Maybe I have a cognitive bias, but I very often agree with activist demands. Upon reviewing the letter Elliott Investment Management sent to SSE PLC’s (LSE:SSE, Financial) chairman, Sir John Manzoni, this morning, I must admit I agree with everything the activist is saying.
Legendary investor Jim Rogers once said, "The way of the successful investor is normally to do nothing - not until you see money lying there, somewhere over in the corner, and all that is left for you to do is go over and pick it up."
SSE seems to be one of those opportunities. Its renewables division is constructing the world’s largest offshore wind farm and the business is a primary beneficiary of the world’s drive for decarbonization and net zero emissions. It also has a regulated electricity business that, in theory, should offer stable returns yet growing returns given the U.K. electricity grid is very tight and needs to be expanded. This means SSE’s regulated asset value has room to expand significantly.
Now Elliott Investment Management is highlighting a 30% conglomerate discount at SSE and pushing for a demerger that would create a focused electricity networks business and a focused renewables business, both large enough to be FTSE 100 constituents. In the U.K. market, there are no real renewable operating companies to invest in, only a bunch of closed-ended funds which charge annual management fees. A large cap-focused renewables business would be most welcome and would attract significant investment.
The fact that Elliott often gets its way means this situation, as someone very interested in energy and with SSE on my watchlist, is very exciting.
The activist firm notes that some of SSE’s competitors, including Acciona (XMAD:ANE, Financial), Eni (E, Financial) and Iberdrola (XMAD:IBE, Financial) are already creating value by advancing or examining plans to list their own renewables businesses.
Elliott quotes Barclays: “We see SSE trying to please everyone…as being a risk of pleasing no one.” This is a typical unfocused strategy when managements want to empire build. It’s the same argument Third Point's Daniel Loeb (Trades, Portfolio) is using against Royal Dutch Shell (RDS.A), and that Elliott itself used successfully with BHP (BHP, Financial), which eventually agreed to spin off its petroleum business and unify its dual share structure.
Elliott’s letter is available here, and SSE’s weak and predictable response is available here.
Below is a summary of the points I thought were most important to Elliott's argument as well as my thoughts on them.
Elliott noted:
"SSE Today: Despite SSE’s attractive renewable power generation and electricity transmission and distribution assets, the Company trades at a significant multiple discount to its Renewables peers and also suffers from deep, persistent share-price underperformance.These issues are directly attributable to the Company’s inefficient conglomerate structure, and they would be best addressed by separating the assets through a listing of the Renewables business."
Figure 1: SSE total shareholder returns during Phillips-Davies’ tenure (%).
Figure 2: Two-year forward EV/Ebitda ratio.
The drivers of SSE’s undervaluation
Elliott notes that SSE’s stock has underperformed the European Utilities index by 77% during the current CEO’s tenure. That is quite damning indeed.
The firm wrote:
"The market’s failure to ascribe fair value to SSE and its portfolio is directly attributable to the Company’s inefficient conglomerate structure and confusing equity story. Renewables and Networks are intrinsically different businesses, supported by divergent shareholder registers, with individual funding needs, growth profiles and strategic priorities, which would be better addressed if the businesses were fully independent. SSE’s existing conglomerate structure forces the Renewables and Networks businesses to compete for capital expenditure and management’s attention."
This is true because renewable power is a complicated business, given its intermittent power generation and it is a growth business, with much construction of generation sill in the pipeline. On the other hand, networks is about electricity transmission and distribution. While there is growth in the U.K., given the grid’s tight capacity, this business is more of an infrastructure business less exposed to power prices.
By holding both businesses in the same group, the market – thanks to something academics call “limits to arbitrage” cannot value the businesses fairly. Elliott quotes an HSBC report: “the market is either pricing in a zero renewables pipeline until 2030 or is attaching too low a premium to SSE’s […] networks business.”
Figure 3: The differences between SSE’s Networks and Renewables divisions.
SSE’s renewable pure-play peer group attract much higher multiples. Elliott claims (and there is no reason why this would not be true) to have conducted a detailed project by project analysis using experts, and has come to the conclusion that SSE’s current valuation "undervalues the business £5 billion ($6.6 billion) of value because of SSE’s inefficient structure. This represents ~30% upside from today’s valuation."
Elliott blames the board for not having any renewables expertise, again making comparisons with European peers who have more relevant experience at the board level.
