Investing in Regulated Utilities (part I, Water)

And United Utilities PLC

The visible hand of the regulator, image courtesy Wikipedia

Investors are attracted to utility companies for their steady income by way of dividend payouts. Although utility shareholders have made windfall gains from takeovers, investors expect capital gains to be modest. The FT's Gas, Water and Multiutility Index (in blue) have performed as one would expect these past 10 years. The shares that make up the Index (Centrica, Dee Valley, Igas energy, Modern Water, National Grid, Pennon Group, Renewable Energy Generation, Severn Trent and United Utilities) have proven to be less volatile and to produce less of a capital gain than the FTSE 250 (Midcap) Index (in green):

Graph courtesy of Yahoo, click to enlarge

Once the higher dividend yield of the utility companies is included (currently from 4 to 5.5%, compared to 2.7% for the FTSE 250), their overall return over 10 years is very similar to the 250 companies that make up the Midcap Index.

So far so good. But regulated utility companies are very different to non-regulated companies. Given that regulated utilities are often providing unique services to the public, government appointed regulators have extraordinary powers to ensure that the public are protected from monopoly pricing. This can be disconcerting for investors.

The water regulator, Ofwat, is in the process of determining the conditions and price controls for the water utilities from 2015 to 2020. Ofwat makes clear its main objectives:

"Our main duties are to:

• protect the interests of consumers, wherever appropriate by promoting effective competition
• enable efficient water and sewerage and water only companies to carry out and finance their functions

One of the ways we deliver our duties is to set the price, investment and service package that customers receive." (Ofwat website) 

Ofwat explains how the new price regime will take into account past efficiency gains by the water companies:

"Once price limits have been set, companies can make higher profits at no expense to the customer by outperforming the assumptions we make when we set price limits through efficiency and innovation. They earn these higher profits until the next price review, when the benefits are passed to customers through lower prices." 

In the past review, both United Utilities (by 13%) and Severn Trent (by 10%) reduced their dividend because Ofwat set prices that annulled the efficiency gains from the previous regulatory period. These gains had been passed on to shareholders. 

As each water company has to present a plan to meet Ofwat's objectives, it is impossible for the individual investor to assess how Ofwat's new price mechanism will affect the water companies' profitability. And to complicate matters, Ofwat will be setting separate prices for wholesale, domestic retail and business retail customers. 

The average dividend cover for the past three years provides some measure of the leeway the four quoted water companies have to absorb a more restrictive pricing regime:

 

Water company	Dividend yield*	Dividend cover*	Price Earnings Ratio**
Dee Valley	4.3%	1.45	16
Pennon	3.9%	1.29	20
Severn Trent	4.0%	1.33	19
United Utilities	4.5%	1.63	14

                *Average over the past 3 years. **Current price/average 3-year earnings per share 

The latest dividend cover for each company and the latest dividend shows a growing payout on a declining cover:

 

Water company	Dividend yield*	Dividend cover*	Price Earnings Ratio*
Dee Valley	4.4%	1.38	16
Pennon	4.5%	0.25**	98**
Severn Trent	4.4%	1.25	18
United Utilities	4.8%	1.26	17

                *In the latest year. **Pennon suffered losses on its non-regulatory business in 2012. 

One way that the water companies have found to improve their 'efficiency' compared to Ofwat's assumptions is to borrow at low interest rates. This reduces their weighted cost of capital. Hence, the water companies have relied heavily on loan financing to meet their capital requirements and to pay generous dividends, with the result that they are all heavily indebted:

 

Water company	Net Debt/Equity	3-year cash flow pounds mn*	Years  to pay off debt
Dee Valley	42%	6	24
Pennon	189%	(138)	n.a.
Severn Trent	528%	782	17
United Utilities	319%	89	201

                *Operating cash flow less capital expenditure for the last 3 years 

It is hard to see how these water companies will survive without issuing new equity. Some indication of the size of the equity issues that might be required to restore their balance sheets can be judged by the following table:

 

Water company Pounds mn	Net Debt	Market Capitalization	Possible capital requirement*	Possible shareholder dilution%
Dee Valley	49	66	5	10%
Pennon	2007	2840	620	22%
Severn Trent	4398	4150	910	22%
United Utilities	5972	4800	970	20%

                *New equity to reduce debt to 200% of equity and/or to cover the present cash dividend for 5 years, allowing for present cash flows. 

