- Limited upside to EU yields - Room to the downside from knock on effects of lower US yields.
- RWE, trading at 10x 2027 PE and a deep discount to peers, despite strong 9M24 results and a trough in earnings.
- Incremental buyback announcement and a CDU victory in the upcoming German elections could renew optimism
Utilities continue to underperform the current European market rally, as the latest hot US CPI report has led the market to adjust its expectations for rate cuts down to a mere 35bp for 2025, from 100bp of cuts expected five months ago. Despite the STOXX 600 and the cyclical heavy SX5E posting +9% and +13% YtD returns, respectively, the SX6P has remained broadly flat as the market anticipates ongoing expansion of government deficits to weigh on yields, exacerbated by expectations of increased defence spending in Europe on the back of a potential US-Russia deal on the war in Ukraine.
Although European yields are less likely to drop significantly in light of the latest news on defence spending and the ongoing open debate on the ECBs upcoming rates strategy, nonetheless further upside to yields limited with more room to downside from a knock-on effect from lower in US yields. In the US, both yields and the DXY appear to be on the path lower, further supported by the US administration’s focus on lower energy prices and long-term yields. In addition, the January CPI prints tend to be the month with the highest surprise vs. consensus, increasing the likelihood of downward surprises at the next print as the market readjusts its inflation expectations upwards. We also note that shelter CPI – which lags by 12 months – accounted for 30% of the headline increase, pointing to a possibility of far more modest inflation ahead.
Within the sector, Germany's biggest power producer, RWE, is one of the worst-performing major European Utilities, posting a -2% YtD return while also trading at 10x 2027 PE (BBG estimates), a c.20% discount to its peers and 8% to the sector, despite the strong 9M24 results. Trump’s executive order to block new permits for wind projects and the CDU's pledge to reduce power prices have also weighed on sentiment. Analysts estimate that the executive order could lower RWE’s 2024-30 capex plan of EUR55bn by up to EUR10bn, translating into additional freed-up capital to increase the existing EUR1.5bn buyback by EUR2-3bn, representing a total of 15-20% of market cap. In addition, amid what appears to be a trough in earnings in 2025 supported by the normalisation of profits from Trading and FlexGen, the company is also set to benefit from structural demand in power consumption from the growth of data centres in Europe, estimated to add up to 2% growth p.a to top-line numbers.
Looking at catalysts ahead, the company reports its FY24 results on 20 March, where it is expected to provide detailed 2025 guidance and update its guidance for 2027. The market will focus on the company’s buyback policy, which is likely to be updated given the recent positioning of the activist Elliot Investment Management in the name. The upcoming German elections on 23 February could also remove uncertainty for the sector, as one of the main areas of focus should the CDU win would be to address the critical issues related to energy policy geared to more flexible generation needs and continued significant investment in networks and, although unlikely to materialise in the short term, reversal of the Nuclear phase out with an estimated EUR3bn annual revenue shared between the major German Utility players. We propose Long June25 32 calls at a net cost of 2.3% of underlying (Spot ref: 28.8, Fut. Ref: 28.3).