SSE – Facing challenges and threats after disposal #SSE

SSE – Facing challenges and threats after disposal #SSE

It has finally happened. After trying for so long, at last they managed to shift their problem child. I’m not talking about bad parents here, but instead about the attempts of energy company SSE to offload its consumer business – seemingly to anyone willing to buy it. A deal with Npower fell through last year. Now it seems it has found a buyer in one of the ambitious upstart industry challengers which it’s hoped will disrupt the Big Six UK suppliers. Ovo agreed to buy the business for £500m.

The deal – assuming there are no last-minute hiccups – looks like a win-win for SSE and Ovo. The former can now focus on its regulated activities, while Ovo is catapulted into becoming the UK’s second-biggest energy supplier, adding 3.5m customers to the 1.5m it already had. It is expected that the deal will finalise either at the end of this year or in the early part of 2020.

What was said about the deal?

Announcing the sale of the business to Ovo, SSE chief executive Alistair Phillips-Davies said: “We have long believed that a dedicated, focused and independent retailer will ultimately best serve customers, employees and other stakeholders – and this is an excellent opportunity to make that happen….I’m confident that this is the best outcome for the SSE Energy Services business.”

The founder and chief executive of Ovo, Stephen Fitzpatrick, described the deal as a “significant moment for the energy industry” saying the companies were a great fit and that “they share our values on sustainability and serving customers.”

With the problem child gone, is SSE a better investment opportunity, or do the problems that haunt competitors like Centrica such as the threat of nationalisation under a Jeremy Corbyn government mean investors should instead run a mile in the other direction?

What’s left?

With the retail gas and electricity business which supplies households gone, SSE is left with assets that combine power generation – the wind farms and hydroelectric part of the business – and a network of electricity transmission assets including 130,000km of lines and cables.

What’s left at SSE is heavily regulated. Investors will be hoping for slow and steady growth like that seen at National Grid for example. It should be easier to manage the smaller, more focused business and that in turn could lead to efficiencies which might drive value for shareholders.

What shape is SSE in?

I don’t think SSE is out of the woods yet. The sale is a move in the right direction and was something management had been keen to pursue. A leaner, more focused group may add value over the longer-term, but more immediately the loss of the consumer arm takes away a source of revenue and profits at the group.

Retail accounted for £122m of operating profit for the group. For context, adjusted operating profit at the wholesale and the networks divisions were £191.9m and £830.2m respectively in the full-year results ending 31 March 2019.

One clear sign that the group has too much debt was the dividend cut. A final dividend of 68.2p made for a full-year payout of 97.5p per share, but the sting in the tail was that it confirmed the cut to the full-year dividend to 80p per share for the new fiscal year. Showing just how far the dividend had run ahead of earnings was that EPS came out at just 67.1p – reflecting losses incurred by Energy Portfolio Management. Reported and adjusted earnings both fell from 2018 to 2019.

For the group in the coming year, SSE said adjusted operating profit was “improving but likely to be negatively impacted by expected phasing of profits” in regulated electricity networks and by renewable output being hedged at less than current market prices.

Another challenge that SSE faces is the need for huge capital expenditure – something that isn’t going to lessen now that it has doubled down on building renewables infrastructure. For 2018-19, the group had capital expenditure of £1.42bn.

Opportunities and threats

When it comes to opportunities for SSE, technologies the company is developing could help it expand beyond the UK and Ireland, where it has traditionally operated. If renewables take off and government and public support gathers pace behind renewables, then SSE will be well-positioned to capitalise on that growth. SSE has over 8GW of on- and off-shore wind farm pipeline developments in GB and Ireland, which will be capable of doubling renewable energy output to over 20TWh by 2025.

It also has the opportunity to support the UK’s decarbonisation objectives through evolution to Distributed System Operators, including the industry-first smart grid trial in Oxfordshire. The emergence of electric cars is also an area of potentially huge growth which SSE is prepared for.

On the other side though, the threats are significant and there are four main ones:

  • Reliability of renewables – SSE has already blamed unfavourable weather for returns from its renewables infrastructure and will likely do so again in the future. When the wind blows and how hard, is a factor beyond its control.
  • Nationalisation – with political turmoil in Westminister investors may well – as they have been for a while – be concerned about what would happen if there was a general election and Jeremy Corbyn won. Utilities would be high on the hit list for nationalisation.
  • High level of debt – Adjusted net debt and hybrid capital stood at £9.39bn at the end of March and guidance from the board indicated it will be around £10bn at the end of this year.
  • Rising interest rates – a combination of SSE’s debt and its appeal to investors for income rather than growth could be a double whammy, if and when interest rates go up. Probably not an immediate concern with Brexit and flat economic conditions, but one to keep an eye on.

My view

The share price has shot up in the last month, although it’s still a bit below its one year high. Overall, it’s a mixed picture for the energy group and I’d be tempted to stay away from investing in the shares. Despite offloading the consumer arm, I think SSE still faces too many challenges and threats to be a profitable investment, despite the rebased dividend and the dividend yield. The forward yield, based on the current share price of 1,214p is around 6.6%, so still well above the average for the FTSE 100.

I’d like to see more evidence as well that SSE can grow profits from renewables year-on-year before buying the shares. Then lastly, when it comes to reporting, it would be good to see less need for adjustments as these often mask the true state of the business and make assessing its health far more difficult.

 

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