Utilities sector still cheap but one stock may have peaked

The potential for further upside in UK utilities this week divided opinion after National Grid (LSE:NG.) was downgraded to Sell but another City firm backed the sector’s defensive growth qualities.

UBS said the past 20 months have been the most supportive UK utilities environment since privatisation in 1995, but that National Grid’s valuation now looks stretched.

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It pointed out that shares trade at a 57% premium to the spot value of its regulated asset base (RAB), which is within the 42-61% range at which its four previous valuation peaks occurred.

These peaks were followed by an approximate 37% share price decline over the subsequent five to 19 months, with an average recovery period being three years. “In our view, the current valuation places a relatively high premium on asset growth.”

UBS said the company has done well to secure returns in excess of the cost of the capital in relation to its US business and UK power transmission and distribution operations.

However, it believes this is now reflected in the share price and that consumer affordability concerns, planning reform and supply chain constraints present downside risks to delivery.

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The bank has a price target of 1,160p, having seen shares surge by 40% over the past year to 1,364p amid their perception as a relative safe haven. National Grid trades with a projected 2.7% dividend yield, which is consistent with peers but lower than UK water stocks.

In contrast, Deutsche Bank continues to hold a positive view on National Grid shares after lifting its valuation estimate to 1,430p. This forms part of an average 12% increase for its utilities coverage, which also includes Pennon Group (LSE:PNN), SSE (LSE:SSE), Severn Trent (LSE:SVT) and United Utilities Group Class A (LSE:UU.).

While acknowledging that National Grid trades “quite strongly” above its 10-year average RAB premium, the bank says this can be justified by the attractive regulatory settlement for UK transmission and its strong RAB growth.

It adds that National Grid as well as SSE, Pennon and Severn Trent all offer annual double-digit growth in earnings per share over the next three years, with United in the mid-single digits.

Despite the past year’s run for stocks across the sector, it said the strong outlook for earnings growth meant they were still looking cheap at 11.5 times 2028-29 earnings for SSE and United Utilities and around 13 times for National Grid, Severn Trent and Pennon.

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It highlighted the sector’s appeal at a time when the market has multiple concerns, including the impact of artificial intelligence (AI), sharply rising commodity prices and a weakening economic backdrop.

This week’s report said: “While the share prices of UK utilities have risen strongly over the last year, the sector seems well placed given this backdrop.

“Utilities have limited downside risks from AI due to their physical assets, while power names such as SSE and National Grid should benefit from increasing electricity demand.

“Higher commodity prices are positive for SSE, and while bond yields are rising all UK utilities have a degree of inflation protection. None have a traditional economic cyclicality.”

Deutsche Bank lifted its price target on SSE to 2,800p, which compares with today’s level of 2,753p, and United Utilities to 1450p compared with 1,378p this afternoon. It also has a Buy position on Pennon with a 650p target price, with a Hold rating on Severn Trent.