Shares in focus: Water stocks offer no safe harbour

Utilities are popular with nervy investors – but you can overpay for safety, says Phil Oakley.

The shares of regulated utilities, such as water companies, are often seen as safe havens by investors. Demand for water won't change much, even in a recession. So the profits and dividends of these defensive stocks are considered reliable. There's an element of truth to this, but that doesn't mean you can bank on a higher dividend year after year.

Advertisement - Article continues below

UK water companies were sold to the public 25 years ago. For the first ten years investors did well. Profits and dividends boomed and some companies were taken over. But the last 15 years have been more mixed.

The industry regulator, Ofwat, has become a lot tougher, squeezing the amount of money that companies can charge their customers. As a result, the utilities have become less profitable.

Yet water companies remain popular with investors. Their assets and revenues are closely tied to the rate of inflation, which has made them particularly attractive to long-term buyers, such as pension funds.

Water companies have continued to be taken over or bid for because they can offer better inflation-proofed returns than index-linked government bonds. So even though they've been loaded up with lots of debt, and now have less scope to cut costs, the last five years have seen something of a bull market in water shares.

Advertisement - Article continues below
Advertisement - Article continues below

If you had invested in any of the three remaining listed water companies Pennon (LSE: PNN), Severn Trent (LSE: SVT) and United Utilities (LSE: UU) you would have at least doubled your money and have trounced the performance of the FTSE All Share index in the process.

And in the last 12 months alone the share prices of Severn Trent and United Utilities are up by more than a third, while Pennon has gained 15% better than a stockmarket tracker fund.

This in itself is quite surprising. Water company share prices don't tend to do well in a year like this one, when Ofwat sets a new five-year pricing limit, because markets are concerned about what might happen.

Last Friday, the regulator told water companies that they would have to cut their bills, while still spending lots of money to reduce water leakage, stop flooding from sewers and clean up beaches. Ofwat also lowered the rate of return companies could earn on their regulated assets to reflect the fact that the cost of borrowing remains cheap.

The outlook for water companies

Five years ago, after the last review, both United Utilities and Severn Trent had to cut their dividends before growing them again. Pennon didn't have to, due to its fast-growing, unregulated waste management business.

Advertisement - Article continues below

It's probably too early to say what will happen for the next five years, but my hunch is that Severn Trent's and United Utilities' shareholders might fare a bit better than Pennon's this time around.

Ofwat's website has lots of data on the review, much of which the average private investor would struggle with. But buried in the depths are spreadsheets with details of how much money Ofwat expects each company to make between 2015 and 2020.

Advertisement - Article continues below

I reckon that if all the expected after-tax profits are paid to shareholders, then Severn Trent and United Utilities can maintain and grow their dividends. I don't have the same confidence about Pennon.

Its waste management unit makes a lot less money than it did a few years ago, while Ofwat is assuming that profits at its South West Water division won't grow much. I've looked at this in more detail in the box on the left.

Advertisement - Article continues below

Verdict: hold United Utilities andSevern Trent, sell Pennon

Which water stocks can keep paying their dividends?

enterprise value (EV)

This often happens around a price review but it didn't this time. A premium (paying above the RAV) is warranted if a company can make more money than the regulator expects, or if it is being taken over.

Share price865p
Market Value£3,449m
Net debt£2,106m
Estimated RAV£3,000m
Value of SWW at 1.2x RAV£3,600m
Implied Value of Viridor£1,955m
Peak Profits 2010/2011£82.6m
EBIT/EV on peak profits4.23%
EBIT/EV on current profits1.45%
Last 12m div per share30.8p
Dividend yield3.56%

Northumbrian Water was taken over a few years ago at a 25% premium, for example not far off the current valuations of Severn Trent and United Utilities, as the table above shows.

Pennon is slightly different given that it has a significant non-regulated business, Viridor. This has been richly valued by City analysts in the past, but its profits have been falling. Valuing Pennon is complicated, but it looks expensive on my ready reckoner (see below).

Share price1,937p903p
Market value£4,641m£6,158m
Net debt£4,383m£5,684m
Enterp. Value (EV)£9,024m£11,842m
Last divi/share82.2p36.6p
Dividend yield4.24%4.05%

If I value South West Water at 120% of its RAV then the value of Viridor looks very rich indeed. Even on its peak profits, a buyer would be getting an earnings yield (EBIT/EV) of just 4.2%, which doesn't look appetising and it's current profits are even lower.

Pennon is hoping that its big investments in waste-to-electricity power plants will pay off they just might. But if they don't, a dividend cut is possible.



Share tips

Share tips of the week

MoneyWeek’s comprehensive guide to the best of this week’s share tips from the rest of the UK's financial pages.
17 Jan 2020
Share tips

Share tips: eight stocks that should deliver robust returns

Ryan Ermey of US publication Kiplinger’s Personal Finance chooses his favourite stocks for the next decade, which should be able to grow for years.
28 Dec 2019
Share tips

Share tips of the week

MoneyWeek’s comprehensive guide to the best of this week’s share tips from the rest of the UK's financial pages.
20 Dec 2019
Share tips

Share tips of the week

MoneyWeek’s comprehensive guide to the best of this week’s share tips from the rest of the UK's financial pages.
13 Dec 2019

Most Popular

EU Economy

Here’s why investors should care about the EU’s plan to tackle Covid-19

The EU's €750bn rescue package makes a break-up of the eurozone much less likely. John Stepek explains why the scheme is such a big deal, and what it …
28 May 2020
Industrial metals

Governments’ money-printing mania bodes well for base metals

Money is being printed like there is no tomorrow. Much of it will be used to pay for infrastructure projects – and that will be good for metals, says …
27 May 2020

As full lockdown ends, what are the risks for investors?

In the UK and elsewhere, people are gradually being let off the leash as the lockdown begins to end. John Stepek looks at what risks remain for invest…
29 May 2020