SSEZF - SSE: Significant Renewables Spending Driving Value

2023-06-06 02:20:08 ET

Summary

• SSE plc focuses on expanding its renewable energy portfolio, aligning with the global shift towards clean and sustainable energy sources.
• The company is investing in energy storage solutions, EV charging infrastructure, and technological advancements to optimize operations, increase renewables output, and enhance grid reliability.
• SSE actively engages in partnerships to foster innovation and accelerate the adoption of clean energy solutions, while also capitalizing on trends such as electrification of heating systems and energy efficiency programs.
• EPS growth forecast is superior to historically achieved due to the renewable push, with the ROI on capex healthy.

Investment thesis

Our current investment thesis is that SSE has benefited from the heightened energy prices, generating substantially higher profits. The company is investing heavily in renewable energy sources, with c.£18bn committed thus far, which has the scope to significantly increase profitability. SSE is trading at a below-average price to book value, representing an opportunity as profitability from its new infrastructure assets increases.

Company description

SSE plc ( OTCPK:SSEZY ) is involved in various aspects of the electricity industry, including generation, transmission, distribution, and supply. They generate electricity from different sources such as water, gas, coal, oil, and multi-fuel. The company distributes electricity to around 3.8 million homes and businesses in Scotland and central southern England. They also own and operate a high-voltage electricity transmission system in the north of Scotland and remote islands.

Share price

SSE's share price has declined over the last decade, as falling energy prices and asset sales contributed to a declining position. When factoring in dividends, however, returns are far more respectable.

Financial analysis

Presented above is SSE's financial performance for the last decade.

Note: SSE's P&L is complex due to exceptional and remeasurements. Our data presented above is on a post-exceptional basis, with the following data on an adjusted basis. The loss in FY23 is due to the movement in unrealized derivatives value (£(2.7)bn).

Revenue

SSE has growth revenue from £7.3bn in FY19 to £12.5bn in FY23, representing a CAGR of 14%. This is a reflection of a change in market conditions, transitioning from a period of soft energy prices to rampant inflation.

Inflationary pressures

In Feb22, Russia invaded Ukraine. At the time, there were already inflationary pressures taking hold, driven by supply chain constraints and historically relaxed monetary policy. Following the invasion, however, we experienced a rapid rise in energy prices due to the supply shock as Russian oil exited the market.

This fueled inflation further, contributing to increased electricity prices for consumers. This materially impacted the UK, similar to other nations, with price inflation of over 50% during 2022.

Both inflationary pressures and the energy supply shock allowed SSE to generate 26% revenue growth in FY22 and 45% in FY23.

The supply concerns are beginning to subside, as new sources of energy generation are secured and production is increased where possible. Apr23 is currently the lowest electricity inflation since the rapid rise. For this reason, we suspect much of the inflated gains have likely been made, although, with 17.3% currently, absolute revenue will still be strong in the coming 24-36 months.

Net Zero

The transition towards renewable energy sources is a dominant trend shaping the energy industry. SSE has strategically positioned itself to benefit from this transition by investing heavily in renewable energy generation, including wind, hydro, and solar power. The company's focus on expanding its renewable energy portfolio aligns with the global shift towards clean and sustainable energy sources. Management continues to disclose what it refers to as "Net Zero Acceleration Programme Plus (NAZAP Plus)". This is SSE's ambitious investment plan to transition both the company and the UK's infrastructure to renewable energy. The upgraded plans will require c.£18bn in capex spending, contributing to an improved level of profitability growth.

Looking at renewables in further detail, 3GW of the 5GW target is already under construction, with 2GWs secured in the pipeline. A heightened attractiveness of SSE is that it owns its renewable assets (Hydro and Wind), which are assets that have scope for significant value appreciation in the coming decades.

The global commitment to decarbonization and achieving net-zero emissions is a transformative trend for the energy industry. Although we have not reached the point of legislation, Governments have shown a clear commitment to this transition and we expect continued financial capital allocation toward these energy sources. This will allow SSE to improve its returns and market position in the UK, as demand transitions from imported oil (for example) to its renewables.

The net impact of NZAP is a transition toward higher margins and better growth, with current forecasts implying EPS can grow by c.14%.

Other trends

The electrification of transportation, particularly the rise of electric vehicles, is reshaping the energy landscape. Investment in EV infrastructure is increasing rapidly, partially from SSE. This has the potential to significantly increase the demand for electricity across the country, as the UK Government targets the end of petrol/diesel cars/vans sales by 2030 . This will only increase further once other vehicles transition.

The shift towards electrifying heating systems, such as heat pumps, and the adoption of decentralized heating networks are gaining momentum. An increasing number of both existing and new homes are incorporating the technology, contributing to increased demand for electricity. SSE has positioned itself to benefit from this.

Margins

Presented above is SSE's adjusted OPM. Operating margin improvement is driven by increased pricing relative to the cost of production, which has moved favorably as consumers are locked in at higher levels while costs decline.

As discussed previously, SSE's NZAP capex spending is positioned to transform the business. Management is disciplined with expenditure to ensure returns are adequate to be accretive to shareholders. National infrastructure is generally low-risk and cash-heavy, so the spread to WACC/ROE looks attractive in our view.

Balance sheet

Management has deleveraging in recent years, positioning the business for the large financial outlay expected as part of the NZAP plan. With large infrastructure businesses, it is not surprising to see substantial leverage, as debt is backed against hard assets and significant capex spending is required. SSE has a good credit rating with a positive outlook given the deleveraging effort.

Our view is that SSE is in a healthy position, with the FY23-FY27 capital structure strategy from Management looking reasonable. Dividend payments will be reduced in FY24 in order to support this, but we concur with the prioritization of balance sheet protection given the spending required.

Valuation

SSE is trading at 2.4x its LTM tangible book value, 2.3x revenue, and with a dividend yield of 5.2%.

With the forecast EPS growth in the coming years, we see an opportunity for value appreciation. The business has a monopolistic position in an inelastic market, its capex investment should yield strong gains, and its cash generation is healthy.

The near-term reduction of dividends is unfortunate; however, this is the correct decision to support future growth.

Final thoughts

SSE is a well-positioned renewable energy business. It is investing heavily in infrastructure development, which it estimates will supercharge EPS growth in the coming years. We believe the yield is attractive and cash use should transition toward distributions as the company continually completes phases of its NZAP plan.

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