After Brexit, what next? The impact on utilities and infrastructure valuations
December 20, 2016
On 24 June 2016, the unpredictable happened as the UK announced its decision to leave the EU. What was perhaps more predictable was the market’s reaction. The pound fell to a 30-year low against the dollar. While stocks suffered initially, they have largely recovered from the initial period of nervousness. International businesses with substantial dollar earnings have done well, for example oil and gas and mining stocks.
The weakening pound has also facilitated the continuation of strong inbound M&A activity with several landmark deals completed, such as Softbank's acquisition of ARM and National Grid's recently announced sale of a majority stake in its gas distribution networks to a consortium of international infrastructure investors in a deal valuing the business at £13.8bn.
If that’s the big picture, what about the wider utilities and infrastructure sectors? What has been the immediate impact on stocks in the utilities and infrastructure sectors, and what trends are we likely to see over time?
We’ve done an analysis study of the two sectors, dividing it into four sub-categories: regulated utilities and PPP assets, renewables funds, non-regulated utilities (integrated power utilities), and listed European airports. From an investor’s perspective, these four groups offer a very diverse range of risk, revenue, and resilience profiles, and will react differently to the impact of Brexit both short term and long term.
Regulated utilities and PPP assets
Regulated utilities and PPP assets are traditionally low-risk stocks, with stable income flows with little to no demand risk and benefit from higher inflation expectations. As the graph shows, in the immediate aftermath of the vote, this segment showed a significant increase in share prices and actually outperformed the FTSE100 and the other sub-sectors. However, as the markets got accustomed to the new reality, FTSE 100 increased as well primarily on the back of many large UK companies having significant exposure to foreign earnings and hence their sterling denominated valuations benefit from the drop in sterling. Share prices of regulated utilities have remained reasonably steady over the past few months following the Referendum. In the short term we expect a combination of higher inflation and lower than expected cost of debt will shore up the financial performance of these assets. In the longer term, these companies could lose access to EIB loans and the medium term cost of debt could increase as a result of increasing bond yields (this has contributed to a ca. 10% drop in share prices since early October). Further, there is likely to be continued political and regulatory pressure to not take their allowed price increases or share outperformance with customers. But taking all the factors together, regulated utilities continue to be safe-haven long term investments and they attract significant investor interest as demonstrated in the recently closed National Grid transaction. Our analysis also shows that these assets have outperformed the market during various previous periods of financial crisis as shown below.
Renewables funds shares prices have risen steadily since June 23rd, probably reflecting factors such as benefiting from increasing RPI (as subsidy mechanisms are linked to inflation), little exposure to demand risk and exchange rate movements as well as ‘grandfathering’ which typically protects existing wind, solar, wave and tidal projects from potential changes in the regulatory regime. All these factors reduce short-term volatility. However, depending upon UK’s long term approach to renewables targets post Brexit, there could be greater uncertainty for the renewables sector down the line.
Non-regulated utilities have a higher risk profile than the regulated sector, and significant exposure to energy prices. These stocks have been much more volatile since June 23rd and moved in line with the market initially immediately after the Referendum results. Post the initial setback, the recovery has been primarily based on company specific factors. In the short term, weakness in the pound will push up power prices which might be beneficial to the valuation of these companies. However, in the long term, the overall outlook for this sector has not fundamentally changed due to the announcement of Brexit.
And finally, airport stocks typically tend to be affected by GDP forecasts, as spending on travel is sensitive to changes in consumer confidence, and freight volumes reflect overall economic activity. As a result, European listed airports (there are no listed UK airports) did react negatively to the Referendum results and declined in line with the market in the period immediately after the referendum. However, post the initial setback, most stocks have recovered with variations in individual stocks depending on airport specific factors. So far UK airports have not witnessed significant decline in passenger numbers as any decline in outbound traffic was compensated by higher inbound traffic driven by the drop in sterling. However, in the event of a material slow-down going forward, valuations may be impacted. In the long term, Brexit may create winners and losers amongst airports in the UK and Continental Europe but the relative impact will depend on the Brexit aviation deal negotiated.
To summarise, regulated utilities, PPP and renewable funds are likely to display the same long-term stability and resilience which has tended to characterise these stocks over time. They could also benefit from their ‘safe haven’ status, should the market see renewed turbulence specially post the start of Brexit negotiations. Other utilities and infrastructure assets are likely to be more volatile, but offer investors different risk/reward profiles depending on their view of where currencies, inflation, commodity prices and regulatory changes are likely to go.
To learn more about our in-depth study of the two sectors please contact us below or schedule a meeting.