A listing of SSE’s renewables business remains the best course of action
By creating two U.K. energy champions, each would have a focused and clear equity story to tell. Analysts could value the businesses more fairly and capital allocation could be done more efficiently, with each company being run by experts within its own domain.
The renewable spinoff would gain value simply because it could access capital at a far lower cost.
Today, the renewables business is only able to raise equity at SSE’s price-earnings multiple of 17. Based on our analysis, its peers have been able to raise capital at a median price-earnings multiple of 26 over the last three years.
Remember, the earnings yield, which is the equity cost of capital, is the inverse of the price-earnings ratio.
Elliott makes the fair point that the renewable business would benefit from significant environmental, social and governance fund flows, especially as this would be the only pure-play renewables business in the FTSE 100.
Separate networks and renewables companies could each focus on their own sets of “net zero” opportunities. With networks working on the U.K. grid expansion, which is desperately needed, the renewables business could expand internationally. Currently, with its split focus and higher cost of capital, SSE is leaving a lot of opportunities on the table.
SSE’s missed opportunity
Elliott also discussed a missed opportunity, writing:
SSE’s announcement on 17 November failed to provide any convincing explanation for why the Company is not pursuing a listing of Renewables. While you announced an initial sale of a minority stake in Networks, both the quantum and the timing of that transaction lacked ambition. Cutting the dividend disappointed many investors, particularly those who are income oriented and invest in SSE for the dividend stream it has historically provided. Finally, the opaque review process raised serious questions about the legitimacy of the review and the adequacy of SSE’s corporate governance under which it was conducted.
The firm attacked SSE’s Nov. 17 Net Zero Acceleration Program as lacking ambition, highlighting the 4% fall in the share price that day. Unfortunately, lacking ambition is a chronic malaise many management teams in the U.K. suffer from as they pander to the country's dividend-obsessed investors. That’s why I always welcome American activists to the U.K. market.
The activist quotes a Sanford Bernstein report, which noted: “[T]he rejection of a renewables spin represents a missed opportunity to unlock further value, reflected in the share-price reaction today.”
SSE had rejected a split because they said a separation would lead to dis-synergies of 95 million pounds each year. Elliott rejects this, again quoting Sanford Bernstein:
“[T]hese [£95m p.a. of] dis-synergies appear very high considering that even GE's recent separation implies only $150-$200m p.a. and diminishing over time.”
SSE’s statement introduced a partial sale of its networks business to fund an investment in renewables. Elliott said, "The partial sale of Networks lacks ambition in both quantum and timing."
SSE had to cut its dividend partly to fund the renewables expansion. Elliott calls this a funding overhang and warns this strategy will weigh on the share price. This should be obvious if one agrees with Elliott’s axiomatic cost of capital arguments. The activist quoted more sell-side analysts regarding their bear reactions to the announcement.
Perhaps most damning, however, is Elliott’s view on SSE’s corporate governance. It said:
"The presentation of SSE’s new strategic plan left investors and analysts both confused and concerned. The arguments presented to the market against the listing of the Renewables business were perceived as perfunctory, dismissing strategic alternatives without proper due diligence… The lack of transparency clouds this clearly inadequate process. There has been no disclosure regarding (1) whether the Board retained third-party advisors who were independent from the management team, (2) who led the review process, (3) the strategic options that were evaluated and (4) how many times the Board has met to discuss alternatives to the strategy favored by management. This raises questions about SSE’s corporate governance and about the Board’s ability to oversee the Renewables strategy given the lack of renewables expertise among its non-executive directors."
What does Elliott want?
Overall, the activist firm founded by Paul Singer (Trades, Portfolio) called for five things:
- Disposal of a larger than 25% stake in networks in 2022.
- Partial listing of the renewables business.
- Disposal of a minority stake in the renewables business.
- Add two new independent directors with renewables experience to the board.
- Create a strategic review committee composed of independent board members.
The warning shots have been fired!
SSE’s response a few hours later was timid, in my opinion, and Elliott is hardly going to stand for it. The company said:
"Since then we’ve continued to have constructive and supportive discussions with our major shareholders and stakeholders about the plan, which was also backed by Moody’s who reaffirmed SSE's Baa1 rating and upgraded their outlook to stable on the strength of the plan."
Arguably, Elliott’s analysis is watertight. A large proportion of the analyst community agrees. Institutional investors will sooner or later wake up and Elliott will probably get its way. At that point, SSE’s conglomerate discount will dissipate and investors will be thankful.
