barcap - uk big 6 utilities - 20111102
TRANSCRIPT
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EQUITY RESEARCH 2 November 20
UK UTILITIES
Time for a price war?
Our analysis in this report argues that two factors could shift the balance of power
between the “Big 6” UK utilities: declining household energy demand, and the shift in
profitability from old fossil fuel generation to cleaner generation. The winners will
have the potential to compete more aggressively in downstream energy supply and
gain market share. The losers could see retail margins squeezed and customer
numbers decline. We believe investors should steer clear of this potential price war,
and focus instead on assets which benefit directly from the changing shape of the
UK utilities industry. Our top picks are Drax (we upgrade to 1-OW) and National Grid.
We downgrade Centrica to 3-UW, and initiate coverage of SSE with a 2-EW rating.
The household energy demand squeeze. Our analysis finds that growing energy
efficiency and pressure on disposable income could drive annual declines in UK
household gas and electricity consumption of 3.7% and 2.4% per annum respectively
to 2015. Centrica appears most exposed to this risk, due to its high gas market share.
The great generation profit transfer. A surge in new gas capacity, an acceleration in
biomass build, offshore wind, potential nuclear life extensions and falling energy
demand are likely to leave owners of older coal and gas capacity struggling to cover
fixed costs, while cleaner generators profit. Drax is now potentially a key beneficiary,
while SSE’s high fossil fuel exposure could act as a drag on earnings.
Time for a price war? We analyse the relative competitive positions of the Big 6. We
find that EdF Energy could see a net increase in relative earnings power of up to£37/customer over the next three years. Centrica could see a relative decrease in
earnings power of up to £18/customer. We believe this divergence in fortunes could be
the trigger for increased price competition. In particular, we believe EdF Energy (and
RWE npower) have both the means and motivation to grab downstream market share.
We see evidence that they are already pricing more aggressively.
Avoid downstream exposure. Centrica is the biggest loser in our analysis. We see risk
of 7% consensus EPS downgrades. We also believe Centrica could experience a P/E de-
rating, leading it to trade at a substantial discount to SOTP. We cut our price target to
£2.60 and downgrade Centrica from 1-OW to 3-UW. On the other hand, Drax’s
potential to convert to biomass confers significant option value. We upgrade from 3-
UW to 1-OW with a £6.75 price target.
We move European Utilities to Neutral. The UK joins the list of regions we see with
weak fundamentals. We take this opportunity to cut our sector stance to 2-Neutral.
Barclays Capital does and seeks to do business with companies covered in its research reports. As aresult, investors should be aware that the firm may have a conflict of interest that could affect theobjectivity of this report.
Investors should consider this report as only a single factor in making their investment decision.
This research report has been prepared in whole or in part by research analysts based outside the USwho are not registered/qualified as research analysts with FINRA.
PLEASE SEE ANALYST(S) CERTIFICATION(S) AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 56.
SECTOR UPDATE
European Utilities
2-NEUTRALfrom 1-Positive
For a full list of our ratings, price target andearnings changes in this report, please seetable on page 2.
European Utilities
Peter Bisztyga
+44 (0)20 3134 4763
Barclays Capital, London
Monica Girardi
+39 02 6372 [email protected]
Barclays Capital, London
Julie Arav
+44 (0)20 7773 1722
Barclays Capital, London
Susanna Invernizzi
+39 02 6372 2681
Barclays Capital, London
Harry Wyburd+44 (0)20 3134 2115
Barclays Capital, London
Wen Du
+44 (0)20 7773 2317
Barclays Capital, London
U.S. Power
Daniel Ford, CFA
1.212.526.0836
BCI, New York
Ross A. Fowler, CFA
1.212.526.3432
BCI, New York
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2 November 2011 2
Summary of our Ratings, Price Targets and Earnings Changes in this Report (all changes are shown in bold)
Company Rating Price Price Target EPS FY1 (E) EPS FY2 (E)
Old New 31-Oct-11 Old New %Chg Old New %Chg Old New %Chg
European Utilities 1-Pos 2-Neu
Centrica (CNA LN / CNA.L) 1-OW 3-UW 2.97 3.70 2.60 -30 0.27 0.26 -4 0.31 0.27 -13Drax Group (DRX LN / DRX.L) 3-UW 1-OW 5.43 3.20 6.75 111 0.47 0.52 11 0.35 0.51 46
SSE (SSE LN / SSE.L) N/A 2-EW 13.44 N/A 12.35 - N/A 1.12 - N/A 1.23 -
Source: Barclays Capital Share prices and target prices are shown in the primary listing currency and EPS estimates are shown in the reporting currency.
FY1(E): Current fiscal year estimates by Barclays Capital. FY2(E): Next fiscal year estimates by Barclays Capital.
Stock Rating: 1-OW: 1-Overweight 2-EW: 2-Equal Weight 3-UW: 3-Underweight RS: RS-Rating SuspendedSector View: 1-Pos: 1-Positive 2-Neu: 2-Neutral 3-Neg: 3-Negative
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CONTENTS
EUROPEAN UTILITIES COMPARABLE ANALYSIS.......................................................................... 4 THE SHIFTING BALANCE OF POWER.............................................................................................. 5 THE HOUSEHOLD ENERGY DEMAND SQUEEZE ........................................................................... 9 THE GREAT GENERATION PROFIT TRANSFER............................................................................ 12 TIME FOR A PRICE WAR?................................................................................................................ 18 COMPANY SECTION ........................................................................................................................ 23 Centrica – not so safe after all............................................................................................................... 25 Drax – from dark to bark ........................................................................................................................ 35
SSE – still struggling for momentum ................................................................................................... 43 National Grid – proactive asset management started ..................................................................... 53
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2 November 2011 5
THE SHIFTING BALANCE OF POWER
Our analysis in this report argues that two factors could shift the balance of power
between the “Big 6” UK utilities over the next two to three years: the twin challenges of
declining household energy demand and the shift in profitability from old fossil fuel
generation to cleaner generation. There will be winners and losers. The winners willhave the potential to compete more aggressively in downstream energy supply and gain
market share. Specifically, we identify EdF Energy and RWE npower as having the
capacity and motivation to compete more aggressively, to the detriment of Centrica, SSE
and E.On Energy. We believe investors should steer clear of this battle, and focus
instead on assets which benefit directly from the changing shape of the UK utilities
industry: such as Drax’s biomass conversion project, and National Grid’s UK electricity
transmission division.
The changing shape of the UK utilities sector
UK energy bills have made headline-grabbing news, with politicians and the public
bemoaning the lack of competition. We believe this could be about to change, driven by a
shift in the balance of power between the Big 6 UK utilities:
The household energy demand squeeze. If improvements in household energy
efficiency continue, we would expect household gas and electricity consumption to
decline by around 2.1% and 0.7% per annum respectively. However, we estimate these
declines could accelerate to 3.7% and 2.4% per annum respectively if household real
incomes remain under pressure. We expect Centrica to be more negatively impacted
than its competitors given its high volume share of the residential gas market. We
estimate it could see a demand decline that amounts to a loss of EBIT margin of
£17/customer over 2012-15E – nearly half of its 2011E margin of £38/customer.
The great generation profit transfer. Our analysis shows that a surge in new Combined
Cycle Gas Turbine (CCGT) capacity, an acceleration in biomass build, potential nuclear
life extensions and falling energy demand will leave owners of older coal and gas
capacity struggling to cover fixed costs. The winners are likely to be those with most
Time for a price war?
Figure 1: Energy consumption per household (kWh) Figure 2: UK power generation capacity (GW)
10,000
12,000
14,000
16,000
18,000
20,000
2 0 0 0
2 0 0 2
2 0 0 4
2 0 0 6
2 0 0 8
2 0 1 0
2 0 1 2 E
2 0 1 4 E
2,500
3,000
3,500
4,000
4,500
5,000
Gas Electricity
0
20
40
60
80
100
2009 2011E 2013E 2015E 2017E
Biomass
Wind
Hydro
Oil
OCGT
CHP
CCGT
Hard Coal
Nuclear
Source: Barclays Capital, ONS. Source: Barclays Capital, National Grid.
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2 November 2011 6
exposure to cleaner generation, or those involved in connecting these assets to the
transmission grid. In our view, Drax and National Grid benefit the most directly.
However, SSE’s significant old fossil fuel exposure is likely to act as a drag on earnings,
despite its renewables and transmission exposure.
Time for a price war? We estimate EdF Energy could see a net increase in generation
and supply earnings power of £31-37/customer over the next three years, driven by itshigh upstream nuclear exposure and low downstream gas exposure. RWE npower and
ScottishPower also have better than average profit momentum in generation. On the
other hand, we believe Centrica could see a decrease of £10-18/customer in its net
generation and supply earnings power as a result of the declining household energy
demand and weaker profits for its CCGT fleet. For SSE and E.On Energy the net negative
impact could be as high £10/customer and £16/customer respectively. This divergence
in fortunes could be the trigger for increased price competition. In particular, we believe
EdF Energy and RWE npower have the motivation to grab downstream market share to
rebalance their “long” generation exposure. Indeed, we see evidence that they are
already pricing more aggressively. We believe investors should steer clear of this battle,
as it is likely to mean lower margins for the whole downstream industry.
Figure 3: Net shift in generation and supply EBITDA (£ per residential single fuel
customer, 2012-15E)
(10 )
37
(8 )
510
(7 )
0
(18 )
31
(16 )
(2 )
3
(14 )(7 )
(30 )
(20 )
(10 )
0
10
20
30
40
50
C N A
E D F
E . O N
R WE
I B E
S S E
" B i g 6 "
A v e r a g e
Slow Demand Decline Scenario Fast Demand Decline Scenario
EdF’s exposure to clean
generation leaves it positioned to
compete more aggressively in
the downstream retail market
Source: Barclays Capital.
We see two principal risks to our UK utilities industry views:
Utilities fail to compete more aggressively. Our cautious stance on the UK downstream
retail energy market may prove to be unfounded should the Big 6 utilities fail to compete
more aggressively on price, despite the potential for a clear shift in the balance of power.
However, if this were to be the case, we would expect regulatory or politicalintervention, in the form of a Competition Commission investigation.
Politicians withdraw from green energy policies. Concerns about the impact that the
transition to cleaner generation will have on household energy bills have raised
questions about the UK Government’s commitment to its renewables and carbon
reduction goals. This raises this risk that this, or a future, government reneges on
policies such as the Renewables Obligation and the carbon price floor. Indeed, there are
already apparent divisions within the Coalition, with the Chancellor, George Osborne,
seeming to distance himself from the UK’s ambitious renewables and carbon reduction
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2 November 2011 7
targets1, and the Prime Minister’s new energy adviser questioning the Department of
Energy and Climate Change’s (DECC) calculations about the impact of renewables policy
on energy bills2. That said, recent comments by the Committee on Climate Change,
which sets the legally binding targets for business, said that it would be “very difficult”
to change the targets3. In any case, green energy policy is a central tenet of the UK
Government’s coalition agreement, and we see little probability of these targets being
abandoned on a 2-3 year view. Instead, we believe the key risk is that politicians force
the downstream energy suppliers to share some of the burden, for example through
windfall taxation.
Stock recommendations
Centrica (3-UW, £2.60 PT) – not so safe after all. Over the past few months we have
argued that Centrica is a relative safe haven. Its defensive characteristics have been
borne out in 14% outperformance relative to the Stoxx 600 since May. Whilst its
financial position remains robust, the economic and retail market environment is
evolving rapidly. In particular, with declines in energy demand accelerating, we now
think both sides of Centrica’s upstream hedge could come under pressure. We believeits competitive advantage in the UK retail market will fade, and that persistently weak
spark spreads will lead to disappointing power generation profits in 2012/13E. We also
see increasing downside risks for BGS, BGB and Direct Energy given the deteriorating
economic environment. We cut our 2012-14E EPS forecasts to 7% below IBES
consensus on average. In the current market environment, we doubt Centrica can trade
at our revised SOTP valuation of £3.29. Given the deteriorating fundamentals, we
believe Centrica’s shares could instead derate towards their historical P/E discount to
the Stoxx Utilities index of -0.5, implying 12% share price downside. We downgrade
Centrica from 1-OW to 3-UW with a new £2.60 price target.
Drax (1-OW, £6.75 PT) – from dark to bark. Drax is a key beneficiary of the current UK
Government’s support for cleaner generation. Following the proposed increase inRenewable Obligation Certificate (ROC) support, we now believe it is highly likely that
Drax will proceed with plans to convert to 50% biomass co-firing. We believe this
completely transforms the equity story of Drax, securing its position in the UK power
market for the long term. A combination of the carbon tax and Renewables Obligation
(RO) support should underpin progressively rising earnings. Over the medium term, our
analysis suggests that Drax has the potential to return significant amounts of cash to
investors. Numerous uncertainties remain, which means Drax remains a risky stock, in
our view. Nonetheless we consider the upside potential to be considerable, particularly if
Drax opts to convert the plant to 100% biomass in the future. We upgrade from 3-UW
to 1-OW and set a new price target of £6.75.
1 “We’re not going to save the planet by putting our country out of business … so let's at the very least resolve that we’re going to cut our carbon emissions no slower but also no faster than our fellow countries in Europe. That’s what I've insisted on in the recent carbon budget” , George Osborne’s speech at the Conservative Party conference, 3October 2011.
2 “Over time it is clear that the impact of our policies on consumer bills will become significantly greater … four policies
stand out as having the most significant impact on household energy bills: carbon pricing (both out own carbon pricefloor and the EU emissions trading scheme), the new Energy Company Obligation, our Electricity Market Reform
package and the Renewables Obligation” , Letter to David Cameron from advisers Ben Moxham and Gila Sacks on theimpact of energy and climate policies on consumer energy bills, The Telegraph, 5 September 2011.
3 “Energy giants told carbon targets are here to stay” , The Times, 1 November 2011.
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2 November 2011 8
SSE (2-EW, £12.35 PT) – still struggling for momentum. We see deteriorating
fundamentals in SSE’s generation and supply business. Its large ageing coal and gas
fleet is likely to struggle to cover its fixed costs once free CO2 permits expire, and it has
less earnings momentum in its UK cleaner generation fleet than some of its competitors.
As a result, we believe SSE will be at a competitive disadvantage in the UK retail market,
which could see its market share and margins come under pressure. However, risk to
EPS is mitigated by SSE’s exposure to UK regulated networks, specifically electricity
transmission. We see just 2% downside to consensus estimates. And whilst we expect a
P/E de-rating, the downside is partially offset by a 5.9% yield and potential for 6-7%
dividend growth. We consider the risks to SSE’s shares, therefore, to be moderate when
compared to the risks we see across other integrated utility names. We initiate coverage
with a 2-EW recommendation and a £12.35 price target.
National Grid (1-OW, £6.80 PT) – proactive asset management started. For exposure
to UK electricity transmission, our preferred play remains National Grid. The RIIO
regulatory review (Revenue = Incentives + Innovation + Outputs), which will define new
tariffs from April 2013, enters into its central phase in the second half of next year.
Preparing for that, the company has already started to follow a strategy of asset
rationalisation, which will result, in our view, in a cleaner structure and more focused
business lines. In the medium term, we see two main drivers of performance for the
stock: 1) the implementation of a regulatory framework which should stimulate rapid
RAV growth; 2) a financing strategy with ongoing asset rationalisation aimed at
achieving the highest possible blended return on the company’s invested capital.
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2 November 2011 9
THE HOUSEHOLD ENERGY DEMAND SQUEEZE
The first of the twin challenges facing the Big 6 UK utilities is that of falling residential
energy demand. If improvements in household energy efficiency continue in line with the
trend over the past five years, and household real incomes start to recover, we would
expect household gas and electricity consumption to continue to decline by around 2.1%and 0.7% per annum respectively. However, if there was little or no growth in real
incomes, we would expect the declines to be 3.7% and 2.4% per annum respectively.
Drivers of falling energy demand
Domestic gas and electricity consumption had been rising steadily by 1.7% p.a. for decades
up until around 2004/05 (Figure 4), driven by rising disposable incomes and increasing
penetration of gas for domestic central heating. However, the past few years have seen
household demand for both electricity and gas decline in absolute terms. For reference,
households account for about 35% of total UK electricity consumption and 60% of UK non-
power generation gas consumption.
In our view, this trend of declining household energy consumption has the potential to
accelerate, driven by two factors:
Rising energy efficiency. Domestic energy intensity4 has been declining for many years
(Figure 5). However, the trend accelerated for gas after 2004, coinciding with the
second phase of the Energy Efficiency Commitment (EEC). This increased theobligations on energy suppliers to achieve improvements in household energy efficiency
via measures relating to insulation, lighting, appliances and heating. Since then the UK
Government has introduced a number of follow-up measures, including the Carbon
Emissions Reduction Target (CERT), Community Energy Saving Programme (CESP) and,
from late 2012, the Energy Company Obligation (ECO) and Green Deal. The latter aims
to create a new financing framework with savings recovered through energy bills,
avoiding the need for consumers to pay upfront costs. In aggregate, the supplier
4 Domestic energy intensity is defined as energy consumption per unit of household disposable income.
Energy efficiency and falling real
incomes put pressure on
demand
Figure 4: Trends in domestic energy consumption (TWh) Figure 5: Domestic energy intensity index* (1987 = 100)
50
100
150
200
250
300
350
400
450
1 9 7 0
1 9 7 4
1 9 7 8
1 9 8 2
1 9 8 6
1 9 9 0
1 9 9 4
1 9 9 8
2 0 0 2
2 0 0 6
2 0 1 0
50
60
70
80
90
100
110
120
130
Gas (Left Axis) Electrici ty (Right Axis)
30
40
50
60
70
80
90
100
110
1 9 8 7
1 9 8 9
1 9 9 1
1 9 9 3
1 9 9 5
1 9 9 7
1 9 9 9
2 0 0 1
2 0 0 3
2 0 0 5
2 0 0 7
2 0 0 9
2 0 1 1 E
2 0 1 3 E
2 0 1 5 E
Gas Electricity
Source: Barclays Capital, DECC Statistics. Source: Barclays Capital.
* Domestic energy intensity is measured as annual energy consumption per
household, per unit of real disposable income.
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2 November 2011 10
obligations – alongside other measures such as building regulations, the roll-out of
smart meters and products standards – are expected by DECC (The Department of
Energy and Climate Change) to deliver 67TWh of annual energy savings by 2016. This
equates to around 13% of current household annual energy consumption of c500TWh.
Figure 6: Expected UK household energy savings
2010E 2016E
TWh MtCO2e TWh MtCO2e
Supplier Obligations 26.7 7.6 61.4 14.8
Building Regulations 22.4 4.3 40.9 7.8
Product Standards 1.4 0.7 8.5 3.8
Smart Meters/In Home Displays - - 5.3 1.4
Renewable Heat Incentive - - 1.3 1.2
Warm Front 8.0 2.4 8.4 2.6
Total 58.5 14.9 125.9 31.7
Source: UK Report on Articles 4 and 14 of the EU End-use Efficiency and Energy Services Directive (ESD) , DECC, July 2011.
Pressure on household disposable income. Although increased efficiency has caused
household energy consumption to decline in recent years, the rate of decline has been
partially mitigated by continued growth in real disposable incomes. However, this may
not be the case going forward. UK households are currently facing a decline in real
disposable income for the first time in 30 years. This has coincided with a 22% increase
in household energy bills over the last 12 months. As a result, we estimate that the
average duel fuel bill now amounts to 7.9% of per capita gross disposable household
income, compared to 6.7% a year ago, and 4.6% in 2004.
The result is that households are cutting back on energy usage: in 1H11, SSE reported
that underlying electricity consumption had fallen by 2.9% y/y, and that underlying gas
consumption had fallen by 5.8%.
Our economists currently expect real household disposable income to decline by 1.7%
in 2011, and then to recover by 1.7% per annum on average to 2015. Not only is this
below the average annual growth of 2.1% over 1999-2009, our economists
acknowledge that there are downside risks to their forecasts from persistently high
inflation and rising unemployment.
