The European utilities sector is still undervalued after rebounding in Q2 in the wake of rising power prices. In fact, the sector’s valuations are close to a decade-low, according to Morningstar’s latest Utilities Pulse.
“We see real opportunity in the utilities sector, with valuations close to a decade low. Renewables projects valuations are highly sensitive to interest rates owing to their long duration and low internal rates of return. All in all, lower European rates would improve utilities’ relative attractiveness, boosting the sector.” said Tancrede Fulop, Senior Equity Analyst, Morningstar
Key takeaways from Morningstar’s latest Utilites Pulse include:
Companies pivot towards value over volume in renewable energy investments: In May, EDPR trimmed its capacity additions targets, emulating most utilities involved in renewables. On the other hand, EDPR raised its returns target. This reflects that renewable projects are still value accretive as construction costs have stabilized while purchase price agreement (PPA) prices remain at healthy levels. The AI-driven boost of data centers should support PPA prices.
Companies Step-Up Networks Investments: National Grid is the biggest bottleneck of the energy transition. All companies operating electricity networks have materially stepped-up their investments over the last months. The latest is National Grid which had to resort to highly dilutive rights issue. On the upside, high interest rates drive higher allowed returns.
Shares are attractive: Morningstar view the sector as undervalued, with a median price/fair value estimate ratio of 0.89. Median trailing dividend yield of 4.7% is in line with the historical one but its premium over government bond yields narrowed in Q2.
According to Morningstar:
- Our preferred renewables developer is Orsted as the execution of its revised business plan including farm-downs should drive a rerating of the stock.
- Diversified utilities offer the best risk/reward profile. Our preferred are RWE and SSE. We expect the latter to raise its 2024 guidance.
- Regulated utilities appear fairly valued. We favor E.On as it benefits from hikes in allowed returns in Germany and should be able to organically fund its high investments. Its dividend policy is attractive.
Natural Gas Prices Have Rebounded Despite High Storage Levels: High gas prices are positive for the sector on average due to their correlation with power prices.
Higher gas prices, meaning higher power prices, result in greater earnings for power producers with low carbon intensity: Companies most favorably exposed to high CO2 prices are those whose power generation mix has a low carbon intensity like Verbund, Engie or Centrica. The former is among the best sector’s performers in Q2.
The undervaluation of renewables developers has driven takeovers by big investment firms at very high multiples. Neoen’s main shareholders accepted an offer at 18 times the EBITDA. The sector is still significantly lagging the market in 2024 because of high interest rates. Should they fall, it will boost the sector. The full report can be found here.
