Buy United Utilities for steady income

Many investors perceive shares in highly regulated water utility companies as bond-like investments, given the reliability of the income such businesses generate and the strictly controlled levels of expenditure. From this perspective, the allure of the solid yields on offer is very clear when compared with the currently negative yields on UK index-linked bonds and five-year UK government bonds yielding little more than 1 per cent. By comparison, the forecast 4 per cent dividend yield that United Utilities is expected to pay this year looks attractive, especially given the company's pledge to increase the payout at least in line with RPI to 2020. And following industry regulator Ofwat's final determination on pricing and investment for the next five years, investors can feel secure about that expected payout.

Indeed, of the three big listed water companies - the other two being Pennon and Severn Trent - we think United looks the safest bet for income. The outcome of the recent five-year review was broadly positive for the company, which confirmed after the final determination was announced in December that it would not need to cut its dividend and that dividend growth of at least RPI should be expected over the next five years. Its fortunes compared favourably with rival Severn Trent, which announced it would implement a 5 per cent dividend cut. Broker Whitman Howard upgraded its target price for United at the time to 1,033p from 959p to reflect the additional stability.

What's more, if the company manages to outperform its Ofwat-set total expenditure targets, which several brokers view as a strong possibility, it could feed through to dividend growth in excess of RPI inflation towards the end of the new regulatory period.

Added comfort was given to investors about the outlook following the final determination by the fact that United has said it expects gearing - measured as net debt to regulatory capital value - to be maintained within a target range of 55 to 65 per cent until 2020. The news is significant as it should keep the credit-rating agencies happy and guard against any downgrades. The company was 57 per cent geared at the time of its half-year results, compared with 59 per cent a year earlier, and analysts at Deustche Bank forecast United could deleverage further to 53 per cent by the end of the regulatory period.

The company got a number of concessions during the review process which should also help underpin prospects for the next five years. For example, the regulator adjusted United's allowance for bad debt driven by deprivation to 15.7 per cent of household retail operating expenditure, or £98.9m. This is especially welcome given the drag bad debts had on United's half-year to the end of September. While revenues managed a small 1.6 per cent rise to £859m - less than the 3.8 per cent allowed by Ofwat due to a one-off £20m customer discount applied to last year's bills - underlying profit grew more modestly due to higher bad debts caused by deprivation in the north west region.

The utility company also surprised the market by managing to gain higher water wholesale and wastewater wholesale thresholds in its final determination from Ofwat. When the review process began, United's total expenditure forecasts for wholesale waste water and water had surpassed the draft determination allowances by £769m and £215m respectively. However, in the final determination this gap had shrunk to £179m and £9m. The regulator accepted special costs relating to projects including its Oldham and Royton wastewater and treatment works, and Davyhulme wastewater treatment works.