19 January 2017 Europe/United Kingdom Equity Research Multi Utilities UK Utilities Research Analysts SECTOR REVIEW Mark Freshney 44 20 7888 0887 [email protected] Three points of focus for the coming months Guy MacKenzie, CFA 44 20 7883 9534 Figure 1: Ratings and total potential return up/downside to our TPs [email protected] Vincent Gilles OUTPERFORM NEUTRAL UNDERPERFORM 25% 22% 44 20 7888 1926 [email protected] 20% 18% 16% 14% Specialist Sales: Jason Turner 15% 44 20 7888 1395 9% 8% [email protected] 10% 5% 3% 0% (5%) (3%) (6%) (10%) (15%) DONG Centrica United Drax UK Utils SSE Severn Pennon National Energy Utilities Trent Grid Source: Thomson Reuters, Credit Suisse estimates (priced as of market close on 12 January 2017) ■ Action: Following poor performance in 2016, we are more positive on UK utilities, and see potential average c9% total return upside on a 1-year view. Consistent with our recent report entitled Brave new world, we prefer commodity-exposed names (DONG Energy, Centrica (CNA) and Drax (DRX)) as they have EPS growth and positive earnings momentum. Overall, we view regulated stocks as less expensive now than in mid-2016, and we see total potential return upside of c16% on United Utilities (UU). ■ Three themes: (1) We expect domestic electricity prices to rise c8- 10% in March: We think the risk is more manageable and the likelihood of adverse intervention is low, not least as discounts on fixed tariffs have halved, to c£69-113 p.a.; (2) Improved power market conditions benefit Centrica and Drax: We see increased volatility in the spot power market, which should benefit generators. We run our new 42p/therm gas price through our model (from 54p) but coal is on the margin, so our power price estimate only falls to c£44/MWh (from c£46/MWh); and (3) Low returns on new projects: Increased cash flows will be difficult to deploy in capex, given competitive tendering has bid down post-tax returns on equity to c6- 9% (i.e. cost of equity). The risk would stem from more share buybacks (a contrarian signal) or M&A (risk of overpaying). Ending scrip dividends would demonstrate better discipline, in our view. ■ Stock calls: We reduce our TP on CNA (TP 255p from 270p, Outperform) on our lower gas price, but see EPS growth in 2017E and 2018E. We upgrade UU to Outperform from Neutral (TP 1,000p from 990p) and SVT to Neutral from Underperform (TP 2190p from 2100p). We reduce our TP on NG (TP 850p from 860p, U/P). PNN (TP 750p, U/P) is our least preferred stock due to risks on energy from waste. We include DONG (TP DKK310, O/P) as, albeit listed in Denmark, c70% of its enterprise value is in the UK and it is the largest investor in UK wind. DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, LEGAL ENTITY DISCLOSURE AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. 19 January 2017 Key charts Figure 3: Percentage of group EBIT and EPS from GB Figure 2: Total shareholder return over 2016, % domestic supply for the 'big six' 60% 56% 60% 50% 51% 50% 40% 37% 30% 40% 19% 28% 20% 14% 30% 8% 10% 6% 6% 6% 19% 3% 0% 20% 13% 8% 7% 6% 10% 5% (10%) (0%) 4% s s x 0 a T E l l U N G i i a c 0 0% t t V i S r U N N r 1 t U S U S P D n E (1%) (0%) 0 e e S p 5 (10%) C T 3 o r F u E Centrica EON SSE Innogy IBE EDF E S I T F C S % of Net Income % of EBIT M Source: Thomson Reuters, Credit Suisse research * We compare 2015 supply profits with 