European Utilities Improving fundamentals amid headwinds

European Utilities started the year 2017 on a muted note. Expectations that the Trump administration would pursue massive fiscal expansion, infrastructure spending and tax rate cuts, along with higher Treasury bond yields weighed on the sector’s performance over 1Q 2017. However, the reflation trade fizzled out over the next few months as T-yields fell from 2.45% in Jan 2017 to 2.3% on 20th October 2017 while the Dollar index fell 8.3% year-to-date and the probability of rate hike in November 2017 is a low 30%. European Utilities started to recover from 2Q 2017. It recorded the second best performance year-to-date (1 Jan – 20 Oct 2017) among European sectors (MSCI European Utilities +9.9%) and outperformed the MSCI Europe index by 2.3%. This has been led by German Utilities players, which benefitted from higher commodity prices, balance sheet de-risking, positive outcome from nuclear tax issues and raising of dividend policies.

Looking ahead, the sector’s performance should be driven by a range of factors in coming months. First, power prices could be supported by higher commodity prices (coal) due to strong Chinese demand and a potential recovery in CO2 prices (implementation of the Market Stability Reserve from January 2019 - a mechanism proposed to correct the imbalance in the carbon emission volumes). Second, ongoing European government’s policies have different implications for the sector. In Germany, the inclusion of Green party (which has carbon floor price on its agenda) in the coalition could have negative implications for RWE. The company could be forced to close 20 of its less environmental friendly plants. On the other hand, ongoing government policies in France are seen as supportive. In Spain, Endesa would be most impacted by uncertainty surrounding Catalonia (50% of the company’s EBITDA is coming from Catalonia), followed by Enagas (22%) and Red Electrica (18%). In the UK, promised new caps on energy bills would affect Centrica the most. Finally, the likelihood of regulatory changes could have an adverse impact on a range of European players. The OFWAT, the UK’s water regulator, issued a price review consultation (for period 2020-25). It also indicated materially lower regulated returns from 2020. Similarly, regulatory returns for Spanish Utilities could drop for 2020-25.This could have a negative impact on Red Electrica, Iberdrola, EDP and Gas Natural’s earnings.

Overall, we are positive on Veolia Environnement (water and waste management). We anticipate the company to benefit from increasing demand as well as low regulatory pressures. Moreover, Veolia Environnement exhibits higher growth potential relative to industry peers (22% YoY EPS growth in FY18). We also like Enel SpA, an integrated Utility with ~75% regulated earnings. Increasing exposure to high growth Latam region and 11% YoY EPS growth in FY18 are among the supportive factors.

Neeraj Mendiratta

Equity Expert

Data & recommendations as of 23 October, 2017 close

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