If improvements in household energy efficiency continue in line with the trend over the past
five years, and our economists are correct about real income growth, we would expect
household gas and electricity consumption to continue to decline by around 2.1% and 0.7%
per annum respectively. However, if there was little or no growth in real income, we would
expect the declines to be 3.7% and 2.4% per annum respectively (Figure 8).
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Figure 7: Real household disposable income (£bn) Figure 8: Energy consumption per household (kWh)
6.4%5.7%
7.7%7.2%
6.7%
7.9%
4.9%
4.6%
800
840
880
920
960
1,000
2 0 0 4
2 0 0 5
2 0 0 6
2 0 0 7
2 0 0 8
2 0 0 9
2 0 1 0
2 0 1 1 E
2 0 1 2 E
2 0 1 3 E
2 0 1 4 E
2 0 1 5 E
3%
4%
5%
6%
7%
8%
9%
10%
Real Household Disposable Income (£bn, Left Axis)Dual Fuel Bill as % Gross Household Income (Right Axis)
10,000
12,000
14,000
16,000
18,000
20,000
2 0 0 0
2 0 0 2
2 0 0 4
2 0 0 6
2 0 0 8
2 0 1 0
2 0 1 2 E
2 0 1 4 E
2,500
3,000
3,500
4,000
4,500
5,000
Gas Electricity
Source: Barclays Capital, ONS. Source: Barclays Capital, ONS.
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2 November 2011 12
THE GREAT GENERATION PROFIT TRANSFER
The second of the twin challenges facing the Big 6 UK utilities is the expected shift in
profitability from old fossil fuel generation to clean generation. Our analysis shows that
a surge in new CCGT capacity, an acceleration in biomass build, potential nuclear life
extensions and falling energy demand will leave owners of older coal and gas capacitystruggling to cover fixed costs. The winners are likely to be those with most exposure to
new CCGT, nuclear generation, wind and biomass.
The transforming power generation market
We believe that the UK power market will become increasingly tough for owners of existing,
ageing coal and CCGT generation, driven by a number of different factors:
9GW of highly efficient new CCGTs. One of the key factors driving down spark spreads
on existing CCGTs in the UK has been new build of highly efficient plant. State-of-the-art
new gas plant, such as RWE’s 2.2GW Pembroke CCGT, due to commission during 2012,
have thermal efficiencies of 59% (gross calorific value). This compares to a UK average
of around 52.4% (2010A), while some of the oldest CCGTs opened in the 1990s have
efficiencies below 48%. The higher efficiency of new CCGTs means marginal costs are
some 20% lower than those of the least efficient plant. As a result, these new plants will
sit low down the merit order, displacing less efficient capacity (see Figure 9) and
lowering the cost curve for the whole market. Around 5.6GW of new CCGT capacity
became operational over 2010/11, and we expect a further 3.3GW to commission
during 2012 (see Figure 10). In addition to this, we believe there are around 3GW of
planned new CCGTs that are likely to go ahead and be operational by 2015/16.
Majority of LCPD plant likely to run until 2014/15. During winter 2010/11 much of the
UK’s opted-out5 coal plant was running so hard that it looked then like it would run out
of operating hours during 2012. However, in spite of a substantial increase in clean dark
spreads since the Japanese earthquake in March 2011, load factors of opted-out coal
plant in the UK during summer have been lower than during 2010. As a result, we only
5 This refers to power stations that have opted out of the LCPD and therefore are limited to 20,000 running hoursbetween 2008-15, and have to close thereafter.
The shape of the UK power
market is changing
Figure 9: New CCGT in the UK merit order, 2011E (GW) Figure 10: Cumulative new CCGT capacity (GW)
0
20
40
60
80
100
120
140
0 20 40 60
Capacity (MW)
Oil
GT
CCGT
CHPNuclear
Hydro
Coal
New CCGT
SRMC (£/MWh)
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
2010 2011 2012E 2013E 2014E 2015E 2016E
Operational Under Construction Potential New Build
Source: Barclays Capital. SRMC = Short-Run Marginal Cost Source: Barclays Capital.
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expect one plant to close by the end of 2012. Furthermore, RWE has already converted
its Tilbury plant into a 750MW dedicated biomass facility that is expected to operate
until the end of 2015. Indeed, as shown in Figure 12, if all the opted-out plants average
their last 12-month load factor going forwards, only two other plants will close before
2015.
Nuclear life extensions. After 2015, when the opted-out coal plant has shut, we believe
some of the pressure on the UK reserve margin could be relieved by life extensions at
British Energy’s nuclear fleet. This would mitigate upside for spark spreads. Currently,
Hinkley Point B (870MW) and Hunterston B (890MW) are due to close in 2016.
However, we believe that the UK carbon price floor significantly improves the economics
of life extensions. As for new nuclear, we believe that the probability of a new plant
becoming operational before 2020 is slim.
Growth in wind capacity. Our European Clean Technology & Sustainability team
forecast that 11GW of onshore and offshore wind will be added in the UK over the
course of 2011-2015E6. This could displace 3.5GW of CCGT capacity on average during
the year.
In our view, these wind capacity forecasts are relatively conservative: they are derived
from current renewables developers’ pipelines and sit between the low and base case
set out by DECC in its UK Renewable Energy Roadmap in July 2011. The proposed
Renewables Obligation Certificate bandings of 0.9 for onshore wind and 1.8-1.9 for
offshore wind appear be sufficient to ensure these pipelines are delivered 7 . Mott
MacDonald estimate that the levelised cost for onshore wind is around £86/MWh, while
the current 2013 forward power price plus 0.9x ROC buyout price equates to £99/MWh.For offshore wind our forecast 2015 power price plus 1.8-1.9x ROC buyout price
equates to £150-155/MWh versus an estimated levelised cost of £112-146/MWh8. See
Figure 23 for more details.
6 See: Global demand outlook - five-year CAGR wind 10%, solar 8%, Barclays Capital, 15 August 2011.7 Consultation on proposals for the levels of banded support under the Renewables Obligation for the period 2013-17 and the Renewables Obligation Order 2012, DECC, 20 October 2011.8 UK Electricity Generation Costs Update, Mott MacDonald, June 2010.
Figure 11: UK opted-out plant load factor (%) Figure 12: UK opted-out plant estimated closure dates
0%
20%
40%
60%
80%
100%
Aug-09 Feb-10 Aug-10 Feb-11 Aug-11
Average Coal Average Oil
Dec-11 Dec-12 Dec-13 Dec-14 Dec-15
Grain
Ironbridge
Kingsnorth
Didcot AFawley
Littlebrook
Tilbury 1*Tilbury 2*
Ferrybridge C
Cockenzie 1
Cockenzie 2
at Ave. Last 12mth Load at Ave. Last 24mth Load
Source: Barclays Capital, BM Reports. Source: Barclays Capital, BM Reports.
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Growth in biomass capacity. Our analysis of current project pipelines suggests thatthere is potential for some 2.6GW of additional dedicated and biomass co-firing capacity
to be added in the UK by 2016, in addition to RWE’s Tilbury plant. The biggest project
within our forecast is Drax’s plan to convert to 50% co-firing capacity by 2015, up from
12.5% currently – equivalent to 1.5GW of additional capacity. The proposed increase in
the ROC banding from 0.5x to 1.0x from 1 April 2013 is likely to be enough, in our view,
for Drax to go ahead with this project. Based on current forward wood pellet prices, we
estimate biomass will be running ahead of all conventional coal and CCGT plant in the
UK merit order (Figure 14).
Falling electricity demand. We have already discussed the potential for residential energy
demand to fall in the UK due to a combination of rising energy efficiency and falling
disposable income. In addition, industrial and commercial electricity demand may come
under pressure if UK economic growth stalls. Figure 15 shows National Grid’s base and low
case forecasts for total UK electricity demand. The low case – which averages at a -1.1%
annual decline in demand – assumes annual growth of 1.4% for GDP, -0.4% for household
disposable income, 1.0% for manufacturing output and 1.4% for non-manufacturing output.
Figure 13: Forecast UK wind and biomass capacity (GW) Figure 14: Biomass in the UK merit order, 2015E (GW)
0.0
5.0
10.0
15.0
20.0
25.0
2010 2011 2012E 2013E 2014E 2015E 2016E
Onshore Wind Offshore Wind
Dedicated Biomass Co-Firing
0
20
40
60
80
100
120
140
0 20 40 60
Capacity (MW)
Oil
GTCCGTCHPNuclearHydroCoalBiomassCo-Firing
SRMC (£/MWh)
Dedicated biomass
DraxOther co-firing
Source: Barclays Capital, DECC RESTATS. Source: Barclays Capital. SRMC = Short-Run Marginal Cost
Figure 15: Forecast total UK annual power demand (TWh) Figure 16: Forecast UK capacity margin (%)
270
280
290
300
310
320
330
2010/11E 2012/13E 2014/15E 2016/17E
Base Low
0%
10%
20%
30%
40%
50%
2009 2011E 2013E 2015E 2017E 2019E
Derated Margin No-Wind Margin
Headline Margin
Source: Seven Year Statement 2010, National Grid. Source: Barclays Capital.
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Implications for power prices and spreads
Our analysis of future supply and demand leads us to several conclusions about the outlook
for the UK power generation market:
Spark spreads to stay low until 2014. Clean spark spreads in the UK have been steadily
declining since the start of 2010. The winter 2012/13 spread is currently trading at just
£1.0/MWh (Figure 17). Unfortunately for gas-fired power generators, we would not expect
these to recover before 2014, based on current relative gas and coal prices (Figure 19).
Clean dark spreads to get squeezed from 2013 onwards. Despite growing pressure on
household energy bills, there is no evidence to suggest that the UK Government is
considering abandoning the UK carbon price floor, introduced in the 2011 Budget. We
believe the carbon floor price will have the desired effect of squeezing clean darkspreads (Figure 19) and gradually pushing coal plant to the margin.
Figure 19: UK power price, clean spark spread (CSS) and clean dark spread (CDS) forecasts (£/MWh, net of carbon price floor)
2011E 2012E 2013E 2014E 2015E 2016E
Baseload Power – BarCap Forecast 51.5 52.4 54.6 61.1 64.7 67.8
Baseload Power – Forward Curve* 51.4 53.7 54.7 - - -
Baseload CDS - 36% Efficiency 10.5 14.3 11.5 10.9 9.8 8.9
Baseload CDS - 40% Efficiency (Drax) 14.6 18.1 15.8 15.9 15.3 14.8
Baseload CSS - 49% Efficiency 5.1 2.0 1.5 4.0 4.5 4.7
Baseload CSS - 59% Efficiency 12.9 10.5 10.4 13.5 14.6 15.3
Source: Barclays Capital, Bloomberg. * Forward curve as at 21 October 2011.
Figure 17: UK seasonal forward clean spark spreads (£/MWh) Figure 18: UK seasonal forward clean dark spreads (£/MWh)
0
5
10
15
20
25
Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11
1st Winter 1st Summer2nd Winter 2nd Summer
0
5
10
15
20
25
Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11
1st Winter 1st Summer2nd Winter 2nd Summer
Source: Barclays Capital, Bloomberg. Source: Barclays Capital, Bloomberg.
Old fossil fuel plant will struggle
to cover fixed costs
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Figure 20: Commodity price assumptions*
2011E 2012E 2013E 2014E 2015E 2016E
Hard Coal - API2 (US$/t) 121.7 116.8 120.4 124.2 127.9 131.8
Oil - Brent Crude (US$/bbl) 111.1 105.1 100.3 100.3 103.3 106.4
Gas - NBP (p/th) 59.9 66.8 68.1 70.2 72.3 74.4
CO2 - EUA (€/t) 13.4 10.9 11.6 12.3 12.6 13.0
CO2 - with price f loor (€/t) 13.4 10.9 15.8 23.3 27.9 31.7
Biomass - Wood Pellet (€/t) 133.9 134.4 138.5 142.6 146.9 151.3
EUR/GBP 1.15 0.87 0.87 0.87 0.87 0.87
GBP/USD 1.61 1.61 1.61 1.61 1.61 1.61
Source: Barclays Capital, Bloomberg. *Commodity prices marked-to-market as at 21 October 2011.
Fossil fuel load factors to decline. As shown in Figure 21, we expect load factors for
older, unhedged CCGT plant to collapse to below 10% over 2012-15E. We only expect
these to pick up as coal plant gets pushed to the margin, by around 2016.
Figure 21: Forecast load factors for UK fossil fuel generation capacity
2012E 2013E 2014E 2015E 2016E 2017E 2018E
Hard Coal - 36% Efficiency 72% 71% 52% 45% 27% 12% 9%
CCGT - 49% Efficiency 10% 7% 8% 5% 18% 26% 23%
Hard Coal - 40% Efficiency (Drax) 80% 80% 80% 80% 80% 65% 59%
CCGT - 58-59% Efficiency 43% 37% 77% 76% 74% 74% 71%
Source: Barclays Capital.
Old fossil fuel plant will not be covering fixed costs. The last free CO2 allocations will
be given to UK fossil fuel generators around February 2012. Once these have been used
up, we believe owners of older capacity will struggle to cover fixed costs. Specifically, we
believe CCGT plant will be unable to cover its fixed costs over the period from 2013-15E,
while old coal plant will become permanently out-of-the money from 2013 onwards.
Indeed, we believe the period from 2013-15E has the potential to be punishing for
generators with significant exposure to old coal and CCGT plant.
Figure 22: Annual EBITDA of 1GW power station, excluding free CO2 (£m)
2010 2011E 2012E 2013E 2014E 2015E 2016E
Hard Coal - 36% Efficiency (24.3 ) (11.0 ) 12.2 (6.7 ) (9.2 ) (17.2 ) (24.4 )
CCGT - 49% Efficiency 14.8 (6.4 ) (9.3 ) (10.3 ) (6.4 ) (8.4 ) 2.2
Source: Barclays Capital.
Transfer of value to cleaner generation. New CCGT, nuclear generation, offshore wind and
biomass (including Drax’s co-firing plans) should all stand to benefit from rising revenues,
driven by a combination of the carbon price floor and the proposed Renewables Obligation
Certificate (ROC) bandings for 2013-2017, as shown in Figure 23. Our modelling shows that
the pass-through of the carbon tax into wholesale power prices should step up in 2017E as
conventional hard coal plant moves to the margin in the UK, substantially improving the
economics of clean generators. Separately, we expect ROC prices to decline due to
accelerating growth in renewable capacity, though the RPI-indexed buyout price should
provide a floor (we think this floor will be reached in 2014/15).
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Figure 23: UK clean generation economics*
2011E 2012E 2013E 2014E 2015E 2016E
ROC Price (£) 47.6 46.4 46.6 44.4 44.6 46.0
ROC Buyout Price (£) 38.3 40.2 42.0 43.3 44.6 46.0
Gross Margin - Nuclear (£/MWh) 41.1 41.7 43.7 50.0 53.4 56.3
Gross Margin - Onshore Wind at 0.9x ROC (£/MWh) 96.2 96.3 98.8 103.5 107.5 111.9
Gross Margin - Offshore Wind at 1.8x ROC (£/MWh) 140.8 140.3 143.0 146.0 150.3 156.0
Gross Margin - Offshore Wind at 1.9x ROC (£/MWh) 145.8 145.2 147.9 150.7 155.1 160.9
Gross Margin - Biomass Co-Firing at 1.0x ROC - Drax (£/MWh) 35.4 35.1 35.6 38.2 40.1 42.5
Source: Barclays Capital.* Gross margins calculated using ROC plus LEC at a 5% discount and excluding own fuel use and non-fuel variable costs.
The prospect of capacity closures
Our power price forecasts assume that 12GW of old coal and oil plant will shut by the end of
2015 under LCPD, and that a further 8.4GW of CCGT capacity reaches the end of its useful
life by 2020. In spite of this, we do not expect the UK reserve margin to becomeuncomfortably tight until the end of the decade (Figure 16). The question is whether more
coal and CCGT capacity could be closed from 2012 onwards, since it is not covering fixed
costs, and whether this would have a material impact on power prices and spreads. We
conclude that material closures are unlikely, and that spreads will remain under pressure:
CCGT closure unlikely to have impact on spreads. Some early CCGT closures are highly
likely, in our view. Indeed, Centrica has been reported to be planning closing 570MW of
CCGT capacity in 2012 (Barry and Kings Lynn) 9. However, since we expect the oldest
8.4GW CCGT plant to be operating at sub-10% load factors and to be at the margin only
c3% of the time, its closure should have little impact on the overall power price level.
Value of flexibility. In a market with growing wind capacity, portfolio generators and
those with residential demand to fill may attribute additional option value to flexible
plant that justifies keeping it available. Alternatively, National Grid may directly contract
certain plant (for example, as it has done with three of Centrica’s CCGTs) to remain on
the system.
Biomass conversion. The prospect of an increased banding for enhanced biomass co-
firing, combined with the carbon price floor, make the economics of converting certain
hard coal plant more attractive. As discussed earlier, partial or full conversion of UK coal
plant would have the effect of displacing older gas or unconverted coal plant in the
merit order, putting further pressure on spreads.
9 “Centrica job and plant cuts could spark price increases” , The Times, 17 October 2011.
We do not expect capacity
closures to drive material upside
to spreads
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2 November 2011 18
TIME FOR A PRICE WAR?
We believe the twin challenges of declining household energy demand and the shift in
profitability from old fossil fuel generation to clean generation could shift the balance
of power between the Big 6 utilities over the next few years. The winners will have the
potential to compete more aggressively in downstream energy supply and gain marketshare. The losers could see retail margins squeezed and customer numbers decline.
Specifically, we identify EdF Energy, RWE npower, as having the capacity and motivation
to compete more aggressively, to the detriment of Centrica, SSE and E.On Energy.
The household energy demand squeeze – winners and losers
As we concluded earlier, if improvements in household energy efficiency continue in line
with the trend over the past five years, and our economists are correct about real income
growth, we would expect household gas and electricity consumption to continue to decline
by around 2.1% and 0.7% per annum respectively – this is our slow demand decline
scenario. However, if there is little or no growth in real income, we would expect the
declines to be 3.7% and 2.4% per annum respectively – our fast demand decline scenario.
Figure 24 shows the impact the loss of volume would have on £/customer margin over 2012-
15E for each of the Big 6 UK utilities. On average, it amounts to £14 per single fuel customer
account – a negative profit delta of £0.7bn for the industry. Two companies stand out:
British Gas. We expect Centrica’s British Gas division to be more negatively impacted
than its competitors given its high volume share of the residential gas market. Indeed,
under our fast demand decline scenario, we estimate British Gas could see a demand
decline that amounts to a loss of EBIT margin of £17/customer over 2012-15E – nearly
half of its 2011E margin of £38/customer.
EdF Energy. EdF Energy, on the other hand, has the highest proportion of electricity
demand relative to gas demand. This means that in our more bearish scenario it needsto recover £11/customer of margin. Indeed, it is possible that since EdF’s customer base
has a large component of Londoners, it may see less of an impact on demand from
falling disposable incomes.
We would expect the industry as a whole to try and compensate for the loss of demand
through higher retail prices. However, there are two points to consider:
EdF Energy could attempt to gain competitive advantage. EdF Energy is in a position
whereby it can raise dual fuel tariffs by £12/customer less than British Gas in order to
keep profits stable. This is equivalent to £90-100m of EBIT for British Gas. However,
since £12 is only around 1% on the UK’s average dual fuel bill, we suspect British Gas
would rather price higher than lose margin.
Political pressure. We estimate that the industry will need to raise household dual fuel
bills by £28/customer (i.e. double the figure shown in Figure 24) in order to compensate
for lost volumes. Whilst this may not sound like much, for the 5.5m fuel poor
households in the UK this is significant10. This alone may dismay politicians, as will the
fact that households are not seeing the full benefit of energy efficiency in their bil ls.
10 5.5m is the official statistic for 2009, the last available verified data from ONS. In reality, the number of fuel poor inthe UK in Britain in 2012-15E is likely to be significantly higher than this.
