The investment case for owning SSE shares used to be simple and straightforward: It was all about paying dividends and growing them at least in line with inflation.
This served shareholders reasonably well with total returns of 105 per cent over the last decade compared with 72.8 per cent for the FTSE All-Share index. Virtually all of that return has come from dividends as the share price over the years has not made much progress.
The dividend strategy has been cast aside. In many ways, SSE was paying an unsustainable dividend for years as volatile profits from conventional power generation and domestic energy supply saw dividend cover become very thin as virtually all the company’s profits were being paid out.
A dividend cut in 2020 following the sale of its energy supply business has been followed by another this year as the company frees up cash to invest in renewable energy assets such as wind farms.
However, if SSE shareholders are getting lower dividends, then to make decent returns on their investment, they are going to need to see the share price move meaningfully higher. This requires significant profit growth from its investments.
At the moment, it seems that the stock market is not too enthusiastic about the company’s change in direction. SSE’s shares have declined by 3.8 per cent over the last year compared to an 8.4 per cent gain in the FTSE All-Share index.
Is the pessimism justified or has it been overdone?
A big bet on net zero
In order to generate meaningful profit growth, SSE has bet the company on the UK’s transition to clean energy and the need to build up its energy security.
Its strategy is based around three main business areas:
- Energy Networks - the company owns the electricity transmission and distribution networks in the north of Scotland and the electricity distribution network in the south of England.
- Renewable Energy - SSE has a portfolio of onshore and offshore wind farms, hydroelectric and pumped storage assets.
- Thermal Energy - SSE’s gas fired power stations are required to keep the lights on when renewables don’t produce electricity.Gas storage assets give a secure supply of gas for the winter months.
SSE is confident that investments in these businesses can generate attractive and reliable returns that will grow profits and allow dividends to grow by 5-10 per cent per year until at least 2027 and possibly some way beyond.
In summary the targeted returns are:
- A (before inflation) return on equity (ROE) of 7-9 per cent on regulated energy networks.
- Offshore wind ROE of at least 10 per cent
- Onshore wind 100-400 basis points above its cost of capital. This suggests a return on capital employed (ROCE) of around 8-12 per cent after tax.
By spending significant sums of money and getting these kinds of returns on it, SSE believes it is an attractive investment proposition.
Energy Networks to provide a growing and secure profit stream
The move away from fossil fuels and the expected increased use of electric vehicles, electric heating systems as well as solar energy and battery storage is going to require big investments in electricity grid networks.
Connecting offshore wind farms to the electricity transmission network (the national grid) is challenging and expensive, whereas electricity distribution networks are going to have to be upgraded to cope with the demands that new electric equipment puts on them.
SSE is already involved in some very big projects to connect Scottish islands to the main electricity grid. These include connecting the islands of Orkney and Skye and a subsea connection from the Shetland Islands to the Scottish mainland.
These substantial investment requirements are likely to lead to very big increases in the regulated asset base (RAB) of SSE’s network business.
The RAB is a measure of the money invested in electricity networks and is used by regulators to determine the amount of profit a utility company can male from owning and operating them.
The profit is based on the company earning a fair rate of return on its RAB for operating a network well and efficiently. The regulator sets price limits on the amount that SSE can charge its customers and how much it can spend on operations and investments.
If the prices set are reasonable, and SSE operates efficiently, its profits should add up to a return on its RAB that is equal to its cost of capital - an estimate of the minimum returns required by investors.
While the rate of return is changeable at each periodic review of prices, it generally holds that a bigger RAB should allow a business to make bigger profits.
Some added peace of mind for investors is that the value of the RAB and the income earned on it is linked to inflation which gives SSE very predictable and secure cash flows and asset values.
The money that SSE is pouring into its networks business should see the RAB double in size from around £8 billion in 2022 to more than £16 billion by 2027. As a result, City analysts expect very strong growth in profits from its networks business.
