High yields from water stocks
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Associate Editor
David Stevenson Feb 05, 2010
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Water companies face a "particularly tough challenge" –
how the CEO of one water firm described Ofwat's latest ruling – from the recent
bad weather to dividend cuts, high borrowing costs and rights issue fears. So
what's left to like about the sector? Well, plenty. Last July the stockmarket
really got the jitters about Britain's
water utilities. The water regulator, Ofwat, issued draft proposals on how much
they could charge their customers between 2010 and 2015. The proposed 'real'
(i.e. before inflation) 4% drop in average household bills over these five years
wasn't exactly what these firms wanted to hear. Nor did Ofwat's view on how
little capital spending (capex) the nation's water suppliers could undertake
(to cover replacing vast numbers of leaking mains pipes, for example) curry
much favour.
The news didn't do the sector's share prices much good.
Investors fretted about likely slashed dividend payouts when profits inevitably
started to suffer. Indeed, by early August 2009, the UBS UK Water index had
undershot the FTSE All-Share by 20% over the year-to-date. But here's the
silver lining: the regulator was largely sabre-rattling. Ofwat's second shot
last November (suggesting just a 0.9% 'real' fall in water bills over the
period) still wasn't ideal for the water utilities, but was an improvement. The
extra £1bn added to permitted capex gave another potential boost to returns.
The utilities had until last week to decide whether to object to Ofwat's 'final
determination', and almost all have decided they don't need to. And even though
the recent cold snap has meant more spending on burst pipes than planned, water
demand picked up in the latter part of last year. So overall revenues should now
prove better than expected.
That means the dividend damage will be much less than had
been reckoned. United Utilities (LSE: UU), for example, where analysts had
predicted a payout trim of up to 25%, will cut its dividend by only half that
amount. What's more, following the reduction, the firm intends to grow its
payout by 2% a year in real terms. Furthermore, water suppliers' cash flows
should now be much higher than was forecast by the stockmarket only six months
ago. So debt servicing shouldn't be the problem it was then feared it would
become.
That's important, because compared to their net assets,
most utilities – not just in water – have high borrowing levels. These have
flowed from the chunky capital expenditure needed to build and operate supply
systems. But unlike industrial or retail businesses, whose cash flows can be
highly volatile, the final agreement with Ofwat means utilities can now look
forward to a steady and predictable income stream to fund their debt interest
bills. In turn, this means there is much less chance of a huge spate of
water-sector rights issues. These tend to be bad news for share prices, because
they invariably involve selling new shares at a discount. So the removal of any
imminent 'rights' threat is more good news.
Yet despite a modest recent share-price rally, all the
earlier uncertainty has still left dividend yields on some water suppliers some
two-thirds higher, at around 5.5%, than the overall market. For income-hungry
investors, that's a very tasty income premium indeed.
Another reason for liking the sector has just appeared
too – takeover talk. Rumours are circulating that the Ontario Teachers' Pension
Plan, which has already snapped up 27% of Northumbrian Water (LSE: NWG), could
return to buy the rest. Bid activity would be bound to give shares in water
suppliers a big boost.
We look at a high-yielding water stock – and possible bid
candidate – below.
The best bet in the sector
FTSE 100 member Severn Trent (LSE: SVT) is one of
Britain's main water providers, supplying over 3.7 million households and
businesses in the Midlands and North Wales. But Severn Trent isn't just a UK play – about
20% of last year's turnover came from its US-headquartered Services division.
This is one of the world's leading suppliers in the fast-growing areas of water
and waste management, concentrating on disinfection, instrumentation technology
and contract operation services. Work has ranged from building desalination
plants in Mexico and
deep-bed filtration systems in China,
to operating public/private partnerships in America.
Severn Trent recently confirmed it won't be appealing
against Ofwat's latest decision, and that next year's payout will be cut by
10%. However, "the policy for subsequent years is for growth in the dividend...
as performance improves", says CEO Tony Wray.
That leaves the stock, at 1,141p, on a current year p/e
of 11.5 and offering a decent prospective dividend yield of 5.5%. Severn has also been the subject of previous bid
speculation. With a market cap of just £2.7bn and a widely spread shareholder
list, it could yet be vulnerable to a bidder seeking a high-quality dividend
stream.
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