources,

but there are no clear signs of that transitioning happening in the foreseeable future. Therefore, Europe

is still dependent on natural gas, and the threat of substitution is assessed as low.

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5.6.2.3 Bargaining Power of Buyers

Before the liberalization of the Danish energy markets, every home and business had to get their

power from the local energy company. Perhaps the monopoly mindset from that era is still ingrained

in the Danish power consumers, because even though they now have the right to change electricity

company, very few households actually exercise that right. The same is true for retail natural gas

(Lindegaard, 2016). Nevertheless, the bargaining power of buyers is assessed as moderate, because

it is easy and cheap to change electricity and natural gas company.

5.6.2.4 Bargaining Power of Suppliers

Natural gas and electricity prices are determined by a number of supply and demand factors including

weather conditions, geopolitical factors, the energy mix in each country. Gas is traded on trading

hubs. DONG Energy uses the dutch, virtual trading hub TTF (DONG Energy, 2013, p. 31). Therefore,

the bargaining power of suppliers is assessed as low.

5.6.2.5 Industry Rivalry

The industry rivalry on both the European and Danish markets are assessed as high. Due to the

relatively low barriers to entry, there are a number of competitors in both gas and electricity sales.

5.6.3 Industry Structure and Environmental Opportunities

The distribution of gas and electricity in Denmark is a mature industry and a natural monopoly,

because it is based on infrastructure. As mentioned the prices are regulated by the government, so

there is no opportunities to earn economic returns above normal.

The gas and electricity sales industry is assessed to be a mature industry for three reasons. First, it

has a slowing growth in total demand. Second, there is no possibility of introducing new products.

And third, since the liberalization of the European energy markets, the increase of international

competition has led to an overall reduction of the profitability of the companies in the industry.

Since energy companies sell commodities, they can not refine their products, Therefore, the obvious

strategic opportunities lie in an emphasis on service and on process innovation in the form of cost

reduction (Barney, 2015, p. 74-75).

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5.6.4 Company Level Analysis

I will begin the company level analysis by examining the highlights of Customers & Markets’ recent

performance and their strategy going forward. Then, I will analyze the business unit with the VRIO

framework.

5.6.4.1 Recent Performance

As mentioned, Customers & Markets was created when DONG Energy in 2013 decided to merge the

two former business units Energy Markets and Sales & Distribution. In 2012, Energy Markets posted

an adjusted operating loss of DKK 5.5bn, corresponding to a ROCE of -78.5%. This terrible

performance was mainly due to provisions of onerous gas contracts and an adverse development of

energy prices.

5.6.4.2 Strategy

Customers & Markets has three strategic targets. First, they aim to be in the top quartile on customer

satisfaction. This focus is in line with the strategic opportunities of this mature industry being

confined to emphasis on service and process innovation.

Second, they aim to quadruple the cumulative energy savings of Danish customers in 2020. This has

to do with what the company has dubbed ”climate partnerships” with Danish public and private

companies. According to DONG Energy; ”A climate partnership helps the company to reduce energy

consumption, use renewable energy and ensure a transparent climate profile” (DONG Energy, 2013,

p. 9). In my assessment, the climate partnership model and the associated energy savings are a

marketing and CSR scheme, that does not significantly affect the future core value creation of the

company, even though it probably has had some effect on DONG Energy’s share of the Danish

electricity market. Therefore, I will not analyze this strategic target further.

Third, Customers & Markets aim to be ”among the best in Europe in terms of handling energy

exposures” (DONG Energy, 2014, p. 3). They do not specify how they want to achieve that goal.

Customers & Markets financial target is to go from a ROCE of 4.8% to at least 8% in 2016 and 10%

in 2020.

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5.6.4.3 VRIO

5.6.4.3.1 Tangible Assets

Infrastructure Assets

Customers & Markets operates and maintains “the company’s electricity, gas and oil infrastructure.”

(DONG Energy, 2014, p. 30). Because the price of distribution is regulated by law, these assets are

not assessed to be valuable in terms of the VRIO framework.

5.6.4.3.2 Intangible Assets

Customer Base

Customers & Markets is the dominating electricity company in the greater Copenhagen area. In

southern Jutland, they are the largest natural gas company. The market shares, that these groups of

customers represent, are assessed to be valuable, rare, difficult to imitate, and exploited by the

organization. As mentioned, households rarely change energy company, even when it is cheap to do

so.

