07 Jun 2019
The Nationalisation manifesto by Labour’s Corbyn has been a major headwind for the UK utility sector since late 2017. Since then, any news of a weakening of Labour’s popularity has generally led to a positive uptick for the share prices of utilities; conversely, any increase in the likelihood of an early election or disintegration of the Tories over Brexit has driven share prices lower.
We acknowledge that the Labour party has expressed their extreme position with regards to compensation for
nationalisation, however, our core belief is that rule of law will prevail and will work in protecting investor interests over the UK government.
If we take a step back, it is still highly uncertain whether nationalisation will eventually occur, as a chain of events have to happen first. For example, will there be an early election? Will Labour be elected with a clear majority? Will labour survive Brexit, and will they be able to push through with nationalisation if they win the election?
We view the risk of Labour winning a majority as reducing rather than increasing. While the risk of an early election has elevated, the rise of other parties outside of the Conservatives and Labour has increased materially as both major parties have lost a lot of support in the polls (the recent European elections in May 2019 showed marked dissatisfaction with the status quo). This actually makes it more difficult for Labour to get a majority. This is why we continue to view nationalisation as a ‘possible but low- probability’ event.
But what if nationalisation actually happens?
We did months of deep dive research to establish that whilst a Labour led UK Government would be perfectly within
its sovereign right to nationalise the utilities, it could not expropriate them. Rather, it would need to act in accordance with international and UK law, and importantly, would have to compensate existing owners to at least the equivalent of 1 x EV/RAB (Enterprise Value/Regulated Asset Base, also known as Regulated Capital Value (RCV)).
This means we have a hard floor to our UK utility stocks which is their Enterprise Value/Regulated Asset Base, and we trade these stocks according when we see divergences that we think make for profitable risk adjusted decisions.
Currently all the UK utilities are trading very close to (or even below) these hard floor levels. This means that the ultimate capital loss to investors if nationalisation occurs should be minimal.
We have held the view, through in depth-analysis, that nationalisation is costly and not feasible for the water utilities. And since Q4 2018, the water sector has also rebounded on conducive news flows supporting our investment thesis for the companies we own.
Positive news included OFWAT’s (the regulator) initial assessment issued on 31 January 2019; that three water companies we held were being fast-tracked for their AMP7 business plans (submitted in September 2018). Share prices of these companies rallied on the back of these positive news.
In addition to the hard floor, there’s another aspect for some
- diversification of the business model as well as playing international pricing arbitrage. In the case of National Grid:
~50% % of the company’s Enterprise Value is from the US. We judge US Utilities to be more into expensive territory, therefore buying National Grid is a way of buying a quality US utility at beaten-up UK utility prices.
Finally it’s important to note the internal drivers of each stock. In the example of SSE, we actually find their guidance for operating profit for FY20 to be in line with the latest market expectation. The dividend guidance through FY23 was also reiterated by management and latest credit metrics are sustainable. Overall we are comfortable with their financial position. The only disappointment we have is the lack of concrete plan for the sale of their energy services business which could potentially be dragged out to 2H 2020.
Balancing all of this, as of today we are comfortable with our position in UK utilities. The listed UK infrastructure companies are also trading at a significant discount to their unlisted counterparts in private equity portfolios which gives us
some element of relative comfort on their base valuations. However, it is also worth bearing in mind that we manage an active, globally diversified portfolio, with the majority
of our exposure outside the UK, which helps us mitigate single country regulatory or political risk. RARE stands for Risk Adjusted Returns to Equity – as we constantly evaluate opportunities against a backdrop of changing risk and return profiles so that we can continue to deliver a meaningful real return to clients over the long term.
Information has been prepared from sources believed reliable. It is not guaranteed in any way by any Legg Mason, Inc. company or affiliate (together “Legg Mason”). In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London, EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorised and regulated by the UK Financial Conduct Authority. Opinions expressed are subject to change without notice and do not consider the needs of investors. This information is only for use by professional clients. It is not aimed at, or for use by, retail clients. Not for onward distribution.