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Who are the winners and losers from SSE/npower merger? - Peter Atherton


13th November 2017

SSE and Innogy have announced the proposed merger of their UK supply businesses (see here).

SSE will contribute its UK household retail customers and its energy-related services business and Innogy its Npower operations which includes both domestic and business customers. The combined company (NewCo) will have 11.5mn customer accounts making it the second largest energy supplier in the UK. NewCo will be listed on the main market of the London Stock Exchange.

SSE will own 65.6% of NewCo with Innogy owning the remaining 34.4%. SSE intends to pass on its shares in NewCo directly to its shareholders via either a dividend in specie or a repayment of capital. Innogy on the other hand has undertaken to retain its shareholding in NewCo for at least six months following the transaction. The deal, subject to regulatory approvals, is expected to close sometime between Q4 2018 or Q1 2019.

When news of the deal first broke last Tuesday there was a positive share price reaction for both companies with SSE’s shares up nearly 4% and Innogy’s nearly 3%. However, within 24 hours these gains had been largely given up - albeit against the background of weak market conditions.

The business rationale for SSE is pretty clear. Under the leadership of Alistair Phillips-Davies, SSE has increasingly moved away from competitive businesses towards regulated and quasi-regulated assets. In particular they have been moving capital out of generation exposed to the wholesale power market and into contracted renewables and regulated networks. SSE believes this reduces its risk profile and underpins its all-important dividend pay-out capacity.

Therefore, exiting energy supply in the UK (although not in the Republic of Ireland) can be seen as the logical next step in its strategy. Whilst SSE’s UK supply operations have been profitable in recent years, that profitability has to some extent been achieved by SSE’s willingness to lose customers (c.1mn since 2015). SSE has maintained margins by sacrificing market share.

For Innogy the rationale is even clearer. npower has been significantly loss making since 2015. Uniquely amongst the Big Six energy suppliers npower lost money on both retail electricity and gas in 2016. npower has also been shedding customers as it has struggled to implement new back-office systems and react to the rise of the independent suppliers.

For both companies another factor will undoubtedly have been the UK government’s decision to legislate for price caps on Standard Variable Tariffs (SVTs). A government-imposed price cap on such a large segment of the market will likely lead to tighter margins for suppliers. The natural reaction to that, in what is a low margin/ high volume business, is to seek scale and the economies of scale.

So, if the logic of the deal is pretty clear, why the muted reaction in SSE’s and Innogy’s share prices? (see Figure 1).

The first reason is that completion of the deal is uncertain (due to regulatory hurdles) and in any case is at least a year away. For SSE there is also the issue of its dividend. SSE is to de-merge its shareholding in NewCo and will not therefore receive any cash for its stake, but will lose the profits from supply that it currently receives.

Jefferies estimates the effect will be to dilute EPS by around 17% in 2019, taking dividend cover to around 1x. It is possible therefore that SSE will seek to rebase its dividend (i.e. reduce it) to take account of the dilution effect.

The other issue for the shareholders of both companies is how to value NewCo? No other standalone supply business of this size exists anywhere in the world, so there are no comparatives. There is also considerable uncertainty on how successfully the two operations can be integrated.

This sector has a terrible track record of implementing new billing / CRM systems. SSE and npower will need to integrate two systems or transfer millions of customers onto a scaled-up version one of their existing systems. Shareholders will be understandably nervous that this can be achieved successfully.

Another issue that shareholders of SSE and Innogy will need more information on is the balance sheet of NewCo.

NewCo naturally will have an energy trading book running into the billions. NewCo will not of course have the benefit of being part of a vertically integrated company, so what capital will it need to fund its trading book – or will the ex-parents provide ongoing energy trading services?

So, whilst the strategic rationale for SSE and Innogy for this deal seems reasonable, shareholders will struggle to value NewCo and will have some concern over the dilution effect on SSE’s dividend.

The real winners, at least in the short term, is likely to be the other suppliers including Centrica. SSE and npower will be distracted throughout 2018 in trying to get the merger approved. Then if it is approved NewCo will likely take all of 2019 and probably much of 2020 integrating systems.

Eventually NewCo may emerge as a strong number two competitor to Centrica, but equally the damage done by two to three years of merger and integration uncertainty may produce a market weakling.

Cornwall Insight Associate Peter Atherton is a well-known equity analyst having headed utility research at several eminent City institutions, most recently Jefferies, and is a respected energy commentator.

Join energy industry leaders and experts, including our own Gareth Miller, Nigel Cornwall and Robert Buckley, at our retail conference on 22 November to understand how the conflicting pressures from technology, innovation and politics are reshaping the energy supply market.

We will also take a closer look at how the important debate around vulnerability and engagement is shaping up.

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