Risk Management Capabilities

As an outsider, it is difficult for me to compare the risk management capabilities of different energy

companies. DONG Energy’s vague formulation ”among the best in Europe in terms of handling

energy exposures” makes the target even more difficult to asssess. Nevertheless, it is safe to say that

in 2012, DONG Energy did not perform adequate risk management, as Energy Markets lost DKK

5.5bn, which contributed to the company getting the lowest credit rating among European utilities.

Based on that, I do not consider DONG Energy’s capabilities valuable or rare.

5.6.4.3.3 Sub-conclusion

Table 14 – Customers & Markets VRIO

Source: Own creation

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5.6.4.4 SWOT

Table 15 – Customers & Markets SWOT

Source: Own creation

Customers & Markets operates in a mature industry, and thus has limited strategic opportunities. It is

the dominating electricity company in Greater Copenhagen and it has a natural monopoly on natural

gas sales in Southern Jutland. It faces a number of price risks.

55

6.Valuation

6.1 Sum of the Parts Valuation

When valuing a multibusiness company like DONG Energy, the first key decision is whether to value

the company on an aggregated or disaggregated basis. Ideally, you would prefer to value each

business unit separately, because that should entail a better estimate of the company’s value (Koller

et al., 2015, p. 378). However, often times that is not possible because the companies do not report

enough details to make a DCF valuation of each business unit. In such cases, analysts sometimes use

relative valuation on each business unit, sum the values to find the enterprise value, and subtract the

debt to find the value of the equity (Damodaran, 2010, p. 542). This is what financial professionals

usually mean, when they use the term ”sum of the parts valuation”.

Other times, a company has so many business units that valuing each of them separately becomes

impractical. In such situations, analysts often value the company as a whole, hoping ”that the laws of

averaging work in our favor” (Damodaran, 2010, p. 543).

In the case of DONG Energy, the strategic analysis revealed that the business units differ significantly

in terms of industry attractiveness, industry structure, strategic opportunities, VRIO assets, risks,

threats, weaknesses, and growth prospects. These differences make a sum of the parts valuation

highly desirable. The challenge is that DONG Energy, like most other companies, do not provide all

the numbers that are needed to make a DCF valuation on a business unit basis. They do, however,

provide enough details about each business unit, so that the required numbers can be estimated. This

valuation follows the guidelines of disaggregated DCF valuation presented by Damodaran (2010) in

his book ”The Dark Side of Valuation”.

6.2 Financial Statement Analysis

The purpose of the financial statement analysis is to assess the financial aspects of DONG Energy’s

business units. Financial data from the company’s annual reports from 2007 to 2013 is used to

assess the historical performance of each business.

6.2.1 Accounting Policies

DONG Energy’s annual reports are written in accordance with the International Financial Reporting

Standards, IFRS, as adopted by the EU and approved by the International Accounting Standards

Board, IASB (DONG Energy, 2014, p. 58). The financial statements were audited by KPMG and

56

Deloitte from 2007 to 2009. In 2010, PWC took over, and they have been the auditor since then. None

of the audits resulted in any qualifications. This is an indication, that the statements provide a true

and fair view of the company’s financial situation.

In 2011, DONG Energy introduced the measure ”business performance” in their income statements

in addition to the legally required IFRS measure. The reason for the introduction of business

performance was that IFRS no longer reflected the way, the company was managed internally. The

technical differences between IFRS and business performance have to do with the timing of the

changes in the value of derivative contracts and hedges. According to DONG Energy, business

performance represent the underlying performance better than IFRS. Over time, the differences

between the measures will sum to zero (DONG Energy, 2012, p. 72). Therefore, I will not elaborate

on the technicalities. However, it should be mentioned that a historical comparison of the two

measures on the group level reveal that business performance tends to make the company look a bit

better than IFRS. However, the differences are so miniscule, that I consider them irrelevant.

What is important in terms if this analysis, is that, from 2010 to 2013, the detailed information about

each business unit, is only reported with the business performance measure. For the years 2007

through 2009, the detailed information about each business unit was reported with IFRS. The change

in reporting measure, combined with the fact that the composition of the business units has changed

a number of times over the years, makes it difficult to conduct a detailed historical performance

analysis and a subsequent DCF valuation on the business unit level. Fortunately, when the business

performance measure was introduced in the annual report for 2011, DONG Energy reported the

historical revenue and EBITDA of each business unit with the business performance measure, as

shown in Table 16.

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Table 16 – Historical Revenue and EBITDA of Business Units

Source: DONG Energy, 2012, p. 4.

While revenue and EBITDA certainly does not qualify as detailed information, Table 16 provides

numbers, that make it possible to make apples-to-apples comparisons of the business units from year

to year. As mentioned, detailed business performance information is available for each business unit

from 2010 to 2013. Since Table 16 was published, the business units Energy Markets and Sales &

Distribution have been merged. This will be adjusted for by simply adding them together in the

analyses.

