Shares in regulated water companies have been trickling down in anticipation of a harsh regulatory review from regulator Ofwat. At the end of November, final proposals on price setting and allowed returns will be released. But the release of draft proposals in July left the industry in no doubt as to Ofwat's intentions. Under pressure to curb rising bills, the regulator has imposed tighter returns for the 2010-15 regulatory period. Coupled with rising power costs and bad debts, this means lower earnings estimates across the sector for the next five years.
As individual stocks are treated differently by Ofwat, there are already clear winners and losers.
Pennon and Northumbrian Water Group are the most efficient water companies, and have therefore received less harsh treatment from the regulator. Pennon boasts the added attraction of generating its own 'brown energy' from waste business Viridor. "Pennon will outperform the water sector, but the bigger question is will it outperform the market?" asks Brewin Dolphin utilities analyst Elaine Coverley.
We continue to rate Pennon's shares as a long-term buy, with Northumbrian as a second favourite as it is well positioned to outperform Ofwat's assumptions. A rights issue and dividend cut of up to 30 per cent is expected at United Utilities, due to Ofwat imposing a hefty price cut next year. Brewin Dolphin forecasts a flat dividend at Severn Trent for the next five years. As a result, share prices in both companies have plunged 12 per cent since July. Given the five-year visibility of Ofwat's framework, water is a sector that is unlikely to bounce. Investors will be in a better position to judge when dividend policies for the next five years are revealed around May 2010.
However, one factor that should not be underestimated is inflation. "The water sector is one of the only equity sectors where investors can gain protection from inflation as all prices are set with regard to RPI," Ms Coverley adds. "In our view, this makes the sector attractive for the longer term."
Shelter from the storm
There are four decent yielding income stocks in the utilities sector that look cheap right now, and we think all of them are worth buying for the future as long-term holdings. We've outlined the factors undermining confidence in the sector and the unpredictability of future returns. The pressure is on the next government to provide sufficient clarification for equity investors to underwrite new infrastructure, and for the debt markets to be supportive of this. And who knows – the added spark of merger and acquisition activity may yet return as the market recovers.
National Grid has underperformed the FTSE All-Share index by 28 per cent since the start of the year, but emerges as the top buy pick of many utilities analysts. Its power transmission and distribution activities are 95 per cent regulated, which means revenues and cash flows are predictable, and the group has no exposure to fluctuating power prices. Earnings are split 50:50 between the UK and Americas, where a series of regulatory rate appeals stand to boost income. The future investment landscape is compelling, too – power networks must be smart enough to deal with the challenges of renewable energy, notably intermittent generation capacity, and supply-side innovation such as smart metering. The dividend policy of 