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Morningstar | SSE's Profit Warning Is Partly Due to Structural Issues but Share Price Reaction Is Excessive

SSE warned on its fiscal 2019 profit, owing to adverse weather conditions and high gas prices. It maintains its GBX 97.5 dividend, along with the five-year dividend plan. We will cut our 2019 earnings estimates by a double-digit percentage and will likely reduce the long-term profitability of the retail business due to the price cap, which will reduce our fair value estimate by a mid-single-digit percentage. For the moment, we reiterate our fair value estimate of GBX 1,470 per share, along with our narrow moat, stable trend ratings. We believe the share price reaction is excessive.

SSE guides that first-half operating profit will fall by half year over year, while operating profit for the first five months is GBP 190 million below budget, versus GBP 80 million in the first quarter.

The wholesale business is guided to report an operating loss in the first half versus profit of GBP 160 million last year. Key to that is the energy portfolio management business, which is guided to report a loss of GBP 100 million in the first half and GBP 300 million for the full year. This division, created last year, is supposed to provide "effective risk management" for wholesale and other businesses. Poor performance is partly due to unfavourable market conditions and should not be extrapolated. Still, this also reflects poor trading performance and a source of risk underestimated by the market in our view. The wholesale business' profitability will also be affected by lower renewable output due to poor wind conditions.

The retail business' operating profit is expected to be break-even in the first half versus profit of GBP 70 million last year, owing to warm weather and increasing gas costs not fully passed on to customers. SSE also mentions that the price cap, to be implemented next January, will result in retail operating profit significantly lower than the group's budget. We will lower our long-term retail profitability estimates to take the price cap into account.

Read-across from this profit warning is negative for the rest of the Big Six, including the leader Centrica. However, the impact for the latter should be mitigated by higher operating profit of the gas production business due to increasing gas prices. Also, the margin squeeze through the end of 2018 will be less significant, as Centrica will implement a second tariff hike in October to offset increasing gas prices. Unfavourable wind conditions should also affect Utilities with sizeable wind production in Northern Europe--that is, Orsted, E.On, and Innogy.