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Morningstar | SSE Adjusts Full-Year Guidance for Capacity Payment Suspension; Shares Materially Undervalued

We reiterate our GBX 1,380 fair value estimate and narrow moat, stable trend rating after SSE released its trading statement for the third quarter of its 2019 fiscal year. We view the shares as materially undervalued.

SSE lowered its 2018-19 earnings per share guidance from GBX 70-75 to GBX 64-69 versus our GBX 72 estimate. This adjustment is fully due to the suspension of the U.K. capacity payments, ruled by the European Court of Justice in November, whose impact amounts to GBP 60 million. We will adjust our 2019 net income estimates accordingly. However, this GBP 60 million could be recouped as the U.K. government stated in February that it intends to ensure that 2018-19 suspended payments are made to capacity holders. In the longer run, we believe a definitive repeal of the capacity payments without any alternative replacement scheme is unlikely. Under this worst-case scenario, the valuation impact would amount to GBX 100 per share, bringing our fair value estimate to GBX 1,280, still 8% above the current share price, reflecting the material undervaluation of the shares.

In line with the first half, the operating backdrop has remained challenging since the end of September. In the retail business, churn remained high as SSE lost 160 thousand customers in the third quarter versus average quarterly losses of 155 thousand customers in the first two quarters. Assuming another 160 thousand losses in the last quarter points to annual churn of 10%, well above our mid-single-digit assumption. Due to unfavorable weather conditions, renewable output was 10% below the group's initial forecasts at the end of December and 25% in January. In all, renewable generation output was flattish as capacity commissioning offset bad weather conditions. Our assumption of a 20% decline appears too conservative. All in all, our overly conservative assumptions for renewable output will be offset by higher churn than in our estimates.

On Feb. 7, regulator Ofgem announced that it will increase the cap on standard variable tariffs by 10% from April owing to increasing gas and electricity costs, which we do take into account. This is well above our overly conservative assumptions that the tariff cap would be unchanged in 2019. All else being equal, factoring in the 10% tariff cap will boost our estimates for SSE's 2020 net income and Centrica's 2019 net income by around 20%. However, we are not changing our long-term retail margin assumptions, given the harsh competitive backdrop. Therefore, the valuation impact will be limited.

SSE confirmed its 2018-19 dividend of GBX 97.50, implying an 8% yield, along with its five-year dividend plan. Furthermore, SSE will launch a GBP 200 million share-buyback program by the end of March with the cash proceeds from the disposal of the Stronelairg wind farm. The impact on earnings per share will be roughly neutral on our calculations.