These are rough and ready numbers, but they do suggest that the new pricing review will be met with a call for new equity and/or a cut in the dividend payout.  

Investors should be very cautious when assessing these water companies. It would be wise to wait. Consider: 

1. Possible rights issues or placings will reduce the earnings per share and value of these companies' shares. 

2. Dividend payouts are likely to fall. United Utilities and Severn Trent reduced their dividend payouts by 13% and 10% respectively after the last Ofwat review. All four water companies will have great difficulty in maintaining their payouts. 

3. The uncertainty over the 2014 Ofwat review will depress water company prices. 

4. Against this, the recent (rejected) bid for Severn Trent valued the company at a 15% premium to the present price. This will help to sustain present prices. 

The water companies have until December 2013 to submit their plans to Ofwat. Ofwat will announce its new price mechanism during 2014.

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United Utilities PLC

Tap water, image courtesy Wikipedia 

United Utilities (UU) shed its electricity business and a series of other businesses by 2008 and returned 1.5 billion pounds to shareholders. Since then, UU is a pure water and waste water business that covers the North West of England. All its business is subject to the price controls, capital commitments and other requirements of the regulator Ofwat.  

UU's large capital expenditure, amounting to 3.5 billion pounds in 2009-14, is the equivalent to more than 2 years revenues. Hence, UU's management are as much engaged in managing new plant and infrastructure as they are in the sales, service and maintenance side of the water business. 

UU's share price (in blue) is back where it was 5 years ago:

 

Graph courtesy Yahoo, blue line for United Utilities, green line for the FTSE 250 Midcap, click to enlarge. 

Investors often see utility companies like UU as an alternative to bonds. The Ontario Municipal Employees Retirement System, the Kuwait Investment Office and the Universities Superannuation Scheme of the UK bid for Severn Trent. Two of the three bidders are in need of long-term income, which is something that water utilities can deliver. If necessary, these institutional investors can assume the utility's debt, which would be another source of income for their members. But the same conditions do not apply to individual investors.  

UU shareholders face an unappetizing future: 

1. In the latest Annual Report, management refers to the decline in both the retail and commercial demand for water.  

2. This year UU increased its dividend payout, but this just brings it back to where it was in 2009. 

3. Earnings per share have shown no consistent increase in the last 5 years. 

4. Net debt stands at 319% of equity and, in the last 5 years, operating cash flow (including capital expenditure) of 380 million pounds has failed to cover dividend payments of 1,235 million pounds. 

5. For a company that relies so heavily on debt, UU cannot be happy that S & P rate their long-term debt as BBB-. This is the lowest investment grade rating.  

6. In the current climate of austerity, it is unlikely that Ofwat will look favourably on improving the returns to investors. To the contrary, Ofwat has stated that, "These separate price controls will create stronger and more targeted incentives on the customer facing services companies provide. This will drive companies to deliver better customer service at a lower cost." (Ofwat's website). 

7. Rising 10-year gilt yields hit UU in two ways. They increase UU's cost of debt and they shrink the difference between what investors can earn from AA government debt and what they receive from UU in the form of dividends.

 

Assuming that UU does not reduce its dividend and that trading results remain about where they are gives, according to my valuation model*, a value of around 600p for UU's shares. They currently trade at 711p. *Assumptions: no earnings per share growth, 15% return on equity as now, dividend yield as now (4.8%), equity per share continues to increase by about 6% p.a., and the stock market values UU on an average P/E ratio of 16.5. Discount rate used is 11.3% - UU's cost of debt is 4.3%, 2% for operating risk and 5% for a margin of safety.  

Even at 600p, the prudent investor will consider: 

1. The possible repercussions of a reduced dividend and/or share issue on UU's share price. 

2. A possibly unsatisfactory price regime imposed by Ofwat for 2015-2020. 

3. Defined pension scheme assets and liabilities, each valued at 2.4 billion pounds, are large in the context of UU's business. Adverse changes in assumptions would cause a further draw on UU assets.