Morningstar equity analysts are reducing their fair value estimate for SSE (SSE) to £14.70 per share from £15.80, owing to more cautious profit estimates, chiefly because of retail supply activity. Shares look slightly undervalued at the current level around £13 a share.
We expect 2018 adjusted earnings per share (EPS) of 113p, versus the 116p guided by management. We are roughly in line with consensus over 2018/19 earnings, but 12% below it on average in 2020 and 2021. In line with our coverage of Centrica – which was sharply downgraded last week – we factor in a tariff freeze for those two years. We believe this is not priced into consensus expectations. The retail supply activity with Innogy is not taken into account and the merger could boost earnings, given £100 million of potential synergies flagged by SSE. Still, there is a risk that the competition authority will not clear the deal, as ownership of retail electricity market will become increasingly more concentrated.
Our fair value estimate implies a dividend yield of 6.5%, which is above the 5.7% average of the last 10 years. Still, we believe this is justified by the uncertainty faced by UK utilities, which include a government-imposed price cap from next year. The management is committed to increasing the dividend at least in line with inflation in 2018 and 2019.
We reaffirm our narrow moat rating, which means the company has a slender competitive advantage. Altogether, we are confident that the company's earnings will exceed its cost of capital 10 years from now.
Regulatory Risks Increasing
SSE’s profits are roughly evenly distributed between regulatory networks and liberalised power generation and energy supply activities.
SSE’s wholesale generation unit operates roughly 11GW. Commissioning of new wind capacity will boost operating profit, which we expect to increase by 50% by 2021. However, thermal assets enable SSE to benefit from capacity payments, which we expect to contribute 10% of the division’s operating profits through 2020.
SSE's regulated electric and gas networks operate within a high-quality regulatory regime that allows it to generate value for shareholders. Regulatory risk is still an issue that investors should heed. The company's regulated networks have historically earned at or near the returns allowed by regulators, and we don't expect this to change.
SSE is the second-largest retail energy supplier in the UK behind Centrica. This activity accounts for roughly one fourth of the group's operating profit. Against a challenging competitive and regulatory backdrop, the decision to spin off this business and to merge it with Npower's retail arm at the end of 2018 makes sense. SSE will then refocus on its core networks and power generation activities. The potential cost synergies, amounting to £100 million, would add 60p to the company’s share price, or 4% of our fair value estimate.
SSE’s earnings and dividend growth has historically been supported by hefty investment in networks and renewables, leading SSE to burn a lot of cash since 2009.
