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Energy stocks: vertical integration smooths out the ups and downs

Europe’s energy industry has been in constant flux over the past decade

First, the move away from fossil fuels towards cleaner energy sources triggered huge corporate overhauls, particularly in Germany. Then Russia’s invasion of Ukraine sparked the biggest energy crisis since the 1973 oil shock.

Energy companies are now examining how they can navigate the new reality. Europe can no longer rely on cheap, plentiful Russian gas. Some governments are imposing hefty windfall taxes on the sector.

Results this week from Spanish group Iberdrola, the world’s second-biggest utility by market capitalisation, show safety remains in diversification.

Energy companies traditionally followed a “vertically integrated” model where they owned power plants, grid infrastructure and retail arms. Some even had oil and gas production fields.

But that model fell out of fashion in the past decade. Some companies sought to specialise in particular parts of the market such as generation or retail. The market orthodoxy was that each business should focus on a core métier, leaving investors to assemble diversified portfolios of their shares.

It is true that conglomerates are hard to value. But they can also damp volatility, build entrepreneurial new businesses and create economies of scale. Lex believes focus or diversification work equally well when circumstances suit either strategy.

Madrid-listed Iberdrola is a good case study. It has been investing heavily in clean energy assets such as solar and wind farms in countries ranging from the US to Mexico. Yet it still owns gas-fired generators and nuclear power stations in some geographies. It owns electricity networks in Spain, the UK, US and Brazil and sells energy to households in its home market and Britain.

In the first quarter, Iberdrola increased profit after tax by a forecast beating 40 per cent year-on-year to €1.5bn. That was despite a €216mn hit from a windfall tax on energy companies in Spain. Two-fifths of its earnings were generated in the EU, followed by the UK, Latin America and the US. Just over 60 per cent came from production and its customer businesses, with 39 per cent from networks.

The results were helped by stronger renewables output this year versus 2022, when drought conditions in Europe hit hydro plants. Its British retail business, ScottishPower, has like other suppliers in the country recently been recouping losses incurred in 2022. Last year it bought electricity and gas for customers at high prices but had to sell at lower, regulated levels.

British gains are not expected to recur in subsequent quarters. But Iberdrola still expects profits after tax to grow by a “mid to high single digit” in 2023.

Iberdrola is investing heavily in growth. It plans to plough €47bn into areas such as renewables and energy networks between 2023 and the end of 2025. Nearly half of that is earmarked for the US, where energy companies stand to benefit from the Inflation Reduction Act, a $369bn package of incentives for clean energy and climate-related projects.

One of the closest examples in the UK to a vertically integrated energy company is Centrica, owner of British Gas, though it doesn’t own networks. Last decade it sought to focus on customer-facing businesses, such as energy supply. But a failure to find suitable buyers for such assets as its 20 per cent interest in UK nuclear power plants meant it remained diverse by default. Those divisions helped Centrica’s operating profit to rise more than threefold in 2022 to a record £3.3bn.

There are challenges ahead. Competition is growing in renewables, with the entry of oil majors such as Shell. Supply chain inflation is a problem. Permitting, planning and regulatory regimes are a brake on investment. Windfall taxes on energy companies remain popular among some politicians.

Iberdrola is not immune from any of these challenges. Valued at a forward price earnings multiple of 16.3 times, close to its five-year average, it looks pricey on paper compared with other European utilities such as Italy’s Enel on 9.8 times and the UK’s SSE at 12.6 times. But its geographic diversity and mix of businesses should provide protection against future storms.

StanChart: undervaluation is standard operating procedure

The advantage of low expectations is that they make it easier to spring pleasant surprises. That applies to Standard Chartered.

The UK-listed, Asia-focused bank has been doing better than pessimists forecast. It this week reported its largest quarterly profit in almost a decade.

Adjusted pre-tax earnings were $1.7bn. Net interest income increased by 13 per cent. This warrants a re-rating for the shares.

Critics say the expansive Asia market strategy of chief executive Bill Winters is too expensive. But the push has yielded outperformance in the latest quarter, especially in China and Hong Kong. The city is StanChart’s biggest market. Here, wealth management income growth has been strong. Affluent new clients have been signing up in droves. Sales of bancassurance and treasury products have also been buoyant. Both are up a fifth.

StanChart’s Asia focus has protected it from turmoil in US and European banks. Customer deposits were stable. The lender reported its highest quarterly liquidity coverage ratio, a measure of cash-like assets held by the bank. These were a record 161 per cent. Hong Kong and Singapore alone accounted for 45 per cent of customer deposits.

StanChart has a target range for core equity tier one (CET1) buffer capital — a measure pored over by analysts, investors and bank bosses — of 13-14 per cent. The figure for the quarter was 13.7 per cent, leaving $500mn spare above the range midpoint, according to Lex calculations. The CET1 buffer consists of the most dispensable capital of the bank, shareholders’ equity and retained earnings.

There are challenges ahead. Cost-down policies will be difficult to maintain amid rising inflation. Expenses were up a tenth on a constant currency basis in the latest quarter. The trading business looks weak. The net interest outlook for this year is down.

StanChart shares are up 30 per cent in the past year, beating HSBC. Yet they trade at half tangible book value, a significant discount to regional peers. Shares are a third lower than when Bill Winters took charge in 2015, despite better profitability. There is scope for an upgrade.

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