Fortum (FOJCF) Stock: Disastrous Long-Term Strategic Decisions

Prelude

Fortum (OTCPK:FOJCF) (OTCPK:FOJCY) has been in the midst of a storm lately. The company has been significantly impacted by Russia’s decision to stop all gas flow from Russia to Europe through the Nord Stream 1 pipeline. This was done in order to put pressure on the EU to lift their sanctions placed on Russia due to the war Russia started in Ukraine. Why does this impact Fortum?

Early 2000s – Lilius fixes his eyes eastwards

It was over two decades ago that Fortum’s CEO at that time, Mikael Lilius, decided to strategically expand Fortum’s operations into Russia. Fortum was the first strategic foreign investor in Russia and planned to benefit from the liberalization of the electricity markets. The big move into Russia came in 2008 when Fortum invested about €2.5 billion in electricity and heat generator TGC-10 and also started to report its Russian operations as a separate segment. The goal was to achieve a €500 million EBIT by 2015 (later restated as RBL 18.2 billion due to the fluctuation of the currency). Fortum never came close to that goal as comparable EBIT in 2015 was €202 million or about RUB 14 billion. The highest comparable EBIT came in 2019 when it was about €316 million (albeit RBL +20 billion). All in all, the investment didn’t live up to expectations. Fortum continued investing into Russia up until the war in Ukraine.

Late 2010s – Lundmark puts the cash to work

Almost two decades after the expansion into Russia, Fortum had found a new target – Uniper. This time it was CEO Pekka Lundmark, a veteran in the cranes industry, who took charge. A little background is necessary. Fortum had recently sold all of its electrical grids in the Nordics during 2014-2015 and had significant excess capital on its balance sheet. The shareholders naturally wanted this capital put to good use. Well, when a man has to deploy about €5 billion plus, what does he do? He deploys it. In 2017 Fortum expanded south with a significant investment into the Germanic company Uniper, which was and still is separately listed. It was a hostile takeover, as the management of Uniper resisted the deal for quite a while. Uniper naturally also had a lot of assets and operations in Russia and was a major gas trader, of which 40% comes from Russia (or came from Russia).

Hindsight is 20/20 – All strategic decisions proved terrible

This was the setup as we came into 2022. Fortum believed Russia was a trusted energy partner (even after the war with Georgia in 2008 and the annexation of Crimea in 2014) which, to be fair, is what most people assumed. I guess you have already figured out why the current EU-Russian conflict has affected Fortum more than most businesses. First off, Fortum’s Russian assets and operations will be sold due to this conflict. In my opinion, there is no conceivable way that Fortum could continue doing business in Russia as long as the current or a like-minded regime is in power. This was actually the worst case people were considering in the first innings of the war (yours included). Second, and a matter of greater significance, Uniper’s gas trading business is losing over €100 million per day and could have bankrupt the whole of Uniper if the German government and Fortum wouldn’t have intervened with a stabilization package in late July. Why is Uniper losing so much money? The issue is fairly simple. Uniper has acted as the middleman between Russian gas imports and the distribution of that gas to German customers. So basically, bought Russian gas with long-term contracts at a specified price and sold it with long-term contracts at a higher specified price. In return for this trading service Uniper has been able to take the spread between the purchase and sales prices as a profit. So, when Russia decided not to honor their contract to supply the gas that was agreed, Uniper was left in a tricky position. It either had to (1) declare force majeure or (2) buy expensive gas in the market and sell it at the agreed lower price. I had actually assumed that if this would ever happen, Uniper could declare force majeure and renegotiate its contracts. That was fairly naive of me. The German government would have none of it, at least up until 1st October 2022 when they will allow Uniper to move 90% of the costs to their customers. However, the damage is already done, as Uniper declared a €12 billion loss for the first half of 2022. The damage is not completely done, however, as Q3 2022 will most likely be the worst quarter for Uniper ever as gas prices are even higher now than they were in H1/2022. For a Finnish citizen, that basically means that we are paying for Germany’s cheap gas up until 1st October 2022 and 10% of it after that. Why is that? Well, Uniper is owned by Fortum, which in turn is owned by the Finnish state, which in turn represents the Finnish taxpayer. It’s not over yet (when it rains, it pours). There have been talks that the German government will nationalize Uniper, as the stabilization package provided in late July has proven insufficient to save Uniper in the end. When it’s all said and done, two decades of investments have been erased in a matter of six months. The situation is still not settled, but it doesn’t look promising for Fortum.

Throwing in the towel

I was a long-term investor until recently. After the stabilization package was declared and there wasn’t going to be an immediate force majeure, I decided to sell. The whole industry is too politically influenced at the moment and I suspect that the abnormal profits Europe’s energy businesses (Fortum’s generation segment for example) are earning may be subject to windfall taxes. Although I don’t expect Fortum to pay any windfall tax due to their overall weak financial year. The current situation is too opaque for my risk tolerance, and therefore, I rate Fortum a sell. One wisdom from Warren Buffett that has stuck with me is “You don’t have to make it back the way you lost it”.

Epilogue

I sincerely hope that the boards of large state-owned companies will challenge the CEO’s recommendations and decisions more often. If Fortum ends up selling its Russian assets for a large discount to cost and Uniper is nationalized, I hope we all learned something from this episode. Otherwise, the last two decades were all for nothing.