Centrica’s exposure to declining
household gas demand is a
competitive disadvantage
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Figure 24: Shift in retail EBITDA margin from declining energy demand (£ per residentialsingle fuel customer, 2012-15E)
(9 )(5 ) (6 ) (7 ) (6 ) (7 ) (7 )
(17 )
(11 )(13 ) (14 ) (13 ) (13 ) (14 )
(25 )
(20 )
(15 )
(10 )
(5 )
0
C N A
E D F
E . O N
R WE
I B E
S S E
" B i g 6 "
A v e r a g e
Slow Demand Decline Scenario Fast Demand Decline Scenario
Source: Barclays Capital.
The great generation profit transfer – winners and losers
The UK Government’s green energy policies are designed to promote clean generation at
the expense of older fossil fuel plant. Whilst there is considerable debate about the long-
term viability of these energy policies, given the costs that they ultimately place on the UK
consumer, we do not see the Government reneging on these policies on a 2-3 year view.
We have summarised the impact of this profit transfer for each of the Big 6 in Figure 25 on a
£/customer basis. Our observations are as follows:
The end of free CO2 allocations. We estimate that the Big 6 will see a step-down in
profits in 2013 equivalent to around £20/cust on average, as free CO2 allocations come
to an end. The exception is Centrica, which does not have any coal generation, whichwe expect to take a hit of just £4/cust.
Three potential winners: EdF Energy, RWE npower and ScottishPower (Iberdrola). We
estimate the contribution from EdF’s 80% stake in British Energy and its new 1.3GW
West Burton CCGT should drive a net profit gain of £43/cust over 2012-15E. Despite its
significant exposure to coal generation, RWE should see a gain of £12/cust from the
conversion of Tilbury to biomass, its offshore wind projects and 3.8GW of state-of-the
art new CCGT capacity. Iberdrola’s onshore and offshore wind pipeline is relatively large
compared to its small customer base, and should drive a net gain of £16/cust.
Three potential losers: Centrica Energy, SSE and E.On Energy. Although we expect
Centrica Energy to see its old CCGT profits squeezed over 2012-13E, it does not carry
the burden of old coal plant or material free CO2 allocations. However, it does not have
a significant portfolio of clean generation relative to the size of its 16m customer base.
As a result, we expect the aggregate profitability of its upstream activities (including gas
production) to be relatively flat between 2012-15E. We believe SSE may only see a net
increase in generation profits equivalent to £4/cust between 2012-15E. We believe its
large exposure to renewables will be offset by substantial exposure to old coal and gas
plant and the largest burden from free CO2 permit expiry. Finally, E.On Energy could
face the toughest few years as it has the biggest exposure to coal generation, and a
relatively modest UK clean generation pipeline.
We see Centrica, SSE and E.On
Energy as relative losers
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2 November 2011 20
Figure 25: Shift in EBITDA from dirty to clean generation* (£ per residential single fuelcustomer, 2012-15E)
(1 )
(2 )
12 16
(1 )7
43
(40 )
(20 )
0
20
40
60
80
C N A
E D F
E . O N
R WE
I B E
S S E
" B i g 6 "
A v e r a g e
Old Fossil Fuel Generation Clean Generation/Upstream Gas Net
Source: Barclays Capital.
* We have included the expiry of free CO2 permits in the “Old Fossil” category. We have also included EBIT fromupstream gas production (net of production taxes) for Centrica and SSE in the “Clean Generation” category. All analysisassumes zero hedging.
The shifting balance of power: the potential for a price war
Figure 26 quantifies the net impact of declining household energy demand and the shift in
profitability from old fossil fuel generation to clean generation on the earnings power of the Big
6’s generation and supply businesses over 2012-15E. This analysis suggests that there could be a
significant shift in the balance of power between the Big 6 utilities over the next few years:
EdF Energy has the potential to price lead the market We estimate EdF’s UK division could
see a net increase in earnings power of £31-37/customer over the next three years. This is
around £28/customer higher than its closest competitor. This gives EdF considerable scope
to price more aggressively in retail supply and gain customer market share.
Centrica, E.On Energy and SSE at competitive disadvantage. We believe Centrica could
see a decrease of £10-18/cust in its net generation and supply earnings power as a
result of the declining household energy demand and the shift in profitability from old
fossil fuel generation to clean generation. For SSE and E.On Energy the net negative
impact could be as high as £10/cust and £16/cust respectively. In practice, we would
expect them to try and raise retail tariffs to offset this, and to try and earn a return on
incremental clean generation investment. However, EdF Energy, RWE npower and
ScottishPower could all be in a position to compete more aggressively on price and try
and gain market share. Indeed, we believe EdF Energy would have the potential to
undercut Centrica’s pricing by nearly £100/cust on an average dual fuel bill.
EdF Energy and RWE npower
have the relative earnings
momentum and motivation to
grab market share
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Figure 26: Net shift in generation and supply EBITDA (£ per residential single fuelcustomer, 2012-15E)
(10 )
37
(8 )
510
(7 )
0
(18 )
31
(16 )
(2 )
3
(14 )(7 )
(30 )
(20 )
(10 )
0
10
20
30
40
50
C N A
E D F
E . O N
R WE
I B E
S S E
" B i g 6 "
A v e r a g e
Slow Demand Decline Scenario Fast Demand Decline Scenario
EdF’s exposure to clean
generation leaves it positioned to
compete more aggressively in
the downstream retail market
Source: Barclays Capital.
We see several motivations for why EdF Energy and RWE npower in particular could start to
price more aggressively in the retail market:
Rebalancing upstream/downstream exposure. As shown in Figure 27, EdF is already
significantly long generation following its acquisition of an 80% stake in British Energy,
while RWE npower’s investment in 3.8GW of new CCGT will leave it long, even after its
opted-out coal plant closes. Both companies currently have relatively low market share
(Figure 27), and have an incentive to increase customer numbers in order to have a
more balanced upstream/downstream hedge.
Kick-starting growth. In our view, RWE’s new group CEO, Peter Terium, faces a challenge
to reposition RWE as a business with genuine growth prospects. Our analysis in this report
suggests that the UK could genuinely provide such an opportunity. More aggressive
competition for customers could allow RWE to significantly increase the scale of its UK
operations over time, though potentially at the expense of near-term profits.
Figure 27: Residential energy customers, 2010 (m) Figure 28: Upstream/downstream hedge (%)
9.3
2.1 2.9 2.6 2.03.6
6.6
3.45.0
4.03.2
5.2
0
2
4
6
8
10
12
14
16
18
CNA EDF E.ON RWE IBE SSE
Gas Electrici ty
0%
50%
100%
150%
200%
250%
300%
CNA EDF E.ON RWE IBE SSE
2010A 2016E
Source: Company reports. Source: Barclays Capital.
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2 November 2011 22
Offset declining average revenues. The decline in energy demand will put pressure on
average revenue per customer for the whole industry. If political pressure makes it
difficult to compensate for this through higher retail tariffs, the alternative is to increase
customer numbers.
Cash cow to fund future investment. A large downstream customer base can be a
source of stable cash generation to help fund future investment in e.g. new nuclear,offshore wind.
There is evidence already that RWE npower and EdF Energy are competing more
aggressively on price: they were the last to raise retail tariffs in the latest round of price
increases, raised their prices by the lowest amount, and based on our estimates will have
the lowest weighted average sales price after the price increases have taken effect.
Figure 29: Big 6 UK utilities residential price increase analysis
Price Increase Weighted Average Sales Price*, 2012E
Date of
Increase Gas Electricity Gas (p/th)
Electricity
(p/kWh)
Average
(Index)
EdF Energy 10-Nov 15% 5% 112 118 100
RWE npower 01-Oct 16% 7% 116 123 104
SSE 14-Sep 18% 11% 122 123 107
E.On Energy 13-Sep 18% 11% 111 132 105
British Gas 18-Aug 18% 16% 127 131 112
ScottishPower 01-Aug 19% 10% 118 127 107
Source: Barclays Capital, company data.* Methodology: we take 2010A WASP quoted in the Ofgem Consolidated Segmental Statements and apply year-
average retail price increases to derive a 2012E WASP. It is important to note that the accuracy of this calculation isaffected by the lack of disclosure on the number of fixed-price customers and changing tariff mix (e.g. discounted
internet tariffs versus standard credit). Therefore, the analysis is for illustrative purposes only . Indeed, Ofgem iscurrently trying to address the difficulty customers face in comparing retail tariffs between companies.
Political pressure is already having an impact
Regulatory and political pressure is already prompting all six of the Big 6 utilities to change
their behaviour. The UK government has asked all of the Big 6 to offer simplified tariffs, to
make it easier for customers to switch, and to indicate to customers whether cheaper tariffs
are available. Ofgem has proposed that it will effectively re-regulate standing charges.
SSE, in particular, has been fast to respond to the political and regulatory criticism. It was the
first to end doorstep selling, suspending it in July 2011 after it was found guilty of mis-selling –
the rest of the Big 6 are now following. It has been the first to scrap discounted internet tariffs,
to respond to accusations of predatory pricing by Chris Huhne, the UK Energy Secretary 11. It
has also written to its customers and to Huhne, pledging a fairer deal for its customers.
In the very short term these measures, somewhat ironically, may reduce customer
switching (less doorstep selling) and raise weighted average sales prices (no more
discounted internet tariffs). However, over time, we believe the changes should lead to
increased customer switching and a migration to lower tariff levels. This could play into the
hands of EdF Energy and RWE npower.
11 “It is not fair that big energy companies can push their prices up for the vast majority of their consumers – who do
not switch – while introducing cut-throat offers for new customers that stop small firms entering the market … that looks to me like predatory pricing. It must and will stop” , Chris Huhne’s speech at the Liberal Democrat partyconference, 20 September 2011.
Political pressure could be a
catalyst for greater competition
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COMPANY SECTION
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COMPANY SNAPSHOT
Centrica Integrated Utilities
Income statement (£m) 2010A 2011E 2012E 2013E CAGR
EBITDA, adjusted 3,320 3,498 3,777 3,823 4.8% Stock Rating 3-UNDERWEIGHT
EBIT, adjusted 2,390 2,603 2,788 2,764 5.0% Sector View 2-NEUTRAL
Pre-tax income, adjusted 1,929 2,222 2,418 2,401 7.6% P rice (31-Oct-2011) £2.97
Net income, adjusted 1,297 1,359 1,397 1,412 2.9% Price Target £2.60
EPS, adjusted (p) 25.2 26.3 26.9 27.1 2.5% Ticker RIC: CNA.L, BB: CNA LN
Diluted shares (m) 5,191 5,213 5,234 5,256 0.4%
Dividend per share (p) 14.3 15.0 15.8 16.6 5.0% Investment case
Margin and return data (%) Average
EBITDA margin 14.0 14.7 15.0 14.6 14.6
EBIT margin 10.1 11.0 11.0 10.6 10.7
Pre-tax margin 8.1 9.4 9.6 9.2 9.1
Net margin 5.5 5.7 5.5 5.4 5.5
ROIC 12.0 10.2 10.1 9.9 10.5
ROA 8.0 7.4 7.2 7.0 7.4
ROE 25.7 22.3 21.1 19.8 22.2 Upside case £3.63
Balance sheet and cash flow (£m) CAGR
Net PP&E 6,398 6,942 7,215 7,320 4.6%
Total net assets 18,820 19,438 20,366 20,524 2.9%
Capital employed (average) 12,680 13,788 14,290 14,492 4.6%
Shareholders' equity 5,819 6,351 6,893 7,407 8.4%
Economic net debt (3,312) (3,310) (3,023) (2,618) NA
Operating cash flow 2,679 2,172 2,307 2,369 -4.0% Downside case £2.06
Capital expenditure (592) (1,298) (1,262) (1,163) NA
Free cash flow 2,087 874 1,045 1,205 -16.7%
Pre-dividend FCF 866 763 1,075 1,235 12.6%
Valuation and leverage metrics AverageP/E (x) 11.8 11.3 11.0 10.9 11.3
EV/EBITDA (x) 6.2 5.9 5.4 5.2 5.7
EV/NOPAT (x) 13.6 14.6 14.1 13.9 14.0 Upside/downside scenarios
Dividend yield (%) 4.8 5.1 5.3 5.6 5.2
FCF yield (%) 13.6 5.7 6.8 7.8 8.5
P/BV (x) 2.6 2.4 2.2 2.1 2.3
EV/IC (x) 1.5 1.5 1.4 1.4 1.4
Net debt/EBITDA (x) 1.0 0.9 0.8 0.7 0.9
Selected operating metrics
Energy hedge ratio (%) 52.2 58.8 61.1 57.0
G as product. (mm therms ) 3,199 2,984 3,076 3,111
Electricity product. (TWh) 32.9 26.7 19.7 18.1 Source: DataStream
BGRE - EBIT margin (%) 8.9 7.4 6.7 7.0 British Gas Residential EBIT Margin (%)
BGRE - Energy cust. (m) 16.0 15.9 15.6 15.4
BGRE - WACOG (p/th) 49.5 57.2 68.2 70.6
BGRE - WACOE (£/MWh) 45.1 61.1 66.3 62.7
Source: Company data, Barclays Capital Note: FY end Dec.
Why a 3-U W? We believe Centrica's competitive
advantage in the UK will fade, dr iven in pa rt by
declining gas demand. We believe weak spreads will
lead to disappointing power generation profits.
Our ups ide case ass umes s pa rk s preads rise by
£5/M Wh and retai l mar gins by 1%. We ass ume
Centrica trades in line with SOTP.
Our downside case sees Centrica's BGRE margin
squeezed by a further 1%, and assumes that
Centrica derates to 8x 2013E P/E
0
2
4
6
8
10
2010E 2011E 2012E 2013E
Downside
Case
206p
(-30.5%)
Price
Target
260p
(-12.3%)
Upside
Case
343p
(15.6%)
103
153
203
253
303
353
403
18-Nov-2010 31-Oc t-11
Downside
Case
206p
(-30.5%)Price
Target
260p
(-12.3%)
Upside
Case
363p
(22.3%)
103
203
303
403
18-Nov-2010 31-Oc t-11
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Barclays Capital | UK Utilities
2 November 2011 25
CENTRICA – NOT SO SAFE AFTER ALL
Over the past few months we have argued that Centrica is a relative safe haven. Its
defensive characteristics have been borne out in 14% outperformance relative to the
Stoxx 600 since May. Whilst its financial position remains robust, the economic and
retail market environment is evolving rapidly. In particular, with declines in energydemand accelerating, we now think both sides of Centrica’s upstream hedge could
come under pressure. We believe its competitive advantage in the UK retail market will
fade, and that persistently weak spark spreads will lead to disappointing power
generation profits in 2012/13E. We also see increasing downside risks for BGS, BGB and
Direct Energy given the deteriorating economic environment. We cut our 2012-14E EPS
forecasts to 7% below consensus on average. In the current market environment, we
doubt Centrica can trade at our revised SOTP valuation of £3.29. Given the deteriorating
fundamentals, we believe Centrica’s shares could instead derate towards their historical
P/E discount to the Stoxx Utilities index of -0.5, implying 12% share price downside. We
downgrade Centrica from 1-OW to 3-UW with a new £2.60 price target.
Power generation squeeze 2011-13E
Clean spark spreads in the UK have been steadily declining since the start of 2010. The
winter 2012/13 spread is currently trading at just £1.0/MWh. Unfortunately for Centrica,
which currently has economic interests in 5.1GW of installed CCGT capacity in the UK, we
would not expect these to recover before 2014, based on current relative gas and coal
prices. Because of these weak spreads, we expect load factors for older, unhedged CCGT
plant to collapse to below 10% over 2012-15E. We only expect these to pick up as coal
plant gets pushed to the margin, by around 2016. Figure 30 summarises our spark spread
and load factor forecasts.
Figure 30: UK power price, clean spark spread (CSS) and CCGT load factor forecasts (£/MWh, net of carbon price floor)
2011E 2012E 2013E 2014E 2015E 2016E
Baseload Power – BarCap Forecast 51.5 52.4 54.6 61.1 64.7 67.8
Baseload Power – Forward Curve* 51.4 53.7 54.7 - - -
Baseload CSS - 49% Efficiency 5.1 2.0 1.5 4.0 4.5 4.7
Baseload CSS - 59% Efficiency 12.9 10.5 10.4 13.5 14.6 15.3
CCGT Load Factor - 49% Efficiency 10% 7% 8% 5% 18% 26%
CCGT Load Factor - 58-59% Efficiency 43% 37% 77% 76% 74% 74%
Source: Barclays Capital, Bloomberg. * Forward curve as at 21 October 2011.
As a result, we believe Centrica’s CCGT fleet will not cover its fixed costs over the next 2-3
years. We expect Centrica to respond by closing some of its least profitable CCGT assets.Indeed, Centrica has already been reported to be planning closing 570MW of CCGT capacity
in 2012 (Barry and Kings Lynn)12. Centrica may also be able to recover some fixed costs by
providing ancillary services to National Grid.
Centrica’s exposure to clean generation via its wind capacity, its 20% stake in British Energy
and its new CCGT capacity should help drive a generation margin recovery over the
medium-term, but we do not expect any material impact before 2013/14, when the UK
carbon price floor kicks in.
12 “Centrica job and plant cuts could spark price increases” , The Times, 17 October 2011.
CNA.L / CNA LN
Stock Rating
3-Underweight
Sector View
2-Neutral
Price Target
£2.60
Price (31 Oct 2011)
£2.97
Potential Upside / Downside
-12.4%
Our power generation EBIT
forecasts are up to 60% below
consensus
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Barclays Capital | UK Utilities
2 November 2011 26
Overall, our forecasts for Centrica’s UK power generation division for 2012-13E are
materially below consensus, as shown in Figure 31. Our forecasts assume British Energy
delivers 53TWh of output, in line with historic average but below our 2011E forecast of
57TWh. Each +1TWh would add +£9m of EBIT.
Figure 31: Centrica’s UK Power Generation EBIT (£m)
2011E 2012E 2013E
BarCap 252 211 150
Consensus 279 332 372
Difference -10% -36% -60%
Source: Barclays Capital, company data.
Greater exposure to falling energy demand
Underlying UK residential gas demand was down around 5.8% in 1H11, double the rate of
decline of electricity demand. Our analysis in this report concludes that if improvements in
household energy efficiency continue in line with the trend over the past five years, and our
economists are correct about real income growth, we would expect household gas andelectricity consumption to continue to decline by around 2.1% and 0.7% per annum
respectively. However, if there was little or no growth in real income, we would expect the
declines to be 3.7% and 2.4% per annum respectively.
We expect Centrica to be more negatively impacted than its competitors given its high
volume share of the residential gas market. Indeed, under our fast demand decline scenario,
we estimate Centrica could see a demand decline that amounts to a loss of EBIT margin of
£17/cust over 2012-15E – nearly half of its 2011E margin of £38/customer.
Increasing downstream competition
Based on our analysis in this report, we conclude that EdF Energy and, to a lesser extent,
RWE npower have both the earnings momentum and the motivation to drive a more
aggressive pricing strategy in the downstream residential energy market. Specifically we
estimate that over 2012-15E EdF Energy could see a positive underlying delta in its UK
generation and supply EBITDA of £31-37/cust, compared to a £10-18/cust delta for
Centrica. This amounts to a net delta in profitability between the two companies of £100
per dual fuel customer.
We believe this could serve to reduce Centrica’s retail pricing power over the next 2-3 years,
and potentially put pressure on Centrica’s BGRE EBIT margin. We estimate EdF Energy’s
weighted average sales price (i.e. across all gas/electricity products) is already below that of
Centrica, following recent tariff increases (see Figure 29), and EdF’s superior profit
momentum could allow it to further widen the gap.
Centrica’s management is unlikely to take this lying down. It could respond by pricing more
aggressively to maintain market share, though this would put significant pressure on its
BGRE EBIT margin; or it could seek to preserve margins, though this could put Centrica back
into a similar position to the one it found itself in 2004-2006 when SSE competed
aggressively on price and Centrica lost 2.7m customers.