6.2.3 Reformulation of Financial Statements

Traditional accounting lump operating activities and financing activities together. Assets are

classified as current or non-current based on when they are likely to generate income. Liabilities are

categorized as either current or non-current based on when they are due. In general, accounting

financial statements are set up to service the needs of the creditors, not financial analysts (Sørensen,

2012, p. 37).

The purpose of this section is to analyze the economic performance of DONG Energy and its business

units. Their underlying ability to create value is best understood as a function of their main operations.

58

Therefore, operating activities need to be separated from financing activities. This is done by

categorizing every accounting item as either an operating or financing activity. The reformulation of

the financial statements is done according to the guidelines presented by Koller et al. in ”Valuation:

Measuring and Managing the Value of Companies” and Petersen & Plenborg in ”Financial Statement

Analysis”.

6.2.3.1 Reformulation of the Balance Sheet on the Company Level

The main purpose of the reformulation of the balance sheet is to calculate the key measure invested

capital, IC, which is used to calculate return on invested capital, ROIC. Return on invested capital is

a key metric in financial statement analysis and it is a key input to the DCF valuation. Koller et al.

defines it in the following way, ”Invested capital represents the total investor capital required to fund

operations, without regard to how the capital is financed” (Koller et al., 2015, p. 170). Invested capital

can be calculated as the sum of net operating working capital, NOWC, and net operating non-current

assets, NONCA:

IC = NOWC + NONCA

Net operating working capital is the difference between operating current assets and operating

current liabilities:

NOWC = operating current assets – operating current liabilities

Net operating non-current assets is the difference between operating non-current assets and operating

non-current liabilities:

NONCA = operating non-current assets – operating non-current liabilities

The balance sheet is reformulated, so that every operating asset and liability fall into these categories.

In addition to that, net financial assets, NFA, is calculated as the difference between financial assets

and financial liabilities:

NFA = financial assets – financial liabilities

59

Since DONG Energy already classified their assets and liabilities as current and non-current, the

reformulation of the balance sheet mostly consisted of classifying the items as being either operating

or financing. For the most part, this was straight forward. Therefore, I will not explain the process in

detail for every item. However, there are three items that deserve an explanation, because they

required calculation or are difficult to categorize; hybrid capital, capitalized operating leases, and

operating cash.

6.2.3.1.1 Hybrid Capital

Hybrid capital is neither equity nor debt. It is something in between, as it has characteristics of both

forms of capital (Koller, 2015, p. 183).

DONG Energy’s predecessor DONG first issued hybrid capital in 2005. The company has since

repaid and issued new hybrid capital a couple of times. As mentioned earlier in the thesis, in 2012,

the rating agency S&P changed their opinion about DONG Energy’s hybrid capital, so it went from

being weighted as 100% equity to 100% debt (Bindslev, 2013). This prompted DONG Energy to

repay the affected hybrid securities and issue new ones, that would be rated as 50% equity and 50%

debt. As of february 2014, that is the weighting, that S&P assigns to DONG Energy’s hybrid capital.

However, I have chosen to weight the hybrid capital as 100% debt based on the principle that an

instrument that only pays annual coupon payments and does not have an upside with regards to

company value, should not be considered equity.

6.2.3.1.2 Capitalized Operating Leases

DONG Energy leases a number of assets, including land and seabed relating to wind farms in the UK,

gas storage facilities in Germany, office premises in Denmark, a port area in Northern Ireland and a

number of vessels (DONG Energy, 2014, p. 96).

By leasing an asset instead of buying it, a company obtains the right to use it, but is not required to

list it on the balance sheet as an asset or a liability. Instead, the lease payments are recorded as an

operating expense on the income statement. The employment of operating leases can impact key

metrics such as ROIC and WACC. This is not desirable, since the purpose of financial statement

analysis is to gain insights on the core business by separating financial activities from it. Therefore,

60

analysts are advised to capitalize the operating leases by recording the present value of them as both

an asset and a liability on the reformulated balance sheet. Subsequently, the interest expenses related

to the operating leases are added back to the analytical income statement when calculating operating

income, and operating taxes are adjusted by removing the associated tax shield (Koller, 2015, p. 198).

DONG Energy reported the present value and the calculated interest expenses of their operating leases

for 2012 and 2013 in their annual report for 2013 (DONG Energy, 2014, p. 96). For 2007-2011, they

have not reported the present values or the interest expenses of the operating leases, but they have

provided enough information for them to be estimated.

