Centrica and United Utilities oversold on regulatory fears - Credit Suisse

UK utility stocks' discount to European peers is overblown, Credit Suisse said, as markets are being too cautious on the likely effect of government price caps.

As a result of its detailed analysis on price caps, the Swiss bank upgraded Centrica to ‘outperform’ from ‘neutral’ and lifted its rating on United Utilities to ‘neutral’ from ‘underperform’.

Shares in the UK utilities sector have fallen around 35% versus European peers over the past 18 months, Credit Suisse noted, after the Labour party proposed "regaining control of energy supply networks" and replacing the "dysfunctional water system".

The Conservative government’s tariff cap bill will see more than 50% of households on price caps, but while Credit Suisse forecasts EBIT margins at "the most-efficient energy suppliers" to fall from around 7% to nearer 5%, the market is currently pricing in margin of only around 1.5%.

"This is on the basis of a c£50 reduction in the standard variable tariff, with half of the reduction offset by cost-cutting."

Analysts said it was "too early to buy regulated stocks" due to 2018 being a year of regulatory risk, but the regulated sector "can avoid dividend cuts".

"Nationalisation of energy and water networks would need compensation and be expensive."

The analysts, which suggested there would be share-price downside of circa 16-39% assuming nationalisation at a price equal to the regulatory asset base, were positive on Drax, with a target price of 350p and Centrica was upgraded with a target price of 170p on the belief that pair carry the biggest risk discounts.

A 2018 dividend cut of circa 33% for Centrica is forecast, but the yield is still above 6%, with it and Drax both generating cash flows to cover the dividends.

UU was upgraded and given a target price of 850p as it now trades below fair value.