Gas demand could fall by a
further 4% pa in 2012/13E
EdF Energy represents a growing
competitive threat
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Barclays Capital | UK Utilities
2 November 2011 27
Earnings outlook deteriorating
We have cut our EPS forecasts to 7% below consensus on average, to reflect the risks we
have identified in this report. Specifically, we have made the following key changes to
forecasts:
British Gas Residential Energy. We factor in our weaker energy demand assumptions,
and assume Centrica picks a middle road between managing market share and margin.
We assume no tariff increase for 2012E, but assume tariffs rise by 15% 2012-15E to
recover some of the cost pressures faced by the industry (though we assume no further
increase in forward wholesale gas prices). We assume 200k net customer losses per
annum to 2015E, equivalent to 0.5% annual market share loss, and that EBIT falls
Centrica’s target level of c£600m in 2011-13E (6.7-7.0%) to c£500m by 2015E (5.7%
margin). Our forecasts assume management take action to reduce operating costs
further (by £30m), and that churn is lower than in the past due to increased penetration
of multi-product customers. While Centrica’s management consider this to be a key
advantage compared to the competition, we believe Centrica will struggle to fully offset
top-line pressures.
British Gas Business and Services. In line with Centrica’s own expectations, we expectrevenue investment to keep EBIT relatively flat in BGB over 2011-13E. We also believe
the scope for longer-term margin expansion will be limited by increasing competition in
the commercial energy market. Centrica is targeting double-digit EBIT growth for BGS,
mainly driven by cost-control rather than top line growth. However, given the
increasingly challenging economic environment, we reduce our 2011-14E forecast from
9.4% to 7.6% EBIT CAGR. We recognise that suspension of marketing activity at a key
competitor, Homeserve, could provide short-term upside to product sales. Separately,
we also believe a challenging economic environment could constrain growth in
Centrica’s North American home services and business supply divisions.
Upstream energy. We mark-to-market our commodity price assumptions13, reflecting
the current contango in the forward gas curve. The current backwardation in theforward curve for Brent crude brings down our forecasts for Upstream Gas and Oil,
which produces 11-12mmboe of liquids per annum. As described above, we are now
more bearish on the outlook for Centrica’s power generation division.
Figure 32: Centrica – EPS revisions (p)
2011E 2012E 2013E 2014E
BarCap EPS - New 26.3 26.9 27.1 28.9
BarCap EPS - Old 26.7 30.7 32.5 35.2
Change -1.7% -12.2% -16.6% -17.8%
Consensus EPS 26.0 28.3 30.7 30.3Difference 1.2% -4.9% -11.6% -4.7%
Source: Barclays Capital, DataStream.
We note that Centrica’s robust cash flow and balance sheet mean that it is progressively
deleveraging. That gives management financial flexibility to enhance EPS through either
acquisitions or share buybacks – an upside risk to our forecasts. We believe Centrica’s
management is comfortable with net debt/EBITDA around 1.0x, suggesting c£1bn of balance
sheet capacity by 2013. We estimate that this would enhance EPS by c5%, or 1.3p/share.
13 As at 21 October 2011.
We cut EPS forecasts to 7%
below consensus on average
Balance sheet re-leverage is a
modest upside risk to earnings
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Barclays Capital | UK Utilities
2 November 2011 28
P/E analysis justifies a £2.60 price target
Our analysis leads us to cut our SOTP valuation from £3.72 to £3.29, principally reflecting a
lower long-term BGRE margin assumption (reduced from 5.5% to 5.0%) and the impact of
lower commodity prices and spreads for Centrica’s upstream activities.
Our SOTP valuation points to modest upside for Centrica. However, we have to accept the fact
that Centrica has rarely traded close to SOTP. For example, over the past two years Centrica
has consistently traded at a 10% discount to its Bloomberg consensus average target price.
Given the negative earnings momentum we now expect for Centrica, we believe P/E may be
a better indicator of where Centrica’s shares could trade on a 12-month view. Figure 33
shows that, over the past five years, Centrica has on average traded at a -0.5 point Y+2 P/E
discount to the Stoxx Utilities index, with a standard deviation of -1.9 to +0.8.
Based on current consensus 2013E EPS, Centrica is trading at 9.7x 2013E P/E, compared to
an average Y+2 P/E for the Stoxx Utilities index of 10.0x this year (current Y+2 P/E is 9.9x).
Give the deteriorating fundamentals, we believe Centrica should de-rate to at least its
historical average discount of -0.5x, implying a target 2013E P/E of 9.5x. When coupled
with our 2013E EPS forecast of 27.1p (12% below consensus), this implies a target price of £2.60 – a 20% discount to our SOTP valuation.
Given our view of the challenges that Centrica is likely to face in the UK, such a discount
may well be warranted. Investors may take a more critical view of the assumptions used to
drive the SOTP. Our SOTP is based on a series of DCF models, and uses a 7.7% post-tax
nominal discount rate and a series of long-term margin assumptions for its downstream
activities. A £2.60 price target would be consistent with a 1ppt reduction in long-term
margin assumptions, and a 1ppt increase in our WACC.
We note a flaw in this approach, which is that Centrica’s robust cash flow and balance sheet
mean that it is progressively deleveraging. That gives management financial flexibility to enhance
EPS through either acquisitions or share buybacks. We believe Centrica’s management is
comfortable with net debt/EBITDA around 1.0x, suggesting c£1bn of balance sheet capacity by
2013. We estimate that this would enhance EPS by around 5%, or 1.3p/share.
Figure 33: Centrica – average forward P/E premium/discount vs. Stoxx Utilities
-4.0x
-3.0x
-2.0x
-1.0x
0.0x
1.0x
2.0x
3.0x
4.0x
Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11
Y+1 Y+2
Centrica has on average traded
at a 0.5 point P/E discount to
European Utilities
Source: Bloomberg, Barclays Capital.
Centrica does not appear to
trade on SOTP…
…we think P/E is a better
indicator of share price
performance
Deteriorating fundamentals
justify a derating
Balance sheet re-leverage is a
modest upside risk to earnings
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Barclays Capital | UK Utilities
2 November 2011 29
Figure 34: Centrica – SOTP valuation (as at 31 December 2012)
£m p/share %EV
EB/EBITDA
2011E
EB/EBITDA
2012E
CAGR
11-15E
British Gas Residential 4,617 89 21.0% 6.9x 7.1x -3.6%
British Gas Business 2,522 49 11.5% 9.6x 9.3x 3.7%
British Gas Services 2,870 55 13.1% 10.5x 9.7x 6.9%
Gas Production and Development 4,474 86 20.4% 3.3x 2.7x 5.8%
Power Generation - Conventional 1,173 23 5.3% 3.2x 3.4x 4.4%
Power Generation - 20% British Energy 2,170 42 9.9% - - -
Industrial and Commercial 12 0 0.1% - 6.0x -
Accord Energy Trading 115 2 0.5% - 6.0x -
Centrica Storage 815 16 3.7% 8.5x 11.2x 5.6%
Direct Energy 3,170 61 14.4% 8.0x 7.1x 7.2%
Enterprise Value 21,937 422 - 6.3x 5.8x 4.0%
Net Debt (3,023 ) (58 )Net Pension Deficit (72 ) (1 )
Provisions (1,746 ) (34 )
Minorities 0 0
Equity Value 17,097 329
Source: Barclays Capital.
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Barclays Capital | UK Utilities
2 November 2011 30
Figure 35: Centrica – Financial ratios and valuation multiples
2008 2009 2010 2011E 2012E 2013E 2014E 2015E
EPS/DPS
EPS - Recurrent (p/share) 21.7 21.7 25.2 26.3 26.9 27.1 28.9 29.9
DPS - Total (p/share) 12.2 12.8 14.3 15.0 15.8 16.6 17.4 18.3
Valuation Multiples
P/E (x) - - - 11.3x 11.0x 10.9x 10.3x 9.9x
EV/EBITDA (x) - - - 5.9x 5.4x 5.2x 5.0x 4.8x
EV/EBITDA - Ex-Upstream Gas (x) - - - 7.7x 7.6x 7.3x 7.1x 6.9x
EV/NOPAT (x) - - - 14.6x 14.1x 13.9x 13.1x 12.5x
Dividend Yield (%) - - - 5.1% 5.3% 5.6% 5.9% 6.2%
FCF Yield (%) - - - 5.7% 6.8% 7.8% 6.7% 7.8%
P/BV (x) - - - 2.4x 2.2x 2.1x 1.9x 1.8x
EV/IC (x) - - - 1.5x 1.4x 1.4x 1.3x 1.3x
Financial Ratios
Dividend Payout Ratio (%) 56.2% 59.0% 56.7% 57.1% 58.6% 61.1% 60.1% 61.1%
Financial Net Debt/EBITDA (x) 0.2x 1.2x 1.0x 0.9x 0.8x 0.7x 0.6x 0.5x
ROE 23.5% 25.8% 25.7% 22.3% 21.1% 19.8% 19.7% 19.0%
ROIC 14.0% 12.5% 12.0% 10.2% 10.1% 9.9% 10.3% 10.4%
WACC - - - 7.7% 7.7% 7.7% 7.7% 7.7%
Weighted Ave. Shares (mm) 4,198 5,121 5,146 5,168 5,189 5,211 5,232 5,253
Source: Barclays Capital, DataStream.
Figure 36: Centrica – Segmental operating profit (£m)
2008 2009 2010 2011E 2012E 2013E 2014E 2015E
Residential Energy Supply 376 598 742 605 579 609 547 507
Business Energy Supply and Services 143 183 233 247 252 263 272 283
Residential Services 193 230 241 262 285 309 324 339
Upstream Gas and Oil 1,164 444 581 855 1,049 1,002 977 969
Power Generation 11 147 226 252 211 150 238 283
Industrial and Commercial (331 ) (93 ) (36 ) 0 1 2 2 2
Proprietary Energy Trading 37 27 0 19 19 19 19 19
Storage UK 195 168 169 70 45 33 66 84
North America 215 153 234 293 345 379 404 421
Other 0 0 0 0 0 0 0 0
Adjusted Operating Profit 2,003 1,857 2,390 2,603 2,788 2,764 2,849 2,907
Growth (%) 2.8% -7.3% 28.7% 8.9% 7.1% -0.8% 3.1% 2.1%
Margin (%) 8.5% 7.9% 10.1% 11.0% 11.0% 10.6% 10.4% 10.2%
Source: Barclays Capital, company data.
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Barclays Capital | UK Utilities
2 November 2011 31
Figure 37: Centrica – Income statement (£m)
2008 2009 2010 2011E 2012E 2013E 2014E 2015E
External Revenue 20,872 21,963 22,423 22,357 23,806 24,704 25,762 26,725
Costs (18,251 ) (19,410 ) (19,246 ) (19,139 ) (20,276 ) (21,154 ) (22,142 ) (22,992 )
Income from Associates 12 28 143 280 247 272 337 367EBITDA 2,633 2,581 3,320 3,498 3,777 3,823 3,957 4,100
Depreciation and Amortisation (630 ) (724 ) (930 ) (895 ) (989 ) (1,058 ) (1,108 ) (1,193 )
Adjusted Operating Profit 2,003 1,857 2,390 2,603 2,788 2,764 2,849 2,907
JV/Associate Interest/Tax (3 ) (11 ) (78 ) (77 ) (65 ) (68 ) (81 ) (87 )
Fair Value Adjustments (8 ) (32 ) (118 ) (120 ) (120 ) (120 ) (120 ) (120 )
Operating Profit 1,992 1,814 2,194 2,407 2,603 2,576 2,648 2,700
Net Interest (45 ) (227 ) (275 ) (195 ) (195 ) (185 ) (167 ) (155 )
Other Finance Income/(Costs) 43 48 10 10 10 10 10 10
PBT 1,990 1,635 1,929 2,222 2,418 2,401 2,491 2,555
Tax (1,026 ) (531 ) (708 ) (960 ) (1,118 ) (1,086 ) (1,076 ) (1,082 )
Effective Tax Rate (%) 51.6% 32.5% 36.7% 43.2% 46.2% 45.2% 43.2% 42.3%
Income from Discontinued Operations (52 ) 40 (5 ) 0 0 0 0 0
Minority Interests (1 ) (50 ) (7 ) 0 0 0 0 0
Fair Value Adjustments - 17 88 97 97 97 97 97
Adjusted Net Income 911 1,111 1,297 1,359 1,397 1,412 1,512 1,570
Growth (%) -18.8% 22.0% 16.7% 4.8% 2.8% 1.1% 7.1% 3.9%
Margin (%) 3.9% 4.7% 5.5% 5.7% 5.5% 5.4% 5.5% 5.5%
Continuing EPS - Basic (p) 1.1 12.7 36.4 24.4 25.1 25.2 27.0 28.0
Continuing EPS - Adjusted (p) 21.7 21.7 25.2 26.3 26.9 27.1 28.9 29.9
Growth (%) -20.1% 0.0% 16.1% 4.3% 2.4% 0.6% 6.6% 3.4%
DPS - Interim (p) 3.5 3.7 3.8 4.3 4.5 4.7 5.0 5.2
DPS - Final (p) 8.7 9.1 10.5 10.7 11.3 11.8 12.4 13.0
DPS - Total (p) 12.2 12.8 14.3 15.0 15.8 16.6 17.4 18.3
Growth - Ordinary DPS (%) 5.4% 4.9% 11.7% 5.0% 5.0% 5.0% 5.0% 5.0%
Payout Ratio (%) 56.2% 59.0% 56.7% 57.1% 58.6% 61.1% 60.1% 61.1%
Source: Barclays Capital, company data.
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Barclays Capital | UK Utilities
2 November 2011 32
Figure 38: Centrica – Cash flow (£m)
2008 2009 2010 2011E 2012E 2013E 2014E 2015E
Operating Profit 652 1,174 3,081 2,275 2,493 2,445 2,464 2,492
+ Depreciation, Amortisation and Impairment 630 917 1,153 895 989 1,058 1,108 1,193
+/- Changes in Provisions (106 ) 11 (105 ) (100 ) 0 0 0 0+/- Change in Working Capital (1,083 ) 899 435 (175 ) (68 ) (8 ) (25 ) (31 )
+/- Other Non-Cash Items 1,111 (12 ) (1,339 ) 0 0 0 0 0
+ Dividends from Associates 0 0 0 173 146 164 209 229
- Net Interest (24 ) 10 (6 ) (195 ) (195 ) (185 ) (167 ) (155 )
- Income Tax (907 ) (503 ) (540 ) (702 ) (1,058 ) (1,106 ) (1,078 ) (1,078 )
Operating Cash Flow 273 2,496 2,679 2,172 2,307 2,369 2,511 2,650
- Capital Expenditure (546 ) (2,964 ) (592 ) (1,298 ) (1,262 ) (1,163 ) (1,473 ) (1,437 )
Free Cash Flow (273 ) (468 ) 2,087 874 1,045 1,205 1,037 1,213
+/- Acquisitions and Disposals (552 ) (1,244 ) (1,243 ) (141 ) 0 0 0 0
+/- Change in Equity 2,199 25 22 30 30 30 30 30
- Dividends Paid to Shareholders/Minorities (500 ) (635 ) (668 ) (760 ) (788 ) (831 ) (876 ) (924 )
Net Cash Flow 874 (2,322 ) 198 2 287 404 191 319
Other Movements in Net Debt (590 ) (303 ) (374 ) 0 0 0 0 0
Non-Recourse Financial Net Cash/(Debt) (511 ) (3,136 ) (3,312 ) (3,310 ) (3,023 ) (2,618 ) (2,427 ) (2,108 )
Net Debt/EBITDA 0.2x 1.2x 1.0x 0.9x 0.8x 0.7x 0.6x 0.5x
Source: Barclays Capital, company data.
Figure 39: Centrica – Balance sheet (£m)
2008 2009 2010 2011E 2012E 2013E 2014E 2015E
Tangible Fixed Assets 4,689 6,059 6,398 6,942 7,215 7,320 7,686 7,930
Intangible Assets 2,181 2,822 3,454 3,454 3,454 3,454 3,454 3,454
Investments 330 2,422 2,507 2,465 2,430 2,397 2,372 2,351
Cash/Marketable Securities 3,002 1,368 490 635 553 475 503 595
Working Capital Assets 5,786 4,632 4,612 4,582 4,877 5,063 5,281 5,478
Other Assets 2,478 1,661 1,359 1,359 1,837 1,814 1,814 1,814
Total Assets 18,466 18,964 18,820 19,438 20,366 20,524 21,109 21,622
Short-Term Debt (330 ) (86 ) (77 ) (77 ) (77 ) (77 ) (77 ) (77 )
Long-Term Debt (3,218 ) (4,594 ) (3,959 ) (4,102 ) (3,733 ) (3,250 ) (3,087 ) (2,860 )
Working Capital Liabilities (4,395 ) (3,955 ) (4,059 ) (3,844 ) (4,061 ) (4,229 ) (4,411 ) (4,568 )
Provisions (1,080 ) (2,007 ) (1,985 ) (1,885 ) (1,885 ) (1,885 ) (1,885 ) (1,885 )
Other Liabilities (5,071 ) (4,545 ) (3,376 ) (3,635 ) (3,695 ) (3,676 ) (3,673 ) (3,677 )
Total Liabilities (14,094 ) (15,187 ) (13,456 ) (13,543 ) (13,451 ) (13,117 ) (13,134 ) (13,067 )
Shareholders' Equity 4,312 4,192 5,819 6,351 6,893 7,407 7,975 8,555
Minority Interest/Other 60 63 0 0 0 0 0 0
Total Equity 4,372 4,255 5,819 6,351 6,893 7,407 7,975 8,555
Source: Barclays Capital, company data.
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COMPANY SNAPSHOT
Drax Generators
Income statement (£m) 2010A 2011E 2012E 2013E CAGR
EBITDA, adjusted 391 321 331 200 -20.0% Stock Rating 1-OVERWEIGHT
EBIT, adjusted 338 264 273 134 -26.5% Sector View 2-NEUTRAL
Pre-tax income, adjusted 315 240 260 116 -28.4% Price (31-Oct-2011) £5.43
Net income, adjusted 233 189 199 94 -26.1% Price Target £6.75
EPS, adjusted (p) 63.8 51.8 51.1 22.6 -29.2% Ticker RIC: DRX.L, BB: DRX LN
Diluted shares (m) 366 366 391 416 4.4%
Dividend per share (p) 32.0 25.9 25.6 11.3 -29.3% Investment case
Margin and return data (%) Average
EBITDA margin 23.7 17.2 17.6 10.1 17.1
EBIT margin 20.5 14.2 14.5 6.8 14.0
Pre-tax margin 19.1 12.9 13.8 5.8 12.9
Net margin 14.1 10.2 10.6 4.7 9.9
ROIC 19.5 18.2 17.5 7.0 15.6
ROA 11.6 9.7 9.0 3.8 8.5
ROE 23.5 17.3 14.1 5.8 15.2 Upside case £15.52
Balance sheet and cash flow (€m) CAGR
Net PP&E 1,184 1,167 1,291 1,461 7.3%
Total net assets 2,047 1,976 2,558 2,771 10.6%
Capital employed 1,043 1,086 1,241 1,659 16.7%
Shareholders' equity 958 1,224 1,605 1,615 19.0%
Adjusted net debt 204 210 422 3 -76.5%
Cash flow from operations 411 169 216 (97) NA Downside case £3.30
Capital expenditure (62) (40) (182) (236) NA
Free cash flow 349 129 34 (333) NA
Pre-dividend FCF 349 129 284 (333) NA
Valuation and leverage metrics AverageP/E (x) 8.5 10.5 10.6 24.0 13.4
EV/EBITDA (x) 4.4 5.4 5.4 11.1 6.6
EV/NOPAT (x) 7.1 8.9 8.8 21.8 11.7 Upside/downside scenarios
Dividend Yield (%) 5.9 4.8 4.7 2.1 4.4
FCF Yield (%) 17.6 6.5 1.5 - 14.8 2.7
P/BV (x) 2.1 1.6 1.4 1.4 1.6
EV/IC (x) 1.7 1.6 1.4 1.3 1.5
Net debt/EBITDA (x) (0.5) (0.7) (1.3) (0.0) - 0.6
Selected operating metrics
Payout ratio (%) 50.1 50.0 50.0 50.0
Power price (£/MWh) - 55.6 55.8 57.0
Dark spread (£/MWh) - 16.8 18.3 16.2 Source: Thomson Reuters Datastream, Barclays Capital est.