According to Koller et al., the best formula for estimating the present value of operating leases is

(Koller et al., 2015, p. 198):

!""#$&'()#*+, = .#/$'(012#/"#*34 + 1

!""#$789#

where t is the current year, kd is the cost of debt, and Asset Life is the expected average life of the

leased assets.

Table 17 shows the capitalized leases of DONG Energy for the years, that have been calculated using

this formula. Numbers in the green cells have been calculated or estimated.

Table 17 – Capitalized Operating Leases

Source: Own creation based on DONG Energy’s annual reports.

The average asset life was calculated by solving for it, using the numbers of 2012 and 2013 and the

above formula. It was then applied to the other years. The present value of the lease payments for

2007-2011 was then calculated using the formula and internal rate of return for 2012 and 2013. The

interest expenses of 2007-2011 was calculated using the average of the 2012 and 2013 rates.

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6.2.3.1.3 Operating Cash

Companies need a certain amount of cash to perform day to day operations. Therefore, cash can not

just be allocated to financial assets in the reformulated balance sheet. The cash amount needed for

operations is commonly referred to as operating cash. Most companies do not disclose this number,

so it has to be estimated. In valuation textbooks, the most widely used rule of thumb for operating

cash is 0.5-2% of revenue (Koller et al., 2015, p. 180-181). However, some authors state that the

analyst should rather rely on his own knowledge of the company in question when estimating

operating cash (Petersen & Plenborg, 2012, p. 77). Since DONG Energy employs active risk

management, which involves hedging with financial derivatives, I have chosen to allocate 50% of the

cash on the balance sheet to operating cash on the reformulated balance sheet.

6.2.3.2 Reformulation of the Income Statement on the Company Level

The main purpose of the reformulation of the consolidated income statement to find total taxes paid

on EBIT. These taxes will later be allocated to each business unit. As with the reformulation of the

balance sheet, line items have to be classified as either operating or financing activities.

6.2.3.3 Reformulation of Income Statements and Key Figures on the Business Unit Level

The business unit income statements from 2010 to 2013, which are not as detailed as the consolidated

income statements, are reformulated to calculate NOPAT and free cash flows, FCF. As mentioned,

NOPAT is equal to EBIT minus taxes on EBIT. The taxes on EBIT, which were calculated on the

reformulated income statement on the company level, are allocated to the business units by their

percentage of EBIT.

In order to calculate FCF, reinvestment needs to be subtracted from NOPAT (Damodaran, 2010, p.

555):

:;: = <=>!? − .#8/A#"$B#/$

Reinvestment is equal to capital expenditure minus depreciation and impairment losses plus the

change in net working capital (Damodaran, 2010, p. 555):

.#8/A#"$B#/$ = ;'28$'(012#/C8$)D# − E#2D#F8'$8G/ − HB2'8DB#/$(G""#" +∆<J;

62

Fortunately, capital expenditure, depreciation, impairment losses, and net working capital are

reported at the business unit level, so the only thing that needs to be calculated here, is the annual

change in net working capital.

In order to calculate the ROIC of each business unit, the last figure needed is invested capital per

business unit:

.=H; = <=>!?H;

Invested capital, which was calculated on the reformulated balance sheet at the company level, is

allocated to each business unit based on ”segment assets”, which is the most similar figure, that is

reported on the business unit level.

6.3 Historical Analysis

The aim of the historical analysis of DONG Energy’s financial statements is to provide insights that,

along with the insights of the strategic analysis, can contribute to the forecasting of future cash flows,

which in turn will be discounted to find the enterprise value of the company.

First, I will look at the overall financials of the company, using DONG Energy’s own reported

aggregate measures to get an overview of the consolidated financial performance. Then, I will

examine the reformulated income statements and key figures of the business units.

6.3.1 Overview of Company Performance

Figure 3 shows the company’s revenue, EBITDA, and profit/loss from 2007 to 2013 in millions of

DKK on the left y-axis. On the right y-axis, the development of ROCE is shown.

63

Figure 3 – Company Performance

Source: Own creation based on DONG Energy’s annual reports

Revenue has been growing steadily from 2007 to 2013. The only break in the trend is 2008, which

was a particularly good year due to high energy prices and a higher production from a gas field

(DONG Energy, 2009, p. 23). The general direction of EBITDA is unclear, although it seems to be

trending upwards with three of the four highest numbers recorded in last four years. Profits have been

very unstable, with 2012 and 2013 resulting in losses. ROCE is also very unstable. The losses of the

past two years have turned ROCE negative. This overview of DONG Energy’s financial performance

shows that it is not revenue growth that is driving ROCE. In order to gain a better understanding of

the company, I will now examine the business units financials.

