UK water utilities. It’s hard to think of a more boring-sounding investment.
However, over the last two years, they’ve been anything but.
For one thing, water company share prices have done much better than the overall market. For another, they’ve paid out better-than-average dividends too.
So shareholders have had a field day.
But can the good times continue? Or are there better bets elsewhere?
Water stocks have thrashed the market in recent years
We’ve been fans of defensive stocks for months now. These are companies that can make their money in the absence of strong economic growth – which is fortunate, given the deteriorating outlook for Britain.
Defensive shares also tend to pay out decent dividends. With returns on savings accounts and gilts now so poor, that makes such stocks even more appealing.
You can’t get much more defensive than a water utility – everyone needs to use water after all, regardless of the economic outlook. And historically, Britain’s water suppliers have been among the best dividend payers in the market.
Indeed, anyone who acted on our tip to buy into the sector exactly two years ago, would have done very well out of it. Including re-invested dividends, shareholders have enjoyed a total return of almost 50%. That’s compared to a 5% return for the FTSE 100 overall.
But that’s history. What should investors do now? The good news is that the latest updates from the sector were out last week, so it’s the perfect opportunity to re-evaluate.
Severn Trent (LSE: SVT) is the largest UK-quoted water supplier by market cap. It provides water and sewerage services to more than 3.7m households and businesses in the Midlands and mid-Wales.
Revenues rose 2% in the six months to end-September. However, underlying profits dipped by 2%. That was a bit worse than expected. Even though Severn Trent is mainly a British water supplier, it still managed to get caught up in the eurozone’s woes – it has a water services operation in Italy.
Over there, the banks aren’t at all keen on lending because of the parlous state of the economy, as we explained two months ago. As a result, Severn Trent’s subsidiary has been struggling to refinance its loans. So the group has had to write off £22m in case this Italian operation fails.
But there was some comfort for shareholders: the interim dividend was lifted by 7.7% as had been promised earlier. That puts the shares on a prospective yield of 4.7%.
It was a similar story at United Utilities (LSE: UU), which supplies water and wastewater services to nearly seven million people in the north of England.
Revenues rose by 4%, while underlying pre-tax profits dipped by 5% as costs proved higher than expected. But again, as promised earlier, the interim dividend was hiked by 6.7%. That means United Utilities is now on a prospective yield of 5.3%.
The best time to buy water stocks
These yields are still OK. But after the sector’s performance over the last two years, they’re not as good as they were (a rising share price means a lower yield). So should we be wary of buying into the sector now? In short, the answer is yes.
As with any other type of share, the best time to buy water companies is when they’re falling out of favour with investors, because that’s when they become cheap.
If there’s one thing that unnerves investors in water utilities, it’s the threat of the water regulator Ofwat – which keeps an eye on the prices charged by suppliers – putting pressure on utilities to accept lower profits.
That’s exactly what was happening two years ago. It looked as though Ofwat was going to tightly limit price rises across the industry. That sent share prices down across the sector.
However, while Ofwat talks tough on occasion, it also knows it needs to keep suppliers onside. More than 40% of London’s water mains have been in use for more than a century. Britain’s urban pipeage in general is decaying. There are leaks all over the place.
Fixing these is down to the water companies. And if they can’t make enough money to repair the nation’s pipes, the general public suffers too. So it came as no surprise that Ofwat then relented later in 2009, and allowed suppliers a bigger price hike than the market had been expecting.
Water companies are due an easy ride – but it’s priced in
Last week, Ofwat published its latest thoughts on how it’ll set future price limits for the sector. There was the usual guff about increased competition and water trading between suppliers. But the overall tone was all about “a reassurance to investors that the stability and transparency of the regulatory process remain high priorities”.
In other words, water suppliers are due an easier ride on pricing. Clearly, that’ll help the companies. But the market has sussed this out already. And it’s factored the potential good news into the valuations of both Severn Trent and United Utilities. Despite falling back amid the recent market turmoil, both now stand on current year p/e ratios of around 17. For utilities, that’s pricey enough for me.
The other water supplier to report last week, South West Water owner Pennon (LSE: PNN), is slightly different. Partly because of its sewage and waste management operation Viridor, it has managed to grow revenues by 8% and operating profits by 7% over the last six months. But on a current year p/e of 16 and yield of just 4%, it doesn’t exactly look cheap either.
So here’s the bottom line. There’s much more value to be found among suppliers of energy rather than water. As we noted earlier this month, electricity provider Scottish & Southern Energy (LSE: SSE) is on a p/e of around 11 and has a prospective yield of more than 6%. That’s much better value than those water stocks. We’d be tempted to take the profits you’ve made in the last two years and switch over to the power sector.
Category: Market updates