Load factor (%) 79.7 80.0 80.0 80.0 Output (TWh)
Output (TWh) 26.4 26.5 26.6 26.5
Source: Company data, Barclays Capital Note: FY end Dec.
Why a 1-OW? We now believe it is highly likely that
D rax wi ll pr oceed with pla ns to convert to 50%
biomass co-firing. This completely transforms the
equity story of Drax, securing its position in the UK
power market for the long-term. Drax also retains
the option to convet to 100% in the future.
Our upside scenario assumes Drax invests further
(we assume £250m) to fully-covert the plant into
dedicated biomass by 2020 at 1.0x ROC.
Our downside case assumes 50% conversion, but
thermal efficiency of 35%, high capex and a 10%
rise in coal prices.
24.0
25.0
26.0
27.0
28.0
2010A 2011E 2012E 2013E
Output (TWh)
28
48
68
88
108
18-Nov-10 31-Oct-11
Downside
Case
330p
(-39.2%) Price
Target
675p
(24.3%) Upside
Case
1552p
(185.%)
165
665
1165
1665
18-Nov-10 31-Oct-11
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2 November 2011 35
DRAX – FROM DARK TO BARK
Following the proposed increase in ROC support, we now believe it is highly likely that
Drax will proceed with plans to convert to 50% biomass co-firing. We believe this
completely transforms the equity story of Drax, securing its position in the UK power
market for the long-term. A combination of the carbon tax and ROC support shouldunderpin progressively rising earnings. Over the medium term our analysis suggests
that Drax has the potential to return significant amounts of cash to investors. Numerous
uncertainties remain, meaning we believe Drax remains a risky stock. Nonetheless, we
see the upside potential as potentially very high indeed, particularly if Drax opts to
convert the plant to 100% biomass in the future. We upgrade from 3-UW to 1-OW and
set a new price target of £6.75.
Biomass conversion transforms earnings outlook
The key driver for Drax’s shares up until now has been the UK “clean dark spread”.
However, if, as we expect, Drax converts to 50% biomass co-firing, this will change. The key
driver of Drax’s EBITDA will instead become the “bark spread” – the gross margin on co-firing biomass. Given the significant pressure we see on dark spreads over the next few
years, this is a transformational story for Drax.
This bark spread has three components: the power price, the ROC price and the cost of
biomass. We think its characteristics will be rather more attractive than that of the clean
dark spread:
Carbon price floor drives progressive growth in power prices. We expect the carbon
price floor to underpin a 30% increase in UK power prices to 2020 (relative to current
EUA futures). Our modelling shows that the pass-through of the carbon tax into
wholesale power prices should step up in 2017E as conventional hard coal plant moves
to the margin in the UK, substantially improving the economics of biomass.
Figure 40: Impact of carbon price floor on UK power prices (£/MWh)
2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E
Baseload Power – with carbon floor 51.5 52.4 54.6 61.1 64.7 67.8 71.2 73.1 74.7 76.6
Baseload Power – no carbon floor 51.5 52.4 52.4 54.2 54.9 56.9 58.0 59.2 60.5 62.0
Difference - - 2.1 6.8 9.7 10.9 13.1 13.9 14.2 14.6
Source: Barclays Capital.
ROC prices supported by buy-out price. Our analysis suggests that growth in UK
renewables (including Drax’s own plans) will put downward pressure on ROC prices
(currently trading at £45). However, the buy-out price should provide support at a level
of at least £40 (see Figure 23).
Implicit inflation protection. Both the carbon price floor and the ROC buy-out price are
linked to UK RPI, giving revenues implicit inflation protection.
Long-term contracts for biomass. We expect Drax to secure a meaningful proportion of
its biomass under long-term fixed priced indexed contracts, giving a much higher
degree of cost visibility than with its current exposure to coal.
DRX.L / DRX LN
Stock Rating
1-Overweight
Sector View
2-Neutral
Price Target
£6.75
Price (31Oct 2011)
£5.43
Potential Upside / Downside
24.3%
The “bark spread” transforms
Drax’s equity story
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2 November 2011 36
As shown in Figure 41, the difference in EBITDA between Drax operating as a normal coal
plant and operating as a biomass plant is profound, though we would expect EBITDA to
start to come under pressure again as coal becomes less economic as a fuel, reducing
Drax’s load factor.
Importantly, we believe Drax will retain the option of converting to 100%, given how the
economics could transform in the latter part of the decade. This could turn Drax into a £1bnEBITDA generating asset. However, this decision would depend on the “bankability” of the
carbon price floor – which currently remains a discretionary tool for the government – or on
the attractiveness of proposed contract-for-difference feed-in tariffs.
Figure 41: Drax – from “dark spread” to “bark spread”
2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E
Clean Dark Spread @ 40% Efficiency (£/MWh) 18.1 15.8 15.9 15.3 14.8 14.3 12.2 9.6 7.1
Bark Spread @ 37.5% Efficiency (£/MWh)* 35.1 35.6 38.2 40.1 42.5 45.1 46.2 47.0 48.1
EBITDA - Normal Coal Operation (£m)** 343 179 206 187 147 133 106 41 (33 )
EBITDA - 50% Co-Firing by 2015 (£m) 331 200 352 427 452 460 437 376 302
EBITDA - 100% Biomass by 2020 (£m) 331 200 352 427 452 567 736 925 1,082
Source: Barclays Capital.* Our EBITDA forecasts assume Drax outperforms this by operating flexibly and by burning up to c10% energy crop biomass at 1.5x ROC.
** Assumes Drax operates as it does today, with up to 12.5% co-firing capability at 0.5x ROC.
Numerous uncertain variables remain
There are still several uncertainties relating to Drax’s plans to convert to enhance co-firing:
ROC banding. DECC has proposed an increase in the banding for enhanced co-firing
from 0.5 to 1.0x14, commencing on 1 April 2013 and grandfathered until 2027 for Drax.
The consultation will run until 12 January 2012, and DECC is expected to announce its
final decision on bandings around March 2012 (this then has to be passed intolegislation). There is a risk that the banding could be reduced, though we would ascribe
a low probability to this, given the implicit support that DECC has provided biomass in
its recent publications. Drax is currently lobbying for a further increase in the banding to
enable it to increase co-firing above 50% in the long-term, so there is also a chance that
the banding could be increased.
Capital investment. Drax is currently indicating that capex will be between £350-500m
for co-firing conversion depending on whether or not boiler modification will be
required in order to increase co-firing to 50%. Drax is likely to also have to invest in
Selective Catalytic Reduction technology on 2-3 of its units over 2013-2015 to comply
with the Industrial Emissions Directive, at an expected cost of £170-250m. For the
purposes of modelling we have taken the mid-point of both of these capex ranges.
Capital structure. We estimate that in order to convert to biomass, Drax will need to
finance around £250m of biomass stock and £350m of ROC inventory build-up over the
course of 2012-14E, in addition to the investment outlay. This implies a total capital
requirement of £950-£1,100m. Drax has indicated it may need to issue equity to finance
a portion of this, and we prudently assume a £250m capital raising in our forecasts to
keep net debt/EBITDA below 1.0x. This dilutes EPS by c10%.
14 Consultation on proposals for the levels of banded support under the Renewables Obligation for the period 2013-17 and the Renewables Obligation Order 2012, DECC, 20 October 2011.
Drax remains a risky stock
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2 November 2011 37
Thermal efficiency. Co-firing is expected to reduce thermal efficiency. Until Drax has
completed the technical analysis, there is no guidance available on the potential impact.
We have assumed a 2.5% reduction in efficiency, to 37.5%. However, it is important to
note that fuel costs, and therefore Drax’s DCF valuation, are very sensitive to this number.
Biomass availability and price. Drax is likely to import the vast majority of its biomass
from accredited sustainable sources, and is seeking to strike long-term fixed-pricecontracts with suppliers. However, there is considerable variability in the price, quality
and availability of biomass.
Drax currently indicates that it is able to source biomass at between 2.0-2.5x the cost of
coal. This implies a fuel cost of in the range of £6.1-7.7/GJ. The current forward wood
pellet price (ENDEX) is in the middle of this range at £6.9/GJ. We use this as the basis of
our modelling. In reality, the range of prices for different types of biomass is very wide.Processed wood pellets typically mark the upper end of the range. Agricultural residues,
for example, are available at £0.5-4.5/GJ. We would expect Drax to be able to achieve
better than average prices given its ability to bulk purchase through long-term fixed
price contracts, and to use less processed feedstock. However, one key uncertainty that
Drax is likely to face is currency risk.
We do not see any material constraints to biomass availability per se, though
bottlenecks in the supply chain will need to be addressed. We estimate that Drax itself –
at 50% co-firing – will consume around 125PJ per annum, and that total UK biomass
generation by 2015 could be c300PJ. This is comfortably below ranges of available
biomass estimated in a report commissioned by DECC15, which suggests that by 2015
there could be 390-670PJ of domestically produced biomass available within the UK at£4/GJ (2010 prices) and a further 403-549PJ of imported biomass. The amount within
these ranges depends on the extent to which constraints are overcome (e.g. processing
plant capacity, transport infrastructure, policy uncertainty). In its recent Renewables
Roadmap16, the DECC appears committed to addressing such constraints.
15 UK and Global Bioenergy Resource – Final Report , AEA, March 201116 UK Renewable Energy Roadmap, DECC, July 2011
Figure 42: Forward wood pellet prices, CIF (£/GJ) Figure 43: Ratio of wood pellet to API2 coal
5.5
6.0
6.5
7.0
7.5
8.0
Nov-08 May-09 Nov-09 May-10 Nov-10 May-11
2010 2011 2012 2013
2.0
2.5
3.0
3.5
4.0
Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11
Source: ENDEX, Barclays Capital. Source: ENDEX, Bloomberg, Barclays Capital.
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2 November 2011 38
Valuation analysis
The high probability that Drax will now pursue biomass conversion transforms the equity
story for Drax. It is no longer a binary call on UK government policy. Our revised 1-OW
recommendation reflects the significant option value that we believe a biomass conversion
strategy creates for Drax. Drax remains a risky stock, in our view, but we estimate the
upside potential under certain scenarios is considerable. We believe the reward is nowworth the risk.
We analyse risk/reward using a DCF scenario analysis. Given Drax is a finite life asset, we
believe DCF is the most appropriate valuation methodology. Our base case DCF valuation is
£5.86. However, this is very sensitive to a number of variables, as shown in Figure 44.
Figure 44: DCF valuation sensitivity and scenario analysis (£/share)
Normal Coal
Operation
50% Co-
Firing by
2015
100%
Biomass by
2020
Base Case DCF Valuation 2.16 5.86 15.52
Equity IRR (based on £5.43 share price) - 7.9% 15.8%
Sensitivities
Power Price +/- 5% 47% 34% 15%
ROC Banding +/- 0.1x 4% 15% 12%
Biomass Price +/- 5% 5% 17% 13%
Coal Price +/- 5% 19% 9% 1%
Thermal Efficiency +/- 1% 2% 9% 7%
Capex +/- £115m 4% 4% 2%
WACC* +/- 50bps 1% 7% 9%
ScenariosLow Case - 35% Efficiency / High Capex / Coal Price +10% 1.15 3.30 12.14
High Case - 38% Efficiency / Low Capex / 1.1x ROC 2.26 7.23 18.08
Source: Barclays Capital.NB. Our base case WACC assumption is 7.62% post-tax real. We assume ROC support is maintained at 1.0x after
2027, however we also assume that the UK carbon price floor remains at £30/t (it is currently stipulated to rise to£70/t by 2030).
Our scenario analysis considers three high level cases:
Normal coal plant operation. This scenario assumes that DECC reneges on its proposal
to raise the banding for enhanced co-firing from 0.5x. This would leave Drax operating
as an increasingly marginalised coal plant, worth less than half of its current share price.
We believe the probability of this scenario is less than 5%.
50% co-firing. Our base case assumes that Drax invests to progressively raise biomass
co-firing to 50% by 2015, at 1.0x ROC. We ascribe an 80% likelihood to this scenario,
which would give investors in Drax today an attractive 7.9% equity IRR.
100% biomass. This scenario assumes Drax invests further (we assume £250m) to fully-
covert the plant into dedicated biomass by 2020 at 1.0x ROC. The potential value upside
here is considerable: £15.52 under our base case power price assumptions, providing
investors with 15.8% equity IRR. We would ascribe a 15% probability to this scenario.
Drax has considerable
option value
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2 November 2011 39
We then consider two alternative sets of operational assumptions:
Low case. This assumes thermal efficiency drops to 35% on co-firing, capex is towards
the top end of the range indicated by Drax (i.e. £750m for 50% conversion and SCR
retrofit), and clean dark spreads get squeezed by a 10% raise in coal prices.
High case. This assumes thermal efficiency is only modestly impacted by co-firing,capex is towards the bottom end of the range indicated by Drax (i.e. c£520m for 50%
conversion and SCR retrofit), and that DECC raises the ROC banding to 1.1x for
enhanced co-firing/ biomass conversion.
We set our price target at £6.75 based on a probability-weighted assessment of these
scenarios. Essentially, we are valuing Drax at £5.86 plus an £0.89, or 15% premium, to
reflect the option value of 100% biomass conversion. This implies 24% upside to the
current share price.
Figure 45: Drax – Financial ratios and valuation multiples
2008 2009 2010 2011E 2012E 2013E 2014E 2015E
EPS/DPS
EPS - Recurrent (p/share) 86.2 57.9 63.8 51.8 51.1 22.6 46.3 56.0
DPS - Total (p/share) 53.0 13.7 32.0 25.9 25.6 11.3 23.1 28.0
Valuation Multiples
P/E (x) 10.5x 10.6x 24.0x 11.7x 9.7x
EV/EBITDA (x) 5.4x 5.4x 11.1x 7.3x 5.8x
EV/NOPAT (x) 8.9x 8.8x 21.8x 12.0x 9.3x
Dividend Yield (%) 4.8% 4.7% 2.1% 4.3% 5.2%
FCF Yield (%) 6.5% 1.5% -14.8% -11.8% 8.8%
P/BV (x) 1.6x 1.4x 1.4x 1.3x 1.2xEV/Capital Employed (x) 1.6x 1.4x 1.3x 1.2x 1.2x
Financial Ratios
Dividend Payout Ratio (%) 61.5% 23.7% 50.1% 50.0% 50.0% 50.0% 50.0% 50.0%
Financial Net Debt/EBITDA (x) 0.5x 0.2x (0.5x) (0.7x) (1.3x) (0.0x) 0.9x 0.5x
ROE 55.5% 23.8% 23.5% 17.3% 14.1% 5.8% 11.4% 12.8%
ROIC 25.3% 15.8% 19.5% 18.2% 17.5% 7.0% 11.4% 12.5%
WACC - - - 7.6% 7.6% 7.6% 7.6% 7.6%
Source: Barclays Capital, company data.
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Figure 46: Drax – EBITDA drivers (£m)
2008 2009 2010 2011E 2012E 2013E 2014E 2015E
Clean Dark Spread - - - 316 350 276 226 180
Biomass Spread - - - 46 52 133 331 463
Other Fuels Spread - - - 24 19 18 18 18Free CO2 Allocation - - - 131 129 0 0 0
Other Revenues - - - 28 28 28 28 28
Retail - - - (1 ) (1 ) 0 1 1
Grid Charges - - - (57 ) (59 ) (61 ) (63 ) (65 )
Operating Costs - - - (166 ) (187 ) (194 ) (190 ) (198 )
EBITDA - - - 321 331 200 352 427
Source: Barclays Capital, company data.
Figure 47: Drax – Income statement (£m)
2008 2009 2010 2011E 2012E 2013E 2014E 2015E
Total Revenue 1,753 1,476 1,648 1,863 1,882 1,987 2,349 2,708
Cost of Sales (1,130 ) (973 ) (1,098 ) (1,357 ) (1,344 ) (1,572 ) (1,786 ) (2,061 )
Operating Costs (169 ) (148 ) (160 ) (185 ) (207 ) (215 ) (211 ) (220 )
Adjusted EBITDA 454 355 391 321 331 200 352 427
Depreciation, Amortisation and Impairment Charges (46 ) (52 ) (52 ) (57 ) (58 ) (66 ) (73 ) (81 )
Adjusted Operating Profit 408 303 338 264 273 134 279 346
Net Finance Costs (22 ) (15 ) (23 ) (24 ) (13 ) (19 ) (35 ) (40 )
Adjusted PBT 386 288 315 240 260 116 243 306
Income Tax Expense (94 ) (83 ) (82 ) (51 ) (61 ) (22 ) (52 ) (73 )
Adjusted Net Income 292 204 233 189 199 94 192 233
Growth (%) -15.6% -30.1% 14.0% -18.8% 5.3% -52.9% 104.4% 21.2%Margin (%) 16.7% 13.8% 14.1% 10.2% 10.6% 4.7% 8.2% 8.6%
Continuing EPS - Basic (p) 98.1 31.4 51.6 106.1 51.1 22.6 46.3 56.0
Continuing EPS - Adjusted (p) 86.2 57.9 63.8 51.8 51.1 22.6 46.3 56.0
Growth (%) -13.3% -32.8% 10.2% -18.8% -1.4% -55.7% 104.4% 21.2%
DPS - Interim (p) 5.0 4.1 14.1 16.0 8.5 3.8 7.7 9.3
DPS - Final (p) 38.3 9.6 17.9 9.9 17.0 7.5 15.4 18.7
DPS - Special (p) 9.7 0.0 0.0 0.0 0.0 0.0 0.0 0.0
DPS - Total (p) 53.0 13.7 32.0 25.9 25.6 11.3 23.1 28.0
Growth - Ordinary DPS (%) 196.6% -68.4% 133.6% -19.0% -1.4% -55.7% 104.4% 21.2%
Payout Ratio - Total DPS (%) 61.5% 23.7% 50.1% 50.0% 50.0% 50.0% 50.0% 50.0%
Source: Barclays Capital, company data.
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2 November 2011 41
Figure 48: Drax – Cash flow (£m)
2008 2009 2010 2011E 2012E 2013E 2014E 2015E
EBITDA (inc. cash exceptionals) 454 355 391 321 331 200 352 427
+/- Changes in Working Capital (21 ) (43 ) 115 (60 ) (11 ) (153 ) (94 ) 99
+ Share-Based Payments 4 2 3 3 3 3 3 3
+ Pension Charge 4 5 6 6 6 6 6 6
- Pension Contributions (10 ) (8 ) (8 ) (11 ) (11 ) (11 ) (11 ) (11 )
+/- Intangible Assets - ROC 0 10 (21 ) (5 ) (36 ) (110 ) (208 ) (135 )
- Net Interest Paid (19 ) (13 ) (20 ) (20 ) (11 ) (16 ) (30 ) (34 )
- Net Tax Paid (102 ) 19 (56 ) (63 ) (56 ) (17 ) (46 ) (61 )
+ Other Changes 0 0 2 0 0 0 0 0
Operating Cash Flow 310 328 411 169 216 (97 ) (29 ) 294
Capital Expenditure (91 ) (93 ) (62 ) (40 ) (182 ) (236 ) (237 ) (96 )
Free Cash Flow 218 235 349 129 34 (333 ) (266 ) 198
Acquisitions and Disposals 0 (12 ) 0 0 0 0 0 0
Change in Equity 0 106 0 0 250 0 0 0
Dividends Paid to Shareholders/Minorities (110 ) (145 ) (87 ) (124 ) (72 ) (86 ) (63 ) (103 )
Net Cash Flow 108 184 262 6 213 (420 ) (330 ) 95
Other Movements in Net Debt (6 ) (4 ) (4 ) 0 0 0 0 0
Financial Net (Debt)/Cash (235 ) (54 ) 204 210 422 3 (327 ) (232 )
Net Debt/EBITDA 0.5x 0.2x (0.5x) (0.7x) (1.3x) (0.0x) 0.9x 0.5x
Source: Barclays Capital, company data.
