Why would anyone want to buy AWG?

Do we really need more evidence that investors have more money than sense right now? Probably not, but the news that utilities group AWG is in takeover talks provides it, says Cris Sholto Heaton.

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Do we really need more evidence that investors have more money than sense right now? Probably not, but the news that utilities group AWG is in takeover talks provides it.

The putative buyer has yet to be identified, but the speculation is that it's a private equity outfit probably an infrastructure fund. The announcement sent AWG's shares up 14% to over 1550p at one point, a new record high for the stock.

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If this deal comes off, it will be a very decent outcome for AWG's investors. MoneyWeek regular contributor James Ferguson took a look at the firm in a recent issue of his Model Investor service and his conclusion was "this really is a case of the emperor having no clothes". Here's why...

For a start, let's consider the dividend. When it comes to utilities, dividend is very important their investors are looking for a substantial, reliable income from their holdings. And AWG's dividend isn't particularly attractive. Before the price rocketed in response to the takeover news, the forecast dividend yield was about 4% roughly in the middle of the utilities group.

A 4% yield wouldn't be so bad if the dividend was well-covered this would give investors some potential for decent increases in the future. But this isn't the case the dividend is only covered 1.3 times. And that's despite a fairly healthy operating profit of £378m over five times the total dividend payout.

The reason why relatively little of operating profit made its way to the shareholders is because AWG is carrying a substantial debt load (which it built up beating off another private equity bid back in 2003). It has total debt of around £4bn on which it paid net interest of £265m last year.

That debt load means there's no scope for the standard private-equity trick of loading up the target with more debt to juice up returns. Water regulator Ofwat wants firms' debt-to-capital ratio to be no more than 65% and AWG's leverage is already around that limit.

Other ways of extracting more cash are also limited. There's not a huge amount of non-core assets that could be flogged the firm trades on a steep price to book ratio of 16.3. And there's no scope for pushing up prices to boost profits either, because water companies' profits are restricted by Ofwat.

So what's the likely reason for the deal? The answer lies with pension funds, which need steady, reliable, long-term cash flows to match their liabilities. Because the government forced them to reduce equity investments and transfer the cash into bonds back in 2004, bond yields have been driven down. The returns they get from these may be steady and reliable but they're scarcely exciting.

So pension funds have pumped a lot of money into infrastructure funds, because incomes at infrastructure companies are also steady and reliable, but are still quite a bit higher than the return than can be got from bonds. With debt so cheap (also a result of bond yields being driven down), buying a water company and gearing it up will net returns that look pretty attractive in these yield-starved times. Whether it will look such a smart move if rates rise in the future is debateable.

But that leaves another question: why choose AWG? With the firm already close to maximum gearing, the real return is going to be around the 4-5% it yields at present. There'll be scope for boosting that by expansion, but not as much return as by buying a less-indebted water firm and gearing that up.

So it's still hard to understand this particular deal. It might be that the buyers see something we don't. Or maybe their investors are pressuring them to make a purchase quickly and AWG is simply the bride most willing to walk down the aisle.

If you would like to know more James Ferguson's Model Investor service, click here.

Turning to the markets...

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The FTSE 100 surrendered earlier gains to end the day 15 points lower, at 5,877, dragged down by the poor start on Wall Street. However, bid speculation surrounding mid-cap AWG boosted the utilities sector, sending Kelda, United Utilities and Severn Trent higher. For a full market report, see: London market close

On the continent, the Paris CAC-40 closed 14 points lower, at 5,123, whilst the German DAX-30 gained one point to end the day at 5,907.

On Wall Street, most stocks closed lower following the news of downgrades of Boeing and General Electric. The Dow Jones closed 15 points lower, at 11,527. The S&P 500 slipped one point to close at 1,316. And the Nasdaq closed one point higher, at 2,228.

In Asia, markets were mixed ahead of this afternoon's US inflation data. The Nikkei 225 fell 75 points to close at 15,866 this morning.

Crude oil last traded at $63.30, whilst Brent spot was at $62.39 in London this morning.

Spot gold was trading at $575.25 this morning, its price having fallen 2% overnight.

And in Singapore today, finance ministers and central bankers from the G7 nations are gathering to talk about the current economic outlook, with the US housing slump likely to be weighing on discussions. They will release a statement at 5.30pm in Singapore tomorrow.

And our two recommended articles for today...

What's the best way to preserve wealth?

- What will the collapse in the value of the dollar mean for the US? Unsurprisingly, it's mainly bad news. However, some investments will thrive. To find out why you should hold on to gold if you want to preserve - and grow - your wealth in the years to come, read: What's the best way to preserve wealth?

The truth about inflation

- Mike Shedlock of Whisky and Gunpowder has yet another argument to add to the inflation debate. He thinks that those inflationists arguing for further US rate hikes in the face of higher long-term oil prices are missing the point, and being very selective as to which data they use. For more of Mike's arguments - including why he thinks inflation will head south in the near future - see: The truth about inflation

Cris Sholto Heaton

Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.

Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.

He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.