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Morningstar | SSE and Innogy Scrap Merger of U.K. Retail Arms; SSE Deeply Undervalued

SSE and Innogy announced on Dec. 17 that they will scrap their plan to merge their U.K. retail energy activities. They were unable to reach an agreement on "revised commercial terms" to provide sufficient cash collateral to get an "appropriate credit rating" against a tough backdrop marked by the default tariff cap and fierce competition. We reiterate our fair value estimate of GBP 1,380 per share and our narrow moat, stable trend ratings for SSE. The deep undervaluation of the shares offsets the current uncertainties and offers an attractive reward/risk profile, in our view. We also reiterate our fair value estimate of EUR 40 per share and our no-moat, stable trend ratings for Innogy.

Had negotiations for additional cash injections been successful, the deal would have been value-destructive for SSE, which was due to have a 66% stake in the new company. Without additional cash injections, we calculate that the deal would have been value-neutral for SSE as synergies would have been offset by the poor profitability of Innogy's U.K. retail arm, Npower. All in all, we leave our fair value estimate unchanged.

SSE's board is now considering other options, including a spin-off, sale, or alternative transaction. We believe any of these options will be challenging, as the failed merger with Npower evidences the structural weakness of a pure retail player in the wild U.K. retail market. Ultimately, the failed deal dents SSE management's credibility.

SSE reiterated its five-year dividend plan, including the dividend cut to GBX 80 in 2020 previously justified by the deal with Innogy. The fact that the dividend cut is maintained despite the cancellation of the deal is disappointing, since the new company in which SSE shareholders would have received shares could have paid a dividend. However, the GBX 80 dividend implies a dividend yield of 7.5%, well above the sector average.

Our Innogy fair value estimate is aligned with the takeover bid price of E.On. The latter has a U.K. retail business that it will have to combine with Npower. E.On's U.K. retail business has the same market shares in gas and electricity as SSE. As the UK Competition and Markets Authority approved the planned merger between SSE's retail arm and Npower, one can reasonably assume that it will do the same for a combination with E.On. According to the latter, the timeline of the deal is unaffected.