Figure 49: Drax – Balance sheet (£m)
2008 2009 2010 2011E 2012E 2013E 2014E 2015E
Tangible Fixed Assets 1,136 1,177 1,184 1,167 1,291 1,461 1,625 1,640
Intangible Assets 0 22 44 49 85 195 403 538
Cash/Marketable Securities 130 135 331 220 632 413 283 303
Working Capital Assets 449 403 350 401 412 564 659 560
Other Assets 392 421 138 138 138 138 138 138
Total Assets 2,107 2,159 2,047 1,976 2,558 2,771 3,108 3,179
Short-Term Debt (15 ) (63 ) (62 ) (10 ) (10 ) (10 ) (10 ) (10 )
Long-Term Debt (350 ) (127 ) (65 ) 0 (200 ) (400 ) (600 ) (525 )
Working Capital Liabilities (295 ) (227 ) (285 ) (280 ) (281 ) (284 ) (290 ) (296 )
Provisions (23 ) (39 ) (44 ) (39 ) (34 ) (29 ) (24 ) (19 )
Other Liabilities (731 ) (679 ) (633 ) (423 ) (428 ) (433 ) (438 ) (451 )
Total Liabilities (1,414 ) (1,135 ) (1,089 ) (751 ) (953 ) (1,156 ) (1,362 ) (1,300 )
Shareholders' Equity 693 1,025 958 1,224 1,605 1,615 1,747 1,879
Total Equity 693 1,025 958 1,224 1,605 1,615 1,747 1,879
Source: Barclays Capital, company data.
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2 November 2011 42
COMPANY SNAPSHOT
SSE Integrated Utilities
Income statement (£m) 2011A 2012E 2013E 2014E CAGR
EBITDA, adjusted 2,227 2,398 2,658 2,764 7.5% Stock Rating 2-EQUAL WEIGHT
EBIT, adjusted 1,455 1,533 1,726 1,792 7.2% Sector View 2-NEUTRAL
Pre-tax income, adjusted 1,310 1,382 1,521 1,545 5.7% P rice (31-Oct-2011) £13.44
Net income, adjusted 1,042 1,048 1,152 1,172 4.0% Price Target £12.35
EPS, adjusted (p) 112.3 111.8 122.7 124.6 3.5% Ticker RIC: SSE.L, BB: SSE LN
Diluted shares (m) 929 939 940 942 0.5%
Dividend per share (p) 75.0 79.7 83.6 87.8 5.4% Investment case
Margin and return data (%) Average
EBITDA margin 7.6 8.0 8.6 8.8 8.3
EBIT margin 5.0 5.1 5.6 5.7 5.4
Pre-tax margin 4.5 4.6 4.9 4.9 4.7
Net margin 3.6 3.5 3.7 3.7 3.6
ROIC 11.1 10.7 11.2 11.0 11.0
ROA 6.1 5.9 6.4 6.4 6.2
ROE 25.0 19.7 20.5 19.8 21.2 Upside case £14.45
Balance sheet and cash flow (€m) CAGR
Net PP&E 8,518 9,634 10,534 11,374 10.1%
Total net assets 21,181 22,300 23,217 24,046 4.3%
Capital employed 11,482 12,561 13,392 14,175 7.3%
Shareholders' equity 5,201 5,457 5,774 6,086 5.4%
Adjusted net debt (5,891) (6,801) (7,403) (7,962) NA
Cash flow from operations 1,719 1,520 1,720 1,779 1.1% Downside case £11.05
Capital expenditure (1,444) (1,694) (1,538) (1,515) NA
Free cash flow 276 (174) 182 263 -1.5%
Pre-dividend FCF 10 (174) 182 263 NA
Valuation and leverage metrics AverageP/E (x) 12.0 12.0 11.0 10.8 11.4
EV/EBITDA (x) 8.3 8.1 7.5 7.5 7.8
EV/NOPAT (x) 15.5 15.1 13.8 13.6 14.5 Upside/downside scenarios
Dividend yield (%) 5.6 5.9 6.2 6.5 6.1
FCF yield (%) 2.2 (1.4) 1.4 2.1 1.1
P/BV (x) 2.4 2.3 2.2 2.1 2.3
EV/IC (x) 1.6 1.5 1.5 1.5 1.5
Net debt/EBITDA (x) 3.0 3.2 3.1 3.2 3.1
Selected operating metrics
Payout ratio (%) 66.8 71.3 68.2 70.5
Thermal Cap. (MW) 10,067 9,947 9,947 9,947
Renewable Cap. (MW) 2,445 2,866 3,501 3,692 Source: Thomson Reuters Datastream, Barclays Capital est.
Electricity Product. (TWh) 47.3 41.8 49.1 48.6 Renewable capacity (MW)
Resi. EBIT Margin (%) 9.7 6.3 4.4 6.0
Energy Customers (m) 9.2 9.1 9.0 9.0
RAB - Scotland (£m) 1,459 1,605 2,103 2,362
RAB - England (£m) 1,863 1,988 2,096 2,201
RAB - SGN (£m) 2,122 2,262 2,372 2,483
Source: Company data, Barclays Capital Note: FY end Mar.
Why a 2-EW? We see weak fundamentals in fossil
fuel generation and believe SSE will be at a
competitive disadvantage in the UK energy market,
despite its investment in renewables. However, this
is offset by SSE's exposure to regulated networks.
Our ups ide case ass umes s pa rk s preads rise by
£5/MWh and retail margins by 1%. We assume SSE
trades in line with SOTP.
Our downside case assumes retail margins decline
by a further 1% and SSE derates to 9.2x 2013/14E
P/E.
0
1000
2000
3000
4000
5000
2011A 2012E 2013E 2014E
Renewable Cap. (MW)
Downside
Case
$56
(-33.9%)
Price
Target
$69
(-18.6%)
Upside
Case
$75
(-11.5%)
28
48
68
88
108
9-Nov-09 2-Nov-10
Downside
Case
1105p
(-17.7%)
Price
Target
1235p
(-8.11%)
Upside
Case
1445p
(7.5%)
552
752
952
1152
1352
1552
1752
18-Nov-10 31-Oct-11
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2 November 2011 43
SSE – STILL STRUGGLING FOR MOMENTUM
We see deteriorating fundamentals in SSE’s generation and supply business. Its large
ageing coal and gas fleet is likely to struggle to cover its fixed costs once free CO2
permits expire, and it has less earnings momentum in its UK cleaner generation fleet
than some of its competitors. As a result, we believe SSE will be at a competitivedisadvantage in the UK retail market, which could see market share and margins come
under pressure. However, risk to EPS is mitigated by SSE’s exposure to UK regulated
networks, specifically electricity transmission. We see just 2% downside to consensus
estimates. And whilst we expect a P/E de-rating, the downside is partially offset by a 5.9%
yield and potential for 6-7% dividend growth. We believe the risks to SSE’s shares are
therefore moderate when compared to the risks we see across other integrated utility
names. We initiate coverage with a 2-EW recommendation and a £12.45 price target.
Fossil fuel exposure acts as a drag
SSE has a significant pipeline of investment in clean generation, focused predominantly on wind.
However, our analysis in this report points to a very tough environment for older gas and coal-fired generation. With economic interests in 10GW of older fossil fuel capacity, as well as the
largest free CO2 allocation of the Big 6, we expect SSE’s exposure to dirty generation to hamper
its relative competitive position and act as a drag on overall earnings growth.
Figure 50: Annual EBITDA of 1GW power station on an unhedged basis, excluding free CO2 (£m)
2010 2011E 2012E 2013E 2014E 2015E 2016E
Hard Coal - 36% Efficiency (24.3 ) (11.0 ) 12.2 (6.7 ) (9.2 ) (17.2 ) (24.4 )
CCGT - 49% Efficiency 14.8 (6.4 ) (9.3 ) (10.3 ) (6.4 ) (8.4 ) 2.2
Source: Barclays Capital.
The last free CO2 allocations will be given to UK fossil fuel generators around February
2012. Once these have been used up, we believe owners of older capacity will struggle to
cover fixed costs. Specifically, we believe CCGT plant will be unable to cover its fixed costs
over the period from 2013-15E, while old coal plant will become permanently out-of-the
money from 2013 onwards (Figure 50). Indeed, we believe the period from 2013-15E has
the potential to be punishing for generators with significant exposure to old coal and CCGT
plant. Unfortunately, SSE has material exposure to both.
Figure 51: SSE – Economic interest in generating capacity (MW)
2009 2010 2011 2012E 2013E 2014E 2015E
Hard Coal 3,984 4,211 4,347 4,347 4,347 4,347 3,350
Gas/Oil 4,870 5,224 5,720 5,600 5,600 5,600 5,533
Renewable 2,226 2,375 2,445 2,866 3,501 3,692 3,875
Total 11,080 11,810 12,512 12,813 13,448 13,639 12,758
Source: Barclays Capital, company data.
Competitive disadvantage in UK retail
SSE has been fast to respond to the political and regulatory criticism facing all of the Big 6. It
was the first to end doorstep selling, suspending it in July 2011 after it was found guilty of
mis-selling – the rest of the Big 6 are now following. It has been the first to scrap discounted
internet tariffs, to respond to accusations of predatory pricing by Chris Huhne, the UK
SSE.L / SSE LN
Stock Rating
2-Equal Weight
Sector View
2-Neutral
Price Target
£12.35
Price (31 Oct 2011)
£13.44
Potential Upside / Downside
-8.1%
SSE has been fast to respond to
political pressure…
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2 November 2011 44
Energy Secretary17. It has also written to both its customers and to Huhne, pledging a fairer
deal for its customers.
Whilst these actions may curry favour with politicians, help to increase customer loyalty and
reduce churn at the margin, we do not believe they will be enough to prevent SSE’s
downstream residential supply business from suffering a challenging few years.
As we discuss earlier, our analysis in this report concludes that EdF Energy and, to a lesser
extent, RWE npower have both the earnings momentum and the motivation to drive a more
aggressive pricing strategy in the downstream residential energy market. Unfortunately, the
pressure on earnings in SSE’s fossil fuel generation fleet, as well as the need to earn a return
on capital on its renewables investment means we believe SSE will not be well positioned to
compete on price.
This is already starting to show. SSE had typically priced towards the bottom end of the Big
6, though since the start of 2010, only British Gas has increased tariffs by more (Figure 52).
That now places SSE towards the top of the pack on weighted average sales price ( Figure
53). As a result, we expect SSE to start losing market share in UK downstream retail for the
first time since competition began. Indeed, SSE has flagged in recent analyst meetings that
it had lost customers in 1H11/12.
Renewables growth finally starting to come through
We forecast that FY11/12E will be the fourth consecutive year of sub-3% EPS growth for
SSE (in fact we forecast a 0.5% decline). However, FY12/13E should see a 10% jump in EPS,
as a number of SSE’s high profile wind projects reach commissioning (specifically Clyde,
Griffin, Greater Gabbard and Walney), increasing capacity to SSE’s target of 3.5GW.
Thereafter, we expect that momentum to slow: SSE’s advanced offshore development
pipeline is 1.1GW, and there are no additional offshore wind projects expected to come on
stream before 2015/16 (after which the ROC banding drops to 1.9x, then 1.8x).
17 “It is not fair that big energy companies can push their prices up for the vast majority of their consumers – who do
not switch – while introducing cut-throat offers for new customers that stop small firms entering the market … that looks to me like predatory pricing. It must and will stop” , Chris Huhne’s speech at the Liberal Democrat partyconference, 20 September 2011.
…but commercial pressure will
be more challenging to manage
Figure 52: Average dual fuel price increase since March 2010 Figure 53: Average estimated dual fuel weighted averagesales price* (Index = 100)
26%23% 22% 21% 20%
18%
0%
5%
10%
15%
20%
25%
30%
B r i t i s h G a s
S S E
E . On U K
S c o t t i s h P o w e r
E D F E n e r g y
R WE n p o w e r
112
107 107105
104
100
90
95
100
105
110
115
B r i t i s h G a s
S S E
S c o t t i s h P o w e r
E . OnE n e r g y
R WE n p o w e r
E d F E n e r g y
Source: Barclays Capital, company data. Source: Barclays Capital, company data.
* See note to Figure 29 for methodology and caveats.
We expect SSE to hit its target of
3.5GW renewables in 2013
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2 November 2011 45
SSE is also investigating options to develop cleaner generation at some of its existing coal
plant: it recently received consent to develop up to 108MW multi-fuel project at Ferrybridge,
with potential completion in early 2015, and is developing a project to repower its
Uskmouth plant into a 100MW biomass unit. However, both these projects are small
compared to RWE’s conversion of Tilbury into a 750MW dedicated biomass plant and
Drax’s plans to develop 2GW of co-firing capacity.
Networks underpin earnings
It is important to remember that regulated network activities continue to represent 40% of
SSE’s Adjusted EBIT. These have benefited from high RPI over the last two years, though
Barclays Capital’s economists expect UK RPI to decline from 5.7% y/y in October 2011E to
2.9% in January 2013E. Nonetheless, this could be more than offset by a substantial tariff
increase for Scottish Hydro Electricity Transmission (SHELT) on 1 April 2012 – the TCPR4 18
rollover initial proposal is currently for a 31% real tariff increase – and the potential for
accelerating regulated asset value (RAV) growth. We currently forecast SHELT’s RAV to
grow from £0.5bn in FY10/11 to £1.8bn by FY17/18E. However, SHELT has identified
growth projects that could see RAV hit £3.0bn by FY17/18E even if only 50% of them were
to be allowed by Ofgem.
Figure 54: SSE – Projected RAV growth (£m)
Year ending 31 March 2009 2010 2011 2012E 2013E 2014E 2015E
Southern Electric Power Distribution 1,729 1,820 1,863 1,988 2,096 2,201 2,299
Scottish Hydro Power Distribution 840 869 927 970 1,002 1,031 1,064
Scottish Hydro Electricity Transmission 387 419 533 635 1,101 1,331 1,522
Scotia Gas Networks 1,815 1,959 2,122 2,262 2,372 2,483 2,593
Total RAV 4,770 5,067 5,444 5,855 6,571 7,045 7,478
SHETL upside from 50% business plan growth projects - - - - - 219 520
SHETL upside from 100% business plan growth projects - - - - - 438 1,039
Source: Barclays Capital, company data.
Stable earnings, but balance sheet becoming more stretched
Overall, we believe SSE will have a relatively stable financial outlook from an earnings
perspective, though we believe its balance sheet is becoming more stretched due to a high
ongoing level of capex.
Modest EPS downgrade risk. We believe the ongoing pressures we see in SSE’s
generation and supply business will be largely offset by stronger growth in electricity
transmission. As a result, we currently see only around 2% downside to consensus EPS
estimates for FY11/12E-FY14/15E.
Balance sheet becoming more stretched. Compared to its integrated utility peers, SSE
has relatively high net debt/EBITDA. Whilst one could argue that this is justified given
the large proportion of regulated network activities in its earnings mix, stripping out
networks reveals that net debt/EBITDA in the non-regulated business could grow to
4.2x. However, we believe SSE could mitigate this by financing new wind farm projects
(especially offshore) off balance sheet.
18 Transmission Price Control Review 4
SSE has exposure to UK
electricity transmission upside
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2 November 2011 46
Figure 55: SSE – Adjusted net debt/EBITDA analysis (£m)
Year ending 31 March 2009 2010 2011 2012E 2013E 2014E 2015E
Adjusted Net Debt (5,100 ) (5,292 ) (5,891 ) (6,801 ) (7,403 ) (8,412 ) (9,541 )
of which: Networks @ 70% Debt/RAV (2,069 ) (2,176 ) (2,326 ) (2,515 ) (2,939 ) (3,194 ) (3,419 )
Adjusted Net Debt/EBITDA - Group 3.0x 2.8x 3.0x 3.2x 3.1x 3.2x 3.2x
Adjusted Net Debt/EBITDA - Networks 3.9x 3.7x 3.3x 3.3x 3.5x 3.5x 3.4x
Adjusted Net Debt/EBITDA - Non-Regulated 2.6x 2.7x 3.1x 3.7x 3.8x 4.1x 4.2x
Adjusted Net Debt/EBITDA - Non-Regulated (ex. new offshore) 2.6x 2.7x 3.1x 3.7x 3.8x 4.0x 4.0x
Source: Barclays Capital, company data.
Moderate earnings and dividend growth. We forecast FY11/12-FY14/15E EPS CAGR of
6.9%, and therefore we believe SSE will be able to continue to deliver on its promise of
sustained dividend growth. We forecast DPS to grow at a 6.7% CAGR FY11/12-
FY14/15E.
P/E analysis justifies a £12.35 price target
Our SOTP valuation for SSE is £12.65. However, as with Centrica, we think P/E analysis may
give a clearer indication of where SSE’s shares could trade on a 12-month view.
Figure 56 shows that, over the past five years, SSE has on average traded at a -0.1 point Y+2
P/E discount to the Stoxx Utilities index, with a standard deviation of -0.8 to +0.6. Based on
current consensus 2013E EPS, SSE is trading at 10.5x FY13/14E P/E, compared to an
average Y+2 P/E for the Stoxx Utilities index of 10.0x this year (current Y+2 P/E is 9.9x).
Similar to Centrica, given the deteriorating fundamentals of its generation and supply
activities, we believe SSE should de-rate to at least its historical average discount of -0.1x,
implying a target 2013E P/E of 9.9x. When coupled with our FY13/14E EPS forecast of
124.6p (2% below consensus), this implies a target price of £12.35 – just a 2% discount to
our SOTP valuation.
Figure 56: SSE – average forward P/E premium/discount vs. Stoxx Utilities
-2.0x
-1.5x
-1.0x
-0.5x
0.0x
0.5x
1.0x
1.5x
2.0x
Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11
Y+1 Y+2
SSE has on average traded at a
0.1 point P/E discount to
European Utilities
Source: Bloomberg, Barclays Capital.
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2 November 2011 47
Figure 57: SSE – SOTP valuation (as at 31 December 2011)
£m p/share %EVEV/EBITDA -
2012E
EV/EBITDA -
2014E
CAGR 2012-
15E
Generation - Coal (735 ) (78 ) -4% - - -
Generation - Gas/Oil 120 13 1% - - -
Generation - Renewable 9,197 980 44% - - -
Generation - EUA Allowance 104 11 0% - - -
Supply 4,192 447 20% - - -
Generation and Supply 12,879 1,372 61% 11.5x 10.1x 7.1%
Power Systems - SE Distribution 2,441 260 12% - - -
Power Systems - SH Distribution 1,158 123 6% - - -
Power Systems - SH Transmission 642 68 3% - - -
Scotia Gas Networks 2,332 248 11% - - -
Networks 6,573 700 31% 6.4x 5.5x 7.9%
Other - Gas Storage 346 37 2% - - -
Other - Gas Production 296 31 1% - - -
Other - Contracting, Connections and Metering 745 79 4% 6.0x - -
Other - Telecoms 154 16 1% 6.0x - -
Other - Property and Corporate Services 19 2 0% 6.0x - -
Other 1,559 166 7% 5.8x 5.2x 3.1%
Corporate Costs (32 ) (3 ) 0% 6.0x - -
Enterprise Value 20,980 2,235 - 9.0x 7.8x 7.0%
Net Debt - Adjusted (5,639 ) (601 )
Net Debt - Scotia Gas Networks (1,569 ) (167 )
Net Debt - Hybrid Capital (1,161 ) (124 )
Net Pension Deficit (553 ) (59 )
Provisions (179 ) (19 )
Minorities 0 0
Equity Value 11,878 1,265
Source: Barclays Capital, company data.
