Sell SSE / Buy Centrica

Today, we are recommending our clients to sell SSE and switch into Centrica.

SSE has had a good run as late, outperforming European utilities, and is now sitting on an expensive March 2014 12x earnings. Citi has just cut its price target to 1270p (current price is 1398p), which would see SSE trade at 11x P/E for 2013e. J.P.Morgan Cazenove do not see the current valuation as fully reflecting the challenges and remain Underweight with a 1190p price target. They see pressure on the balance sheet coming from depressed spark spreads, falling coal profits and lower investment in renewable power due to uncertainty around government policy. They also dislike SSE’s significant capex requirement, high net debt and low dividend cover.

We would use the recent rally in the share price as an opportunity to take profits and switch into Centrica, a FTSE 100 company we believe to be poised for a rerating. The company is increasing its gas production, seeing improvements in its home services division and is expanding into North America, an attractive market characterised by lower political risk, higher profit margins and less regulation.

Centrica’s shares look attractive from both an income and a growth perspective. Based on current forecasts, the shares are yielding 5.1% and the cash-generative nature of the business means this looks secure, being covered 1.3 times by earnings. Centrica looks set to increase Earnings Per Share by 4% this year and the shares look attractive on a 2013 earnings multiple of just 11.9x. J.P.Morgan Cazenove has a 365p price target, providing a potential 13% return on top of the 5.1% dividend yield.