Fair Value Estimate: 1,100p | Uncertainty Rating: Medium | Economic Moat: Narrow
Thesis (Last updated 01/11/10)
As one of the United Kingdom's largest energy companies, Scottish and Southern (SSE) offers investors exposure to both the regulated and nonregulated elements of the energy value chain. With its commitment to a solid dividend and greater potential upside than a fully regulated utility, Scottish and Southern is worth a closer look from income-oriented investors seeking diversification outside the US power markets.
Formed by the merger of Scottish Hydro Electric and Southern Electric in 1998, Scottish and Southern has weathered the ups and downs of electric deregulation in the UK while maintaining its integrated structure. The company has since expanded into gas storage, telecommunications, and energy services, though these constitute a small percentage of overall profits. Its flagship businesses are the nonregulated generation and retail supply segments, which together account for about 60% of operating profits. The company operates more than 11,300 megawatts of primarily thermal capacity in the UK, though its portfolio of hydro, wind, and other renewable generation assets is expanding.
We are not especially fond of Scottish and Southern's current generation mix, though the company is exploring potential nuclear development in the UK Adding nuclear generation would significantly improve its asset profile, if the consortium with GDF Suez and Iberdrola Renovables can keep construction costs under control. We consider nonregulated nuclear plants to be wide-moat assets. The growth of its wind portfolio would improve returns dramatically as well if power prices were to recover, though at present the economics of wind power generation are supported entirely by the government's incentive programme.
Scottish and Southern's other primary businesses are its regulated electric and gas networks. These operate under a high-quality regulatory regime that we believe allows the company to generate value for shareholders. Capital-investment programmes and rate structures are set on five-year cycles that allow utilities to earn incentives for efficiency, reliability, and safety. Regulatory risk is still an issue that investors should heed, however. The company's regulated networks have historically earned at or near their allowed returns, and we don't expect this to change. Growth could come from Scottish and Southern's plans to bid for transmission projects connecting substantial new wind projects, especially offshore. It could also drive growth through required upgrades to its existing systems.
This company's performance will hinge on three major factors: demand for electricity, electricity prices, and Scottish and Southern's ability to earn returns on regulated spending. While we believe that higher demand and prices may provide additional upside for some of Scottish and Southern's peers, the company's dividend, its exposure to power markets, and its regulated growth profile could combine for an appealing total return proposition for income-oriented investors.
Valuation
We are maintaining our fair value estimate of 1,100p per share after updating our expectations for 2011 results. Our valuation is driven by a capital budget forecast of £5.2 billion through 2015, which does not include potential expenditures for building a nuclear plant at Sellafield in the UK or plans for offshore transmission projects. We continue to project EBITDA of £1.9 billion for fiscal 2011 and £2.0 billion for 2012 on the basis of planned wind farm investments, investments in regulated networks, flat per-unit generation margins in 2011, and 4% growth in generation margins in 2012. We anticipate 5% average annual growth in EBIT through 2013 and 3.7% through 2015 after adjusting 2010 results for charges. These estimates could change with significant improvement or deterioration in the UK power markets, or with a shift in government renewable-energy policy toward a more lucrative feed-in tariff. We do not incorporate any acquisitions. We discount cash flows at an 8.4% weighted average cost of capital to arrive at our fair value estimate, based on a 10.5% cost of equity. A 50-basis-point increase in our assumed cost of equity would result in a fair value estimate of 1,009p. A 50-basis-point decrease would result in a fair value estimate of 1,201p.
Risk
The company's generation fleet is exposed to the UK power markets, where volatile fuel prices and fluctuations in demand can eat into profits. The supply business must contend with public outcry due to fuel poverty and resistance to price increases. The regulated operations are subject to regulatory risk, as the UK energy networks regulator effectively sets the level of profits. Specific risks to our valuation include higher or lower expected generation margins, overpaying for large-scale acquisitions, and more aggressive carbon emissions targets.
Management & Stewardship
We give Scottish and Southern a fair mark for overall stewardship. The CEO and chairman roles are split, and we think the board is reasonably independent and not held captive to the desires of executive directors, though we would prefer a declassified board. We especially appreciate that nonexecutive directors chair the audit, nominations, and remunerations committees. Executive compensation is reasonable and held below the median for peer averages. We are not impressed by an incentive structure that is focused on earnings per share and share price. We'd rather see it structured to motivate management to maximise capital efficiency. We also think more substantial executive ownership would more closely align management's interests with those of shareholders. That said, we think current management has done a solid job of generating value for shareholders. CEO Ian Marchant and COO Colin Hood have nearly 50 years of industry experience between them. Earlier acquisitions have been disciplined, though management seems eager to dip its hand in many pots, which could lead to a loss of strategic focus. Marchant took home roughly £1.23 million during 2010, which we think is reasonable, given the company's size and complexity.
Overview
Financial Health: The current spending push has swelled the debt burden. The company is no longer underleveraged relative to its European peers, with total debt/capital of 66% as of March 31. Any more acquisitions could lead to a substantial equity issuance to shore up finances.
Profile: Scottish and Southern Energy is an energy holding company based in the United Kingdom. The bulk of its profits come from the company's more than 11,300 megawatts of power generation, nonregulated electric and gas supply businesses, and regulated networks business, which includes electric and gas distribution and transmission systems. The firm is also involved in a number of smaller, related businesses such as gas storage, home energy services, contracting, and telecom.
Bulls Say:
1. Scottish and Southern is one of the biggest players in the UK power markets, with a diversified presence across the value chain.
2. Renewable targets in Britain should provide opportunities for nonregulated generation and regulated transmission investment for many years.
3. New nuclear is seen by many as essential to meeting Britain's power needs. Scottish and Southern is poised to participate in a sizable greenfield opportunity with GDF Suez and Iberdrola Renovables.
4. The company has roughly £1 billion in assets under construction that aren't yet earning returns, providing some visible medium-term growth.
Bears Say:
1. The company expects margins to shrink at its UK generation business during the years ahead. Expanding margins at its supply business might not be sufficient to make up for those lost profits.
2. Declining demand will weigh on results unless economic improvement in the UK spurs a recovery in usage.
3. Scottish and Southern is less sensitive to power prices than some of its European peers, meaning less upside potential if power prices increase
4. The company's big plans for offshore wind will face numerous regulatory hurdles and delays, and we expect cost estimates to climb.
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