2016 estimates Net Income and EBIT. Consensus for EDF) Source: Credit Suisse research Figure 4: GB baseload power; our new and old Figure 5: Premium to RAB of recent deals (line is trailing forecasts, and the forward curve, £/MWh average of last five deals), % premium to RAB 53 51 60% 50 49 50% 47 48 47 46 40% 45 46 45 30% 44 44 44 20% 41 41 39 10% 38 40 0% … … … … … … … … … … … r s k s y s k n n h n 1 h 5 a K U N D G r t t r e r c a e e e 1 1 d o t i l l l o u u U (10%) t - e U e - O l G t a 35 W r G a m e o w v o h g a w E t a u 7 t p d t A i a A A A A E E E E e u K i S S l W a V a W 0 u i r S (20%) e 1 A 3 4 5 6 7 8 9 0 h t l S - A 6 o o 7 9 6 n 1 1 1 1 1 1 1 2 G e 1 T 2 v G o 3 o 0 e - 0 t 3 0 0 0 0 0 0 0 0 0 0 S e - 1 c t o r - 1 - - F 9 V 6 s - 1 2 2 2 2 2 2 2 2 t - p i v a a v D S - 7 N 0 0 r g D c b e - 2 - o o n 0 N t t M u 7 B e 6 E - 1 S O u t c N c N - 1 A 1 6 F J c - Market price (11 Jan. 17) 1 - 0 n O t 1 O n 1 1 - u O c - - a t c l CS estimate of System Marginal Price (11 Jan. 17) J O J c u e J O D CS estimate of System Marginal Price (6 Oct. 16) Source: The BLOOMBERG PROFESSIONAL™ service, Credit Suisse estimates Source: Credit Suisse research, Credit Suisse estimates Figure 6: IRRs discounted by different assets, along Figure 7: Synthetic FY+1 dividend yield less 10Y bond with the CS estimated cost of equity, % yield 9% 5% Cost of debt Market-implied cost of equity 8% instruments 7% 4% 3.5 % 7.5% 7.5% 7.1% % 6% 6.9% 8 6.7% . 5% 7 - 3% 4% % 1 4.4% . 3% 7 2% 2% 1% 2.0% 1% 0% 1.4% d d d o E E E E E l t d n e d d e l t O O O O O i e l d o n t l l e n 0% y i C C C C C d d b o n a e d u y UK utils yield - UK 10Y treasury yield i t e e b r n c s u d n t e t e o y i n t y r o n t s e o r o n c n i i - e n 0 y t s s t c o s u n u r i i i i r G u 0 l 1 p s t i d o i n o i T u f l i (1%) t o t D 1 p r c c e m a S D c v n 5 U s s b e P i m i n r E s t o G UK utils yield - UK 10Y treasury yield i 2 y i d e d e o D D i O 0 d N G D H t v e d e 2 e r t C i e a e Average r K (2%) r G n S N C E U N U S Dec-05 Dec-07 Dec-09 Dec-11 Dec-13 Dec-15 S Source: The BLOOMBERG PROFESSIONAL™ service, Credit Suisse estimates Source: Thomson Reuters, Credit Suisse research UK Utilities2 19 January 2017 Table of contents Key charts 2 Executive summary 4 1. Political risk on bills looks manageable 7 2. Tight power markets and the advent of capacity payments from Oct. 2017 11 3. Returns for new projects low … M&A and on-market buybacks likely 17 4. Valuation: Multiples lower, still not cheap 22 Our recent research 28 DONG Energy A/S (DENERG.CO) 29 United Utilities (UU.L) 31 Centrica (CNA.L) 33 Drax (DRX.L) 35 SSE (SSE.L) 37 Severn Trent (SVT.L) 39 National Grid (NG.L) 41 Pennon Group (PNN.L) 44 UK Utilities3 19 January 2017 Executive summary In this report, we update our commodity price forecasts and roll forward our company valuations by one year to December 2017 (or March 2018) and adjust our target prices. We upgrade UU to Outperform (from Neutral) and Severn Trent to Neutral (from Underperform) on valuation. We show in Figure 8 the changes to our estimates. Note that we include DONG for the first time in a UK Utilities sector review. Although the stock is listed in Danish krone on the Danish exchange, we think it is worth including because c70% of its enterprise value is in the UK and it is a major investor involved in many of the themes.