-10,0%

-5,0%

0,0%

5,0%

10,0%

15,0%

-10000

0

10000

20000

30000

40000

50000

60000

70000

80000

2007 2008 2009 2010 2011 2012 2013

Revenue EBITDA Profit/lossfortheyear ROCE

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6.3.2 Business Unit Performance

Table 18 – Exploration & Production’s Financial Performance

Exploration&Production 2010 2011 2012 2013Revenue 8264 10469 11871 12344NOPAT 1872 1851 1830 -445FCF -201 -483 1390 -8452ROIC 12% 11% 9% -2%

Source: Own creation based on DONG Energy’s annual reports

Table 18 shows that even though the revenue of Exploration & Production has been steadily

increasing from 2010 to 2013, NOPAT and ROIC have decreased. The increase in revenue is mostly

due to increased gas production from the Ormen Lange field and increasing gas prices. Oil production

and average annual oil prices have been relatively stable in the period. The large drop in NOPAT and

ROIC from 2012 to 2013 is due to an impairment loss of DKK 3.7bn in 2013. The decrease in FCF

from 2012 to 2013 is because of increased investment. As mentioned earlier in the thesis, DONG

Energy is investing heavily in Exploration & Production in 2013 and 2014.

Table 19 – Wind Power’s Financial Performance

WindPower 2010 2011 2012 2013Revenue 2952 4312 7737 11960NOPAT 538 428 240 1264FCF -5538 -11852 -7533 -2555ROIC 3% 2% 1% 4%

Source: Own creation based on DONG Energy’s annual reports

Table 19 shows that Wind Power’s revenue has quadrupled from 2010 to 2013. NOPAT has also

increased, albeit not by as much. ROIC has been positive in the period. 2013 was the best year with

a ROIC of 4%. FCF have been negative in all the years, because Wind Power is investing heavily in

new wind farms. The returns on some of those investments will come in the next few years, as the

wind farms start to generate power.

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Table 20 – Thermal Power’s Financial Performance

ThermalPower 2010 2011 2012 2013Revenue 11731 10665 9063 9658NOPAT 15 215 -4008 -1912FCF -2568 1154 -1673 -1226ROIC 0% 1% -34% -25%

Source: Own creation based on DONG Energy’s annual reports

Thermal Power has had the most stable revenue of the four business units. From 2010 to 2013, it

decreased slightly due to lower electricity prices and divestments. In terms of NOPAT and ROIC,

2012 and 2013 were terrible with ROIC at -34% and 25%, respectively. This dramatic shift in

profitability is due to lower contribution margins of coal-fired power plants. Since the low

contribution margins are expected continue for the foreseeable future, Thermal Power recorded

significant impairment losses in both 2012 and 2013.

Table 21 – Customers & Markets’ Financial Performance

Customers&Markets 2010 2011 2012 2013Revenue 45701 46698 46569 49663NOPAT 2236 394 -2934 565FCF 2436 1272 -3139 2182ROIC 8% 1% -10% 2%

Source: Own creation based on DONG Energy’s annual reports

Customers & Markets has had increasing revenue for the past four years. In 2013, Customers &

Markets’ revenue accounted for 59% of DONG Energy’s total revenue. Unfortunately, Customers &

Markets has an EBITDA margin below 10%, so large revenue does not necessarily entail large profits.

The large revenue is rather a result of DONG Energy’s increase in trading and hedging activities in

the past four years.

Large provisions of gas contracts caused NOPAT, FCF, and ROIC to turn negative in 2012.

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6.4 Forecasting

In this section how the four business units’ free cash flows, that are to be discounted to get the present

value of the entreprise, are forecast. The strategic analyses, DONG Energy’s expectations for the

future, and the historical analyses of each business unit are synthesized to create the forecasts. For

each business unit, free cash flows are forecast for a set number of years. After that period, a

continuing value is calculated. Since the business units operate in different industries and are at

different stages in the life cycle of business, I have chosen different forecast periods for each business

unit. The forecasts can be seen in section 6.6 Discounted Cash Flow Valuation.

6.4.1 Exploration & Production

Exploration & Production has two main financial value drivers; prices and production volume.

Damodaran, who has valued two of the largest oil companies in the world, ExxonMobil (Damodaran,

2010, p. 420) and Royal Dutch Shell (Damodaran, 2017, p. 67), has regressed their stock prices

against the average annual oil price for the past 30 years. He found that the correlation was above

90% in both cases. In other words, the stocks price movements were almost solely explained by

movements in the oil price.

