The view of European utilities as bond proxies was debunked by a City bank today as it picked out renewables giant SSE (LSE:SSE) as one of the “biggest anomalies” of trading this year.
Deutsche Bank believes investors have overestimated the importance of rising bond yields, when really it's the relative earnings outlook that is key for performance.
The sector has come in 6% below the wider market since the mid-September spike in bond yields, with concerns over the outlook for renewables another downside factor.
The bank said it sees scope for at least part of this trend to reverse: “Earnings growth for the sector should slow, as bumper energy-driven earnings normalise, although will prove defensive if the economic backdrop weakens.”
The most attractive investment cases are in integrated utilities, making RWE (XETRA:RWE), Enel SpA (MTA:ENEL), SSE, Engie SA (EURONEXT:ENGI), and E.ON SE (XETRA:EOAN) core picks. They all trade on attractive valuation multiples of between 8-10x earnings and typically have asset mixes well aligned to the energy transition.
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Deutsche Bank lowered its target price on FTSE 100-listed SSE from 2,150p to 1900p, but this still represents an upside of almost a fifth on this afternoon’s price.
Today’s note said: “SSE feels to us like one of the biggest anomalies of trading this year. In spite of a very upbeat presentation at the full-year results, the stock subsequently underperformed.
“The result is that the stock, which historically has traded broadly on a sector multiple, now trades at a significant discount on only about 9x. This feels odd to us given the company’s strengths.”
Positives in favour of SSE shares include the company’s balanced mix of renewables and flexible gas, a strong balance sheet and better earnings quality than in the past.
Across the sector, the bank cut its average price target by 7% to reflect a higher cost of equity and more conservative long-term value creation assumptions for renewable pipelines.
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Utilities have less cyclical earnings than the broader market, meaning that if the bond yield rises due to a buoyant economy then investors should expect the sector to underperform.
If a falling bond yield is due to an imminent recession, the sector should outperform.
Deutsche Bank said recent yield rises in Europe do not seem to be indicating a buoyant economic outlook, although consensus forecasts are still projecting fairly robust mid-single-digit earnings growth for the wider market in 2024.
This contrasts with the sector where earnings growth should slow to around 3% per year following buoyant increases in recent years.
Deutsche Bank said: “Consensus at the moment is forecasting stronger earnings growth for the market than the sector in 2024, leaving the sector on only a 3% discount to the market on price/earnings (P/E).
“This suggests only moderate recovery potential to the norm of PE parity. If we start to see consensus downgrades for the market, as the economy slows, the relative upside could be more material.”
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