Rising Interest Rates Overshadow Strong First-Half Results Leaving European Utilities Cheap

European utilities have underperformed the European market by 4% year to date with most of the underperformance occurring in the third quarter because of the rise in interest rates. This overshadowed strong second-quarter results driven by the easing of the energy crisis, persisting commodity price volatility, and the hedging improvement. These drivers have persisted in the third quarter. Moreover, some power price clawbacks expired at the end of June like in Germany and Belgium. On the flip side, the comparison basis will be tougher as of the third quarter.

Renewables unit construction costs have increased by about 20% since 2021 while the cost of capital was soaring, but this has been offset by rising power purchase agreement prices. The weak spot consists of projects awarded before the rise in interest rates and not contracted. It chiefly concerns offshore wind as evidenced by the upcoming massive impairment of U.S. projects by Orsted in the third quarter. Solar is gaining momentum due to the drop in polysilicon prices in first-half 2023 and the easing of supply chain issues.

Overall, we view the sector as significantly undervalued with a median price/fair value estimate ratio of 0.89, close to the lowest since the beginning of the year. Two thirds of the companies we cover are in buying territory. Integrated utilities have an attractive reward/risk profile.

Our two Best Ideas are RWE and Engie, for which we confirm our fair value estimates of EUR 55 and EUR 17, respectively. RWE’s average 2023-24 P/E of 10 reflects a material undervaluation of the shares, partly driven by a read-across from Orsted’s issues with its U.S. offshore wind projects. This read-across is excessive since RWE has no U.S. offshore wind project awarded before the steep rise in interest rates and that has yet to be sanctioned. Regarding Engie, the nuclear deal reached with the Belgian government in June has considerably derisked the equity story. The dividend yield of 9.5% is appealing.