The profitability of DONG Energy’s business unit Exploration & Production is also very much

dependent on the prices of oil and natural gas. There are a couple of ways to model this financially.

You could record a histogram of the historical oil prices, adjusted for inflation, and make a

corresponding statistical distribution. You could then assign that distribution to the oil price variable

in the model and run monte carlo simulations to get a distribution of possible valuations. Everything

else being equal, the shape of the value distribution will be almost identical to the shape of the oil

price distribution, which is skewed to the right, as can be seen in Figure 4.

Figure 4 – Oil Price Distribution

Source: Damodaran, 2018, p. 211.

67

While this is a viable approach, there is no telling if the future price distributions of oil and natural

gas will look like those of the past.

Instead, I have chosen to model the revenue of Exploration & Production as a function of the average

revenue in DKK per produced BOE from 2010 to 2013, and expected production volume. This is a

way of averaging out the price and production mix variations of oil and gas of the past four years.

The production mix has trended towards more and more gas relative to oil in the period, but I expect

that to change, as new oil fields are under development.

Exploration & Production aims to produce a total of 47mn BOE in 2016 and 55mn BOE in 2020. I

think that those targets are realistic, so I have put them into the model. The forecast period is 7 years,

from 2014 to 2020. For the terminal period, the period after the last forecast year, I have set the

growth rate of the free cash flows to -10%, because I expect oil and gas production in the North Sea

to decline rather rapidly as reserves dry up. This results in a relatively low continuing value.

6.4.2 Wind Power

Wind Power is DONG Energy’s most promising business unit. It is the global market leader in a

rapidly growing industry. I expect Wind Power to continue taking advantage of their technological

leadership, and I believe that the learning curve will continue to serve as a barrier to entry. Wind

Power has experienced very rapid revenue growth in the past four years. While I do not think that

they can sustain growth rates above 50%, I do think that they can hit the targets of a total installed

capacity of 3.5GW in 2016 and 6.5GW in 2020. I have incorporated these targets into the model and

extended the forecast period of high growth to 2023. Volume growth is the main financial value

driver, because even though costs per installed MW is expected to continue decreasing in the future,

the prices of electricity generated by wind power is expected to decrease with them.

The financial model reflects my belief that Wind Power can sustain a competitive advantage for at

least 10 years. After that period, I project free cash flows to decline by 2% a year, as increased

competition gradually removes Wind Power’s competitive advantage.

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6.4.3 Thermal Power

Thermal Power is DONG Energy’s least important business unit. The industry is mature, so strategic

opportunities are limited. In 2013, Thermal Power was responsible for just 13% of the company’s

revenue and 5% of the EBITDA. Declining contribution margins have resulted in losses in the past

two years. The low margins are expected to continue in the foreseeable future, so the business model

has a negative outlook.

The financial model projects that revenue will decline by 1% for the next five years. I expect DONG

Energy to be able to stop the bleeding of the past two years by reducing costs and shifting fuel from

coal to biomass in some power stations. This will result in free cash flows around zero. The long term

growth rate of the free cash flows for the terminal period is set to -2%.

6.4.4 Customers & Markets

Customers & Markets is the result of a merger of the former business units Energy Markets and Sales

& Distribution. The strategic analysis revealed that Energy Markets does not have a competitive

advantage with regards to energy trading and hedging exposure. Sales & Distribution has large market

shares in the selling of natural gas and electricity in Jutland and the Greater Copenhagen area,

respectively. These customer bases constitute a sustainable competitive advantage.

In 2012, Customers & Markets suffered a great loss due to provisions of onerous gas contracts. I

consider this loss a one-off event. The financial model forecasts that revenue will grow by 4% a year

in the next five years, while costs remain stable. This results in positive free cash flows. The long

term growth rate of the free cash flows for the terminal period is set to -2%.

6.5 Weighted Average Cost of Capital

To find the present value of the projected free cash flows of each business unit, they are discounted

using the weighted average cost of capital, WACC, as the discount rate. WACC can be thought of as

the combined opportunity costs of all capital providers. It consists of three primary components; the

required return on equity, the required return on debt, and the capital structure of the company. It is

calculated with the following formula (Koller et al., 2015, p. 283) (Petersen & Plenborg, 2012, p.

246):

69

J!;; = EE + 0 ∗ D4 ∗ 1 − $ + 0

E + 0 ∗ DL

where D is the market value of net interest bearing debt, E is the market value of equity, rd is the

required return on debt, t is the corporate tax rate, and re is the required return on equity.