Renewables potential dependent on more government support
The outlook for SSE’s renewables business is favourable based on the projects it has in place. That said, profits from renewables are volatile and are dependent on weather patterns.
To make decent profits, its wind farms and hydroelectric plants need plenty of wind and rain. 2023/24 will highlight the risks of renewables to investors as lower electricity output due to unfavourable weather will hit SSE’s profits.
SSE currently has around 4.5 gigawatts (4500 megawatts) of renewable power assets of which around 3GW are wind farms with the remainder coming from hydroelectric and pumped storage.
Heavy investment in high profile offshore wind projects such as Seabank in Scotland and Dogger Bank (which will be the world’s largest offshore wind farm) in England is expected to increase SSE’s installed capacity to around 9GW by 2027. This should result in average annual profits growth of 20 per cent a year over the next few years.
However, there is potential for SSE to have a much bigger renewables portfolio and profits as the UK needs much more renewable power if it is to meet its net zero targets.
SSE’s Berwick Bank project could be as big as 4.1 GW but will only get built if the UK government provides the financial support needed to allow investments to make their required returns.
The government has been running annual auctions where companies submit renewable power projects that will receive a minimum guaranteed power price. The problem at the moment is that the power price guaranteed by the government has not been high enough to attract new investment as higher interest rates and construction costs need more money to pay for them.
In 2023, no new renewable capacity was secured through the auction, while this year’s auction began in the last week of March. The government is putting up more subsidies, but it is still not expected to have a lot of takers.
Gas power stations becoming more valuable to keep the lights on
The third part of SSE’s strategy is to maximise the value from its gas fired power stations. These stations are needed to keep the lights on when renewables are not producing electricity.
In order to make sure gas stations are available, the government makes capacity payments to cover their costs when they are not working. When they are needed, they are guaranteed to receive £65 per megawatt hour in return.
For SSE with big gas stations at Peterhead, Keadby and an investment in Triton Power, this arrangement is working very well. A lack of wind over the last year has seen them needed more often which should result in bumper profits of around £750mn and average annual profits of £500mn for the next three years.
The current capacity payments schedule lasts until 2027. While they are still likely to be needed after then, SSE is planning to maintain the value of its gas stations for the longer term by adapting them to burn hydrogen and investing in carbon capture and storage (CCS) in an attempt to reduce emissions and carbon costs.
Fully funded investments to drive steady profits and dividend growth
If all goes well, SSE is targeting earnings per share (EPS) of between 175p and 200p by 2027 compared with 153p expected for the year to March 2024. This is achievable from its current approved projects which are fully funded and supported by a strong financial position.
Debt levels are expected to increase as the company invests, but the net debt to Ebitda ratio is not expected to become too stretched (the ratio is expected to reach 3.8 times in 2027), with SSE retaining an investment grade debt rating.
Analysts currently expect 2027 EPS to be at the bottom of the range with a dividend per share of 75.6p.
The shares look cheap
Sentiment towards SSE shares is quite weak at the moment. Some analysts have been reducing their forecasts slightly to reflect lower electricity prices and lower profit margins on gas stations (known as spark spreads).
That said, there are strong grounds for saying that SSE shares look very cheap. Its renewables business is arguably undervalued by the market, while its valuation is at a discount compared to many other electricity grid companies.
Granted, the stock market valuations attached to renewable operators such as Orsted (DK:ORSTED) have come down a lot over the past year as new project returns have become less favourable, but it is by no means clear as to why SSE should be valued so low.
At the current share price of 1639p, SSE is valued at just 9.2 times on a one-year forecast EV/Ebit basis, which is close to a 10-year low. This is despite an outlook of decent profit growth.
The discount to Spanish utility Iberdrola (ES:IBE), which has a similar business mix and strategy, looks way too big at nearly 35 per cent.
If you believe that a UK government will eventually have to put more money behind wind farm projects – where few alternatives exist – then the medium-term outlook for SSE looks far better than its current valuation suggests.