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2 November 2011 48
Figure 58: SSE – Financial ratios and valuation multiples
Year ending 31 March 2009 2010 2011 2012E 2013E 2014E 2015E 2016E
EPS/DPS
EPS - Recurrent (p/share) 108.0 110.2 112.3 111.8 122.7 124.6 135.9 129.5
DPS - Total (p/share) 66.0 70.0 75.0 79.7 83.6 87.8 92.2 96.8
Valuation Multiples
P/E (x) - - 12.0x 12.0x 11.0x 10.8x 9.9x 10.4x
EV/EBITDA - exc. Assoc (x) - - 8.7x 8.5x 7.9x 7.8x 7.5x 7.7x
EV/EBITDA - inc. Assoc (x) - - 8.3x 8.1x 7.5x 7.5x 7.2x 7.3x
EV/NOPAT (x) - - 15.5x 15.1x 13.8x 13.6x 12.7x 13.1x
Dividend Yield (%) - - 5.6% 5.9% 6.2% 6.5% 6.9% 7.2%
FCF Yield (%) - - 2.2% -1.4% 1.4% 2.1% 3.7% 4.7%
P/BV (x) - - 2.4x 2.3x 2.2x 2.1x 2.0x 1.9x
EV/IC (x) - - 1.6x 1.5x 1.5x 1.5x 1.4x 1.4x
Financial Ratios
Dividend Payout Ratio (%) 61.1% 63.5% 66.8% 71.3% 68.2% 70.5% 67.9% 74.8%
Adjusted Net Debt/EBITDA (x) 3.0x 2.8x 3.0x 3.2x 3.1x 3.2x 3.2x 3.3x
ROE 32.0% 33.3% 25.0% 19.7% 20.5% 19.8% 20.4% 18.6%
ROIC 13.7% 12.4% 11.1% 10.7% 11.2% 11.0% 11.4% 10.8%
WACC - - 7.0% 7.0% 7.0% 7.0% 7.0% 7.0%
Weighted Ave. Shares (mm) 883 922 928 938 939 941 942 944
Source: Barclays Capital, company data, DataStream.
Figure 59: SSE – Segmental operating profit (£m)
Year ending 31 March 2009 2010 2011 2012E 2013E 2014E 2015E 2016E
Power Systems - Scotland 160 159 168 199 243 264 298 273
Power Systems - England 243 257 287 292 327 357 386 295
Scotia Gas Networks 181 184 187 200 215 210 214 219
Generation and Supply 832 896 883 892 975 987 1,076 1,146
Other Businesses 134 140 137 164 181 189 190 187
Unallocated Expenses (9 ) (10 ) (9 ) (9 ) (9 ) (9 ) (9 ) (9 )
Adjusted EBIT 1,541 1,626 1,653 1,737 1,932 1,998 2,156 2,112
JV & Associate Tax/Interest (168 ) (157 ) (198 ) (204 ) (207 ) (206 ) (211 ) (217 )
Adjusted Operating Profit 1,374 1,469 1,455 1,533 1,726 1,792 1,944 1,895
Growth (%) 13.2% 6.9% -1.0% 5.4% 12.5% 3.9% 8.5% -2.5%
Margin (%) 5.2% 6.6% 5.0% 5.1% 5.6% 5.7% 6.2% 6.0%
Source: Barclays Capital, company data.
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2 November 2011 49
Figure 60: SSE – Income statement (£m)
Year ending 31 March 2009 2010 2011 2012E 2013E 2014E 2015E 2016E
External Revenue 25,424 21,550 28,334 29,020 29,719 30,135 30,265 30,618
Costs (23,799 ) (19,771 ) (26,463 ) (26,996 ) (27,453 ) (27,762 ) (27,725 ) (28,111 )
Associates - EBIT 246 264 299 312 327 322 326 331Adjusted EBITDA 1,872 2,043 2,170 2,336 2,592 2,694 2,866 2,839
Depreciation and Amortisation (330 ) (417 ) (518 ) (599 ) (660 ) (696 ) (710 ) (727 )
Adjusted EBIT 1,541 1,626 1,653 1,737 1,932 1,998 2,156 2,112
Associates - Interest (128 ) (107 ) (140 ) (144 ) (145 ) (145 ) (151 ) (156 )
Adjusted Net Finance Cost (160 ) (229 ) (203 ) (211 ) (266 ) (308 ) (328 ) (352 )
Adjusted PBT 1,254 1,290 1,310 1,382 1,521 1,545 1,677 1,604
Associates - Tax (12 ) (16 ) (23 ) (24 ) (26 ) (26 ) (25 ) (25 )
Current Tax (289 ) (258 ) (245 ) (262 ) (296 ) (300 ) (324 ) (308 )
Effective Tax Rate (%) 24.0% 21.2% 20.3% 19.0% 19.0% 19.0% 19.0% 19.0%
Minority Interests 0 (0 ) 0 0 0 0 0 0
Hybrid Capital 0 0 0 (47 ) (47 ) (47 ) (47 ) (47 )
Adjusted Net Income 953 1,016 1,042 1,048 1,152 1,172 1,280 1,223
Growth (%) 4.5% 6.6% 2.6% 0.6% 9.9% 1.7% 9.3% -4.5%
Margin (%) 3.6% 4.5% 3.6% 3.5% 3.7% 3.7% 4.1% 3.8%
Continuing EPS - Basic (p) 12.7 134.0 162.2 105.8 117.3 120.6 130.3 124.3
Continuing EPS - Adjusted (p) 108.0 110.2 112.3 111.8 122.7 124.6 135.9 129.5
Growth (%) 2.3% 2.0% 1.9% -0.5% 9.8% 1.5% 9.0% -4.7%
DPS - Interim (p) 19.8 21.0 22.4 24.2 25.5 26.7 28.1 29.5
DPS - Final (p) 46.2 49.0 52.6 55.5 58.1 61.1 64.1 67.3DPS - Total (p) 66.0 70.0 75.0 79.7 83.6 87.8 92.2 96.8
Growth - Ordinary DPS (%) 9.1% 6.1% 7.1% 6.2% 5.0% 5.0% 5.0% 5.0%
Payout Ratio (%) 61.1% 63.5% 66.8% 71.3% 68.2% 70.5% 67.9% 74.8%
Source: Barclays Capital, company data.
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Figure 61: SSE – Cash flow (£m)
Year ending 31 March 2009 2010 2011 2012E 2013E 2014E 2015E 2016E
Operating Profit 1,398 1,362 1,354 1,425 1,605 1,676 1,830 1,781
Depreciation, Amortisation and Impairment Losses 330 417 518 599 660 696 710 727
Change in Working Capital (1,218 ) 525 324 0 0 0 0 0Changes in Provisions/Other Non-Cash Items (193 ) (90 ) (88 ) (88 ) (88 ) (88 ) (88 ) (88 )
Dividends from Associates 40 22 82 54 60 58 57 57
Income Tax (145 ) (239 ) (277 ) (236 ) (278 ) (309 ) (333 ) (349 )
Net Interest (259 ) (308 ) (194 ) (235 ) (240 ) (255 ) (282 ) (300 )
Operating Cash Flow (46 ) 1,689 1,719 1,520 1,720 1,779 1,894 1,828
Capital Expenditure (1,280 ) (1,315 ) (1,444 ) (1,694 ) (1,538 ) (1,515 ) (1,426 ) (1,231 )
Free Cash Flow (1,326 ) 374 276 (174 ) 182 263 467 596
Acquisitions and Disposals 82 (86 ) (275 ) 0 0 0 0 0
Change in Equity 480 7 9 0 0 0 0 0
Dividends Paid to Shareholders/Minorities (552 ) (619 ) (514 ) (736 ) (784 ) (822 ) (865 ) (908 )
Net Cash Flow (1,316 ) (323 ) (504 ) (910 ) (602 ) (559 ) (397 ) (312 )
Other Movements in Net Debt (118 ) 131 (95 ) 0 0 0 0 0
Adjusted Net Cash/(Debt) (5,100 ) (5,292 ) (5,891 ) (6,801 ) (7,403 ) (7,962 ) (8,359 ) (8,671 )
Net Debt/EBITDA 3.0x 2.8x 3.0x 3.2x 3.1x 3.2x 3.2x 3.3x
Source: Barclays Capital, company data.
Figure 62: SSE - Balance sheet (£m)
Year ending 31 March 2009 2010 2011 2012E 2013E 2014E 2015E 2016E
Tangible Fixed Assets 7,232 8,209 8,518 9,634 10,534 11,374 12,112 12,638
Intangible Assets 977 1,015 973 952 930 909 887 866
Investments 937 1,615 1,925 1,979 2,039 2,097 2,155 2,212
Cash/Marketable Securities 296 262 477 448 426 377 310 202
Working Capital Assets 6,026 4,723 5,286 5,286 5,286 5,286 5,286 5,286
Other Assets 2,301 2,305 4,003 4,003 4,003 4,003 4,003 4,003
Total Assets 17,769 18,128 21,181 22,300 23,217 24,046 24,752 25,206
Short-Term Debt (1,060 ) (904 ) (447 ) (447 ) (447 ) (447 ) (447 ) (447 )
Long-Term Debt (4,336 ) (5,143 ) (5,160 ) (6,041 ) (6,621 ) (7,132 ) (7,461 ) (7,665 )
Working Capital Liabi li ties (4,791 ) (4,389 ) (5,382 ) (5,269 ) (5,170 ) (5,081 ) (4,988 ) (4,903 )
Provisions (348 ) (810 ) (848 ) (848 ) (848 ) (848 ) (848 ) (848 )
Other Liabilities (4,260 ) (3,761 ) (4,413 ) (4,509 ) (4,628 ) (4,722 ) (4,829 ) (4,899 )
Total Liabilities (14,794 ) (15,007 ) (16,250 ) (17,113 ) (17,713 ) (18,229 ) (18,572 ) (18,761 )
Shareholders' Equity 2,977 3,125 5,201 5,457 5,774 6,086 6,449 6,714
Minority Interest/Other (2 ) (4 ) 0 0 0 0 0 0
Total Equity 2,975 3,121 5,201 5,457 5,774 6,086 6,449 6,714
Source: Barclays Capital, company data.
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COMPANY SNAPSHOT
NATIONAL GRID European Utilities
Income statement (£m) 2010A 2011E 2012E 2013E CAGR
EBITDA 4,291 4,906 5,071 5,533 8.8% Stock Rating 1-OVERWEIGHT
EBIT 3,121 3,600 3,638 3,970 8.3% Sector View 2-NEUTRAL
Pre-tax income 1,974 2,473 2,545 2,696 11.0% P rice (31-Oct-2011) 618p
Net income 1,421 1,751 1,781 1,887 9.9% Price Target 680p
EPS (p) 50.2 51.7 49.9 51.9 1.1% Ticker NG/ LN
Diluted shares (m) 2,476 3,374 3,549 3,614 13.4%
Dividend per share (p) 38.5 36.4 39.3 40.1 1.4% Investment case
Margin and return data (%) Average
EBITDA margin 30.6 34.2 34.0 35.7 33.6
EBIT margin 22.3 25.1 24.4 25.6 24.3
Pre-tax margin 14.1 13.8 16.6 16.4 15.2
Net margin 10.1 12.2 12.0 12.2 11.6
ROIC 8.5 9.3 8.7 8.7 8.8
ROA 3.9 4.7 4.5 4.4 4.4
ROE 33.7 19.3 17.9 17.6 22.1 Upside case 720p
Balance sheet and cash flow (£m) CAGR
Net PP&E 36,994 37,961 40,177 42,862 5.0%
Total net assets 36,153 37,596 39,797 42,468 5.5%
Capital employed 26,350 27,769 30,020 32,741 7.5%
Shareholders' equity 4,211 9,069 9,976 10,746 36.7%
Net debt (22,139) (18,700) (20,045) (21,994) NA
Operating cash flow 3,275 3,454 3,031 3,389 1.1% Downside case 590p
Capital expenditure (3,176) (3,600) (3,649) (4,249) NA
Free cash flow (589) (968) (1,632) (1,950) NA
Pre-dividend FCF 99 (146) (618) (860) NA
Valuation and leverage metrics AverageP/E (x) 12.3 12.0 12.4 11.9 12.1
EV/EBITDA (x) 9.4 8.7 8.9 8.6 8.9
EV/EBIT (x) 13.0 11.8 12.4 11.9 12.3 Upside/downside scenarios
FCF yield (%) -3.8 -4.6 -7.4 -8.7 -6.2
Price/BV (x) 3.6 2.3 2.2 2.1 2.6
Dividend yield (%) 6.2 5.9 6.4 6.5 6.2
Total debt/capital (%) 84.0 67.3 66.8 67.2 71.3
Net debt/EBITDA (x) 5.2 3.8 4.0 4.0 4.2
Selected operating metrics CAGR
Dividend payout ratio 76.7 70.4 78.7 77.2
Interest cover 2.70 3.17 3.31 3.45
UK RAV (£m) 18,940 20,348 22,365 24,922 9.6% Source: Thomson Reuters Datastream, Barclays Capital est.
US Asset Base (£m) 9,788 9,241 10,236 10,817 3.4% EBITDA (£m) and ROIC
Premium to RAV (%) 2.14 5.89 3.23 0.80 -28.0%
Source: Company data, Barclays Capital Note: FY end March.
Why 1-Overweight? NG benefits from diversification
by activity (mainly transmission and distribution)
and geography (UK and US). The dividend policy,
together with growth in the regulatory asset base,
posi tions NG as the most attractive inves tment
opportunity within European regulated utilities, in
our view.
We assume unchanged blended returns in the UK
post RIIO introduction, a target ROE for US activities
of10%, an increase of100bpsin domestic RPI and a
decline of 100bps in 10- year bond yields.
We assume a cut in the blended return on UK assets
post RIIO of 200bps , an unchanged ROE for US
activities, a decline of 200bps in domestic RPI and an
increase of 200bps in 10-year bond yields.
0
1000
2000
3000
4000
5000
6000
2010A 2011E 2012E 2013E
5%
6%
7%
8%
9%
10%EBITDA ROIC
Downside
Case
610p
(-0.73%)
Price
Target
640p
(4.1%)
Upside
Case
670p
(9.0%)
242
342
442
542
642
742
18-Nov-10 31-Oct-11
Downside
Case
590p
(-4.14%)
Price
Target
680p
(10.4%)
Upside
Case
720p
(16.9%)
242
342
442
542
642
742
842
18-Nov-10 31-Oct-11
Downside
Case
590p
(-4.45%)
Price
Target
680p
(10.1%)
Upside
Case
720p
(16.5%)
265
365
465
565
665
765
865
18-Nov-10 31-Oct-11
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2 November 2011 53
NATIONAL GRID – PROACTIVE ASSET MANAGEMENT STARTED
For exposure to UK electricity transmission, our preferred play remains National Grid.
The RIIO regulatory review, which will define new tariffs from April 2013, enters into its
central phase in the second half of next year. Preparing for that, the company has
already started to follow a strategy of asset rationalisation, which will result, in ourview, in a cleaner structure and more focused business lines. In the medium term, we
see two main drivers of performance for the stock: 1) the implementation a regulatory
framework which should stimulate rapid RAV growth; 2) a financing strategy with
ongoing asset rationalisation aimed at achieving the highest possible blended return on
the company’s invested capital. Our rating on National Grid remains 1-OW.
RIIO will be something for next year
The ongoing review, which will regulate tariffs from 1st April 2013, will be finalised during
the second half of 2012. What emerged from recent publications from National Grid and the
regulator is that the system will require £30.7bn of new investments into networks. This
could translate into very significant UK Transmission RAV growth.
Figure 63: National Grid’s RAV evolution - Transmission
0
5,000
10,000
15,000
20,000
25,000
30,000
2012/13E 2014/15E 2016/2017E 2018/2019E 2020/2021E
Gas Electrici ty
Source: National Grid, Ofgem, Barclays Capital
We therefore expect Ofgem to create a balanced structure allowing companies to maintain
attractive rate of returns and where future increases for customers will be compensated by
effective improvements in the level of service. For this reason, we think that the base
allowed return is just one, important but single, component of the equation and that the
new RIIO system will have to be judged in its entire form, including incentives and
transitional arrangements.
Before year end, National Grid will face a small regulatory review; the rollover until March
2013 of the current framework. The final proposals will be out on 21 st November and, as
pointed out in our report “ Constructive TPCR4 Rollover ” , 2 August 2011, we believe it is the
firm intention of the regulator to minimise regulatory changes; we therefore expect a broad
confirmation of the structure, incentives and base return. In our model, we factor in just a
small fine-tuning of the vanilla return for transmission activities, from the current 5.05%
down to 4.75% on a change to the base risk free rate.
NG.L / NG/ LN
Stock Rating
1-Overweight
Sector View
2-Neutral
Price Target
£6.80
Price (31 Oct 2011)
£6.18
Potential Upside / Downside
10.1%
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2 November 2011 54
US rate cases likely in 2012 as well
Also in 2012, we anticipate that the company will file a general rate case in New York and
Rhode Island for both Niagara Mohawk and Narragansett. These two subsidiaries constitute
the US assets that continue to under earn their allowed returns. Management structure
realignment by regulatory region and their $200 million cost cutting programme should
both bolster regulatory relationships and show the intent of the company to do its part tokeep cost of service reasonable. We believe this should provide a framework for
constructive regulatory outcomes in both regions by 2013. However, if these regulatory
outcomes are not satisfactory, we would not be surprised if the company began to think
strategically about the long-term viability of its two under-earning US assets. That said, we
continue to believe that a wholesale disposal of the entire US business remains off the table.
Now we see the company focused on asset rationalisation
We believe National Grid’s strategy will continue to focus on asset rationalisation. Recently
the company announced the disposal of OnStream, a small part of its metering business, for
a total consideration of £274.3m, which pointed to solid implied multiples19. In addition, the
company has also disposed of non-core assets in the US. On 8 December 2010, National
Grid sold Granite State Electric and Energy North in New Hampshire to Algonquin Power &
Utilities for £178m, which represented a solid implied multiple of 11.9x 31 March 2010
EBITDA. Also, on 26 September 2011 the company sold Seneca-Upshur Petroleum to PDC
Mountaineer for approximately £95m.
Those two transactions, even if small, in our opinion support the group’s intention to
maximise implied IRRs in its portfolio of activities and we think this rationalisation process
will continue with the aim to fund better returns assets with the proceeds.
We continue to be positive on the stock
We do not see a risk of a short-term need of capital and we believe that the RIIO system can
offer the right mechanisms to stimulate investments without diluting shareholder returns.
Among regulated utilities, we think that National Grid represents an attractive equity story
where future investments will fuel growth and the company, uniquely in the European
market, is in a ramp-up phase of its capex rather than living in more mature markets.
Figure 64: Pan-European regulated energy utility valuation multiples
Company Rating
Target
Price
Current
Price
Potential up
/(downside)Div. Yield TSR Dividend Payout Ratio
2011E 2012E 2013E 2011E 2011E 2012E 2013E
Enagas 1-OW € 16.50 € 14.27 15.6% 6.1% 6.6% 7.0% 21.8% 60.0% 60.0% 60.0%
National Grid 1-OW £6.80 £6.18 10.1% 6.1% 6.4% 6.5% 16.2% 74.9% 76.2% 93.1%
Red Electrica 2-EW € 39.00 € 34.98 11.5% 4.9% 5.7% 6.6% 16.4% 60.5% 60.5% 60.5%REN 2-EW € 2.50 € 2.10 18.9% 8.2% 8.3% 8.5% 27.1% 85.2% 82.3% 83.0%
Snam RG 1-OW € 3.80 € 3.52 7.9% 6.8% 6.9% 7.2% 14.7% 85.2% 82.3% 83.0%
Terna 1-OW € 3.15 € 2.77 13.9% 7.6% 6.9% 6.9% 21.5% 114.8% 99.4% 96.2%
Average 13.0% 6.6% 6.8% 7.1% 19.6% 80.1% 76.8% 79.3%
Source: Barclays Capital, Thomson Reuters. Shares prices as at 31 October 2011.