Since DONG Energy does not disclose the capital structure of each business unit, one option is to just

estimate the WACC for the company as a whole and discount all of the free cash flows using that

same WACC. This would get increasingly imprecise as the relative weightings of the business units

change in the future. Another option is to try to estimate the debt and equity for each business unit by

allocating them using a proxy that is disclosed on a business unit level, such as total assets. However,

I have chosen to use a third approach recommended by Damodaran in his chapter on valuing

multibusiness companies on a disaggregated basis. Damodaran recommends using the company’s

debt ratio and cost of debt for all business units, but varying the required return on equity by business

unit (Damodaran, 2010, p. 557).

The required return on equity can be estimated in a number of different ways (Koller et al., 2015, p.

286). I have chosen to use the capital asset pricing model, CAPM, approach, since that is

recommended in most textbooks, and it is the one used by practitioners in the Danish financial

industry (PWC, 2016, p. 2). According to the CAPM, the required return on equity is equal to the

riskfree interest rate plus Beta times the market risk premium:

DL = DM + N ∗ (0 DP − DM)

where rf is the riskfree interest rate. In Denmark, the rate of the 10 year government bond is used in

practice. In February 2014, it was 2% (PWC, 2016, p. 2), so that is the rate I will use as the riskfree

rate. E(rm)-rf is the difference between the expected return on the market portfolio of stocks and the

riskfree rate. It is a measure of the extra compensation that stock investors demand in return for taking

on the risk of owning stocks rather than government bonds. Therefore, it is called the market risk

premium. In 2013 and 2014, the average market risk premium used by Danish practitioners was 5.3%

and 6.0%, respectively (PWC, 2016, p. 4). I have chosen to use the average of those two numbers;

5.65%.

Beta is a measure of the systematic risk embedded in a stock. A stock with a beta of 0.5 goes up by

0.5%, when the stock market goes up by 1%. A stock with a beta of 1.2 goes up by 1.2%, when the

70

market goes up by 1%. Likewise, it also goes down by 1.2%, when the markt declines by 1%. Put

differently, stocks with a beta between 0 and 1 are less volatile than the market. Stocks with a beta

above 1 are more volatile than the market. Stocks with betas below zero move in the opposite

direction of the market, but such companies are very rare.

Practitioners use regression analysis to estimate betas of different stocks and industries. Since neither

DONG Energy nor its individual business units are listed, I can not do that. Instead, I will use the

European unlevered industry betas that Damodaran publishes on his website every year (Damodaran,

2014). Since DONG Energy uses leverage, I have to convert the unlevered betas to levered betas,

using the following formula (Damodaran, 2010, p. 302):

7#A#D#CR#$' = S/(#A#D#CR#$' ∗ (1 + 1 − $ ∗ (E0)

where t is the corporate tax rate, D is debt, and E is equity.

Having calculated the levered beta of each business unit, I can calculate the required return on

equity, and subsequently the WACC. Table 22 summarizes the estimates.

Table 22 – WACC by Business Unit

Business Industry Unlevered LeveredRequiredReturn WACC

Unit Beta Beta onEquity Exploration&Production E&P 1,09 1,80 12,2% 8,4%WindPower GreenEnergy 0,44 0,73 6,1% 5,1%ThermalPower Power 0,65 1,08 8,1% 6,2%Customers&Markets Utility 0,66 1,09 8,2% 6,2%

Source: Own creation

Exploration & Production is the most risky industry and unsurprisingly has the highest WACC. For

Wind Power, I chose the industry ”Green Energy”, since Damodaran does not have a separate

category for wind power. I was a bit surprised that European green energy is significantly less risky

than the other categories, but I suspect it is due to large subsidies. For DONG Energy, it certainly

makes sense that cash flows from wind farms that already have been built or are in the pipeline are

discounted with a low rate, because in most cases the power they produce is sold at a fixed price,

guaranteed by the government.

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6.6 Discounted Cash Flow Valuation

The purpose of this section is to find the value of DONG Energy’s equity. The forecast cash flows

of each business are discounted with their respective WACC to find their present value. The sum of

the values of the business units is equal to the value of DONG Energy’s operating assets. To find the

value of DONG Energy’s equity, net financial assets are added the value of the operating assets.

Tables 23 through 26 show the forecast revenue, free cash flows, WACC, discount factor, present

values of the free cash flows and the continuing value, and the total value of each business unit.

Table 23 – DCF for Exploration & Production

Exploration&Production E2014 E2015 E2016 E2017 E2018 E2019 E2020Revenue 14323 16303 18282 18985 19688 20392 21095FCF 635 722 810 1064 1318 1572 1826Discountrate,WACC 8,4% 8,4% 8,4% 8,4% 8,4% 8,4% 8,4%Discountfactor 0,92 0,85 0,78 0,72 0,67 0,62 0,57PVofFCF 586 615 636 770 880 968 1038PVofContinuingValue 5637Totalvalue 11130

Source: Own creation.

Table 24 – DCF for Wind Power

WindPower E2014 E2015 E2016 E2017 E2018 E2019 E2020 E2021 E2022 E2023Revenue 14352 17222 20667 24800 28520 32798 37718 43376 49882 57364FCF -3611 -3128 -2307 -1032 -331 603 1825 3400 5407 7939Discountrate,WACC 5,1% 5,1% 5,1% 5,1% 5,1% 5,1% 5,1% 5,1% 5,1% 5,1%Discountfactor 0,95 0,91 0,86 0,82 0,78 0,74 0,71 0,67 0,64 0,61PVofFCF -3436 -2831 -1987 -846 -258 447 1288 2283 3454 4826PVofContinuingValue 112869Totalvalue 71552

Source: Own creation

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Table 25 – DCF for Thermal Power

ThermalPower E2014 E2015 E2016 E2017 E2018Revenue 9610 9562 9514 9466 9419FCF 8 3 -2 -7 -12Discountrate,WACC 6,2% 6,2% 6,2% 6,2% 6,2%Discountfactor 0,94 0,89 0,84 0,79 0,74PVofFCF 8 3 -2 -6 -9PVofContinuingValue -111Totalvalue -117

Source: Own creation

Table 26 – DCF for Customers & Markets

Customers&Markets E2014 E2015 E2016 E2017 E2018Revenue 51401 53200 55062 56989 58984FCF -70 193 475 777 1099Discountrate,WACC 6,2% 6,2% 6,2% 6,2% 6,2%Discountfactor 0,94 0,89 0,83 0,79 0,74PVofFCF -66 171 397 610 813PVofContinuingValue 10181Totalvalue 12105

Source: Own creation

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In Table 27, the results of the individual DCF analyses are summed to find the value of DONG

Energy’s operating assets. Net financial assets are added to find the value of DONG Energy’s equity.

Table 27 – Value of DONG Energy’s Operating Assets

Forecast PVof PVof Total

periodforecastperiod

continuingvalue

Exploration&Production 7 5493 5637 11130WindPower 10 2941 68611 71552ThermalPower 5 -6 -111 -117Customers&Markets 5 1924 10181 12105Valueofoperatingassets 94670Netfinancialassets -43306Valueofequty 51364

Source: Own creation

The value of the operating assets is DKK 94.7bn. The net value of financial assets is negative DKK

43.3bn. The value of DONG Energy’s equity is DKK 51.4bn.

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7.Conclusion

The purpose of this thesis has been to answer the main research question: Did the Danish government

sell the shares of DONG Energy at a fair price in the capital increase of 2014?

In the capital increase deal between the Danish government, Goldman Sachs, ATP, and PFA, the

equity of DONG Energy was valued at DKK 31.5bn.

After conducting a disaggregated discounted cash flow valuation, I have estimated that the fair value

of DONG Energy’s equity was DKK 51.4bn at the time of the sale. Since my valuation of the equity

is DKK 19.9bn, corresponding to 63%, higher than the one in the deal, my conclusion is that the

Danish government did not sell the shares at a fair price in the capital increase of 2014.

The valuation in this thesis is based on strategic and financial analyses of DONG Energy’s four

business units: Exploration & Production, Wind Power, Thermal Power, and Customers & Markets.

Exploration & Production, which produces oil and natural gas, is in a risky business because its

profitability is highly dependent on the prices of oil and natural gas.

Wind Power is the global market leader within construction and operation of offshore wind farms.

This market is expected to continue its growth as the global energy mix is shifting towards more

renewable energy. Wind Power first mover advantage in the form of technological leadership serves

as a sustainable competitive advantage, and this makes it the most valuable of the business units.

Thermal Power, which generates electricity and district heating in Denmark, is the least valuable of

the four business units, because the business model is suffering due to low contribution margins, that

are expected to stay low in the foreseeable future.

Customers & Markets sells and distributes electricity and natural gas in Northern Europe. It also

hedges DONG Energy’s energy exposures. While the hedging activities are not assessed to

particularly valuable, the customer bases within natural gas and electricity sales are valuable, and

they serve as a sustainable competitive advantage.

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9.Appendix

All calculations of the valuation can be found in the Excel file named ”DONG Energy Valuation”.