19 We estimate an implied EV/EBITDA March 12 of 7.3x.
We expect constructive
regulatory outcomes
NG has an ongoing asset
disposal strategy
We reiterate our 1-OW
recommendation
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Valuation Methodology and Risks
European Utilities
Centrica (CNA LN / CNA.L)
Valuation Methodology: We value Centrica using a SOTP based on divisional DCF models. We assume a 5.0% long-term BGRE EBIT margin andmarked-to-market commodity prices. We use a post-tax nominal WACC of 7.7%, reflecting Centrica's relatively low gearing. However, given
challenging market conditions, we believe Centrica is likely to trade at a discount to SOTP. Based on its historic valuation range relative to theStoxx Utilities, we believe Centrica should trade on 9.5x 2013E P/E. This is how we derive our £2.60 price target.
Risks which May Impede the Achievement of the Price Target: The outlook for Centrica's earnings and valuation is dependant on a number of factors, most notable the evolution of energy prices. In the short-term, a fall in wholesale energy prices would improve Centrica's competitiveposition, though in the long-term it would reduce valuation in our view. A more benign regulatory environment would allow Centrica to earn ahigher than expected retail margin. On the downside, growing competition, slowing economic growth or regulatory risk may inhibit futuregrowth both in the UK and US.
Drax Group (DRX LN / DRX.L)
Valuation Methodology: We value Drax based on a DCF valuation model. We assume a 7.6% post-tax WACC and mark our commodity priceassumptions to market. Our central scenario assumes that Drax converts to 50% biomass co-firing by 2015, with biomass costs at 2.2x coal onaverage. However, we also assign a 15% probability to Drax converting to 100% biomass by 2020. In combination, this leads to a £6.75 pricetarget.
Risks which May Impede the Achievement of the Price Target: Drax is a risky stock and several uncertainties remain, which could trigger bothupside and downside risks: 1) future ROC bandings or feed-in tariff support; 2) the level of capex required to convert the plant; 3) technical
uncertainties, including the impact of conversion on thermal efficiency; 4) capital structure; 5) biomass availability and price; 6) the overall levelof power prices. Drax's DCF is highly sensitive to these assumptions.
SSE (SSE LN / SSE.L)
Valuation Methodology: We value SSE using a SOTP based on divisional DCF models. We assume a 5.0% long-term retail margin and marked-to-market commodity prices. We use a post-tax nominal WACC of 7.0%. However, given challenging market conditions, we believe SSE is likelyto trade at a discount to SOTP. Based on its historic valuation range relative to the Stoxx Utilities, we believe SSE should trade on 9.9x 2013E P/E.This is how we derive our £12.35 price target.
Risks which May Impede the Achievement of the Price Target: SSE's power generation business is exposed to spark spreads, dark spreads andabsolute power prices. These could drive both upside and downside to the shares. SSE's network assets are exposed to UK RPI, and haveupcoming regulatory reviews which could alter returns. SSE's balance sheet is relatiev stretched which could impede future investments. SSE's UKsupply business is at risk should aggressive price competition break out.
Source: Barclays Capital
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ANALYST(S) CERTIFICATION(S)
We, Peter Bisztyga, Monica Girardi, Julie Arav, Susanna Invernizzi, Harry Wyburd, Daniel Ford, CFA and Ross A. Fowler, CFA, hereby certify (1) thatthe views expressed in this research report accurately reflect our personal views about any or all of the subject securities or issuers referred to inthis research report and (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or viewsexpressed in this research report.
IMPORTANT DISCLOSURES CONTINUED
For current important disclosures, including, where relevant, price target charts, regarding companies that are the subject of this research report,please send a written request to: Barclays Capital Research Compliance, 745 Seventh Avenue, 17th Floor, New York, NY 10019 or refer tohttp://publicresearch.barcap.com or call 1-212-526-1072.
The analysts responsible for preparing this research report have received compensation based upon various factors including the firm's totalrevenues, a portion of which is generated by investment banking activities.
Research analysts employed outside the US by affiliates of Barclays Capital Inc. are not registered/qualified as research analysts with FINRA.These analysts may not be associated persons of the member firm and therefore may not be subject to NASD Rule 2711 and incorporated NYSERule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst’saccount.
Barclays Capital produces a variety of research products including, but not limited to, fundamental analysis, equity-linked analysis, quantitativeanalysis, and trade ideas. Recommendations contained in one type of research product may differ from recommendations contained in othertypes of research products, whether as a result of differing time horizons, methodologies, or otherwise.
Primary Stocks (Ticker, Date, Price)
Centrica (CNA.L, 31-Oct-2011, GBP 2.97), 3-Underweight/2-Neutral
Drax Group (DRX.L, 31-Oct-2011, GBP 5.43), 1-Overweight/2-Neutral
National Grid Plc (NG.L, 31-Oct-2011, GBP 6.18), 1-Overweight/2-Neutral
SSE (SSE.L, 31-Oct-2011, GBP 13.44), 2-Equal Weight/2-Neutral
Materially Mentioned Stocks (Ticker, Date, Price)
E.ON (EONGn.DE, 31-Oct-2011, EUR 17.51), 3-Underweight/2-Neutral
Enagas SA (ENAG.MC, 31-Oct-2011, EUR 14.27), 1-Overweight/2-Neutral
Endesa S.A. (ELE.MC, 31-Oct-2011, EUR 17.26), 1-Overweight/2-Neutral
Enel SpA (ENEI.MI, 31-Oct-2011, EUR 3.41), 1-Overweight/2-Neutral
Fortum (FUM1V.HE, 31-Oct-2011, EUR 17.63), 2-Equal Weight/2-Neutral
Gas Natural SDG SA (GAS.MC, 31-Oct-2011, EUR 13.49), 2-Equal Weight/2-Neutral
GDF Suez SA (GSZ.PA, 31-Oct-2011, EUR 20.52), 3-Underweight/2-Neutral
Iberdrola SA (IBE.MC, 31-Oct-2011, EUR 5.26), 3-Underweight/2-Neutral
International Power Plc (IPR.L, 31-Oct-2011, GBP 3.38), 1-Overweight/2-Neutral
Red Electrica Corporacion SA (REE.MC, 31-Oct-2011, EUR 34.98), 2-Equal Weight/2-Neutral
Redes Energeticas Nacionais (RENE.LS, 31-Oct-2011, EUR 2.10), 2-Equal Weight/2-Neutral
RWE (RWEG.DE, 31-Oct-2011, EUR 30.95), 3-Underweight/2-Neutral
Snam Rete Gas SpA (SRG.MI, 31-Oct-2011, EUR 3.52), 1-Overweight/2-Neutral
Terna SpA (TRN.MI, 31-Oct-2011, EUR 2.77), 1-Overweight/2-Neutral
Verbund (VERB.VI, 31-Oct-2011, EUR 21.04), 2-Equal Weight/2-Neutral
Other Material Conflicts
GSZ.PA: Barclays Capital is acting as advisor to GDF Suez SA on the proposed joint sale of 10% of GDF Suez LNG Liquefaction SA and of a 30%minority stake in GDF SUEZ E&P International SAS to China Investment Corporation
Barclays Capital is acting as advisor to GDF Suez SA on the proposed sale of the 22.5% stake in Elgin Franklin Oil & Gas Limited owned by GDFSUEZ to ENI S.p.A
Guide to the Barclays Capital Fundamental Equity Research Rating System:
Our coverage analysts use a relative rating system in which they rate stocks as 1-Overweight, 2-Equal Weight or 3-Underweight (see definitionsbelow) relative to other companies covered by the analyst or a team of analysts that are deemed to be in the same industry sector (the “sectorcoverage universe”).
In addition to the stock rating, we provide sector views which rate the outlook for the sector coverage universe as 1-Positive, 2-Neutral or 3-
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IMPORTANT DISCLOSURES CONTINUED
Negative (see definitions below). A rating system using terms such as buy, hold and sell is not the equivalent of our rating system. Investorsshould carefully read the entire research report including the definitions of all ratings and not infer its contents from ratings alone.
Stock Rating
1-Overweight - The stock is expected to outperform the unweighted expected total return of the sector coverage universe over a 12-monthinvestment horizon.
2-Equal Weight - The stock is expected to perform in line with the unweighted expected total return of the sector coverage universe over a 12-month investment horizon.
3-Underweight - The stock is expected to underperform the unweighted expected total return of the sector coverage universe over a 12-monthinvestment horizon.
RS-Rating Suspended - The rating and target price have been suspended temporarily due to market events that made coverage impracticable orto comply with applicable regulations and/or firm policies in certain circumstances including when Barclays Capital is acting in an advisorycapacity in a merger or strategic transaction involving the company.
Sector View
1-Positive - sector coverage universe fundamentals/valuations are improving.
2-Neutral - sector coverage universe fundamentals/valuations are steady, neither improving nor deteriorating.
3-Negative - sector coverage universe fundamentals/valuations are deteriorating.
Below is the list of companies that constitute the "sector coverage universe":
European Utilities
Centrica (CNA.L) Drax Group (DRX.L) E.ON (EONGn.DE)
Enagas SA (ENAG.MC) Endesa S.A. (ELE.MC) Enel SpA (ENEI.MI)
Fortum (FUM1V.HE) Gas Natural SDG SA (GAS.MC) GDF Suez SA (GSZ.PA)
Iberdrola SA (IBE.MC) International Power Plc (IPR.L) National Grid Plc (NG.L)
Red Electrica Corporacion SA (REE.MC) Redes Energeticas Nacionais (RENE.LS) RWE (RWEG.DE)
Snam Rete Gas SpA (SRG.MI) SSE (SSE.L) Terna SpA (TRN.MI)
Verbund (VERB.VI)
Distribution of Ratings:
Barclays Capital Inc. Equity Research has 1916 companies under coverage.
44% have been assigned a 1-Overweight rating which, for purposes of mandatory regulatory disclosures, is classified as a Buy rating; 56% of companies with this rating are investment banking clients of the Firm.
41% have been assigned a 2-Equal Weight rating which, for purposes of mandatory regulatory disclosures, is classified as a Hold rating; 49% o f companies with this rating are investment banking clients of the Firm.
12% have been assigned a 3-Underweight rating which, for purposes of mandatory regulatory disclosures, is classified as a Sell rating; 35% of companies with this rating are investment banking clients of the Firm.
Guide to the Barclays Capital Price Target:
Each analyst has a single price target on the stocks that they cover. The price target represents that analyst's expectation of where the stock willtrade in the next 12 months. Upside/downside scenarios, where provided, represent potential upside/potential downside to each analyst's pricetarget over the same 12-month period.
Barclays Capital offices involved in the production of equity research:
London
Barclays Capital, the investment banking division of Barclays Bank PLC (Barclays Capital, London)
New York
Barclays Capital Inc. (BCI, New York)
Tokyo
Barclays Capital Japan Limited (BCJL, Tokyo)
São Paulo
Banco Barclays S.A. (BBSA, São Paulo)
Hong Kong
Barclays Bank PLC, Hong Kong branch (Barclays Bank, Hong Kong)
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IMPORTANT DISCLOSURES CONTINUED
Toronto
Barclays Capital Canada Inc. (BCC, Toronto)
Johannesburg
Absa Capital, a division of Absa Bank Limited (Absa Capital, Johannesburg)
Mexico City
Barclays Bank Mexico, S.A. (BBMX, Mexico City)
Taiwan
Barclays Capital Securities Taiwan Limited (BCSTW, Taiwan)
Seoul
Barclays Capital Securities Limited (BCSL, Seoul)
Mumbai
Barclays Securities (India) Private Limited (BSIPL, Mumbai)
Singapore
Barclays Bank PLC, Singapore branch (Barclays Bank, Singapore)
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IMPORTANT DISCLOSURES CONTINUED
Centrica (CNA LN / CNA.L) Stock Rating Sector View
GBP 2.97 (31-Oct-2011) 3-UNDERWEIGHT 2-NEUTRAL
Rating and Price Target Chart - GBP (as of 31-Oct-2011) Currency=GBP
Date Closing Price Rating Price Target
18-Jul-2011 3.19 1-Overweight 3.70
10-May-2011 3.09 3.20
Closing Price Target Price Rating Change
Jan-09 Jul- 09 Jan-10 Jul- 10 Jan-11 Jul- 11
2.00
2.25
2.50
2.75
3.00
3.25
3.50
3.75
21-Jun-2010 3.03 3-Underweight 2.95
Link to Barclays Capital Live for interactive charting
Barclays Bank PLC and/or an affiliate has received compensation for investment banking services from Centrica in the past 12 months.
Barclays Bank PLC and/or an affiliate trades regularly in the securities of Centrica.
Barclays Bank PLC and/or an affiliate has received non-investment banking related compensation from Centrica within the past 12 months.
Centrica is, or during the past 12 months has been, an investment banking client of Barclays Bank PLC and/or an affiliate.
Centrica is, or during the past 12 months has been, a non-investment banking client (securities related services) of Barclays Bank PLC and/or anaffiliate.
Valuation Methodology: We value Centrica using a SOTP based on divisional DCF models. We assume a 5.0% long-term BGRE EBIT margin andmarked-to-market commodity prices. We use a post-tax nominal WACC of 7.7%, reflecting Centrica's relatively low gearing. However, givenchallenging market conditions, we believe Centrica is likely to trade at a discount to SOTP. Based on its historic valuation range relative to theStoxx Utilities, we believe Centrica should trade on 9.5x 2013E P/E. This is how we derive our £2.60 price target.
Risks which May Impede the Achievement of the Price Target: The outlook for Centrica's earnings and valuation is dependant on a number of factors, most notable the evolution of energy prices. In the short-term, a fall in wholesale energy prices would improve Centrica's competitiveposition, though in the long-term it would reduce valuation in our view. A more benign regulatory environment would allow Centrica to earn ahigher than expected retail margin. On the downside, growing competition, slowing economic growth or regulatory risk may inhibit futuregrowth both in the UK and US.
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IMPORTANT DISCLOSURES CONTINUED
Drax Group (DRX LN / DRX.L) Stock Rating Sector View
GBP 5.43 (31-Oct-2011) 1-OVERWEIGHT 2-NEUTRAL
Rating and Price Target Chart - GBP (as of 31-Oct-2011) Currency=GBP
Date Closing Price Rating Price Target
19-Jan-2011 3.95 3-Underweight
25-May-2010 3.26 2-Equal Weight
Closing Price Target Price Rating Change
Jan-09 Jul- 09 Jan-10 Jul- 10 Jan-11 Jul- 11
3.0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
30-Mar-2010 3.80 3-Underweight 3.20
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Barclays Bank PLC and/or an affiliate has received compensation for investment banking services from Drax Group in the past 12 months.
Barclays Bank PLC and/or an affiliate trades regularly in the securities of Drax Group.
Barclays Bank PLC and/or an affiliate has received non-investment banking related compensation from Drax Group within the past 12 months.
Drax Group is, or during the past 12 months has been, an investment banking client of Barclays Bank PLC and/or an affiliate.
Drax Group is, or during the past 12 months has been, a non-investment banking client (securities related services) of Barclays Bank PLC and/oran affiliate.
Valuation Methodology: We value Drax based on a DCF valuation model. We assume a 7.6% post-tax WACC and mark our commodity priceassumptions to market. Our central scenario assumes that Drax converts to 50% biomass co-firing by 2015, with biomass costs at 2.2x coal onaverage. However, we also assign a 15% probability to Drax converting to 100% biomass by 2020. In combination, this leads to a £6.75 pricetarget.
Risks which May Impede the Achievement of the Price Target: Drax is a risky stock and several uncertainties remain, which could trigger bothupside and downside risks: 1) future ROC bandings or feed-in tariff support; 2) the level of capex required to convert the plant; 3) technicaluncertainties, including the impact of conversion on thermal efficiency; 4) capital structure; 5) biomass availability and price; 6) the overall levelof power prices. Drax's DCF is highly sensitive to these assumptions.
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IMPORTANT DISCLOSURES CONTINUED
National Grid Plc (NG/ LN / NG.L) Stock Rating Sector View
GBP 6.18 (31-Oct-2011) 1-OVERWEIGHT 2-NEUTRAL
Rating and Price Target Chart - GBP (as of 31-Oct-2011) Currency=GBP
Date Closing Price Rating Price Target
19-May-2011 6.22 6.80
19-Jan-2011 5.31 6.40
18-Nov-2010 5.88 6.20
15-Nov-2010 5.90 6.15
26-Jul-2010 5.09 5.80
Closing Price Target Price Rating Change
Jan-09 Jul- 09 Jan-10 Jul- 10 Jan-11 Jul- 11
4.75
5.00
5.25
5.50
5.75
6.00
6.25
6.50
6.75
7.00
7.25
7.50
19-Apr-2010 6.49 1-Overweight 6.74
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Barclays Bank PLC and/or an affiliate has been lead manager or co-lead manager of a publicly disclosed offer of securities of National Grid Plc inthe previous 12 months.
Barclays Bank PLC and/or an affiliate has received compensation for investment banking services from National Grid Plc in the past 12 months.
Barclays Bank PLC and/or an affiliate expects to receive or intends to seek compensation for investment banking services from National Grid Plcwithin the next 3 months.
Barclays Bank PLC and/or an affiliate beneficially owns 1% or more of any class of common equity securities of National Grid Plc.
Barclays Bank PLC and/or an affiliate trades regularly in the securities of National Grid Plc.
Barclays Bank PLC and/or an affiliate has received non-investment banking related compensation from National Grid Plc within the past 12months.
National Grid Plc is, or during the past 12 months has been, an investment banking client of Barclays Bank PLC and/or an affiliate.
National Grid Plc is, or during the past 12 months has been, a non-investment banking client (securities related services) of Barclays Bank PLCand/or an affiliate.
Valuation Methodology: We value National Grid with a SOTP approach. UK regulated activities are valued with an RAV-adjusted approach, USassets with EV/EBITDA multiples differentiated by businesses and not regulated activities at DCF or multiples as appropriate. Net debt is includedat book value.
Risks which May Impede the Achievement of the Price Target: National Grid financials and valuation are based on current tariffs. A change tothe regulatory framework might affect our estimates.
Other Material Conflicts: Barclays Capital, the Investment Banking Division of Barclays Bank PLC, is acting as corporate broker to National GridPlc.
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IMPORTANT DISCLOSURES CONTINUED
SSE (SSE LN / SSE.L) Stock Rating Sector View
GBP 13.44 (31-Oct-2011) 2-EQUAL WEIGHT 2-NEUTRAL
Rating and Price Target Chart - GBP (as of 31-Oct-2011) Currency=GBP
Closing Price
Jan-09 Jul- 09 Jan-10 Jul- 10 Jan-11 Jul- 11
14
16
18
20
22
24
Date Closing Price Rating Price Target
Link to Barclays Capital Live for interactive charting
Barclays Bank PLC and/or an affiliate has been lead manager or co-lead manager of a publicly disclosed offer of securities of SSE in the previous12 months.
Barclays Bank PLC and/or an affiliate has received compensation for investment banking services from SSE in the past 12 months.
Barclays Bank PLC and/or an affiliate beneficially owns 1% or more of any class of common equity securities of SSE.
Barclays Bank PLC and/or an affiliate trades regularly in the securities of SSE.
Barclays Bank PLC and/or an affiliate has received non-investment banking related compensation from SSE within the past 12 months.
SSE is, or during the past 12 months has been, an investment banking client of Barclays Bank PLC and/or an affiliate.
SSE is, or during the past 12 months has been, a non-investment banking client (securities related services) of Barclays Bank PLC and/or anaffiliate.
Valuation Methodology: We value SSE using a SOTP based on divisional DCF models. We assume a 5.0% long-term retail margin and marked-to-market commodity prices. We use a post-tax nominal WACC of 7.0%. However, given challenging market conditions, we believe SSE is likelyto trade at a discount to SOTP. Based on its historic valuation range relative to the Stoxx Utilities, we believe SSE should trade on 9.9x 2013E P/E.This is how we derive our £12.35 price target.
Risks which May Impede the Achievement of the Price Target: SSE's power generation business is exposed to spark spreads, dark spreads andabsolute power prices. These could drive both upside and downside to the shares. SSE's network assets are exposed to UK RPI, and haveupcoming regulatory reviews which could alter returns. SSE's balance sheet is relatiev stretched which could impede future investments. SSE's UKsupply business is at risk should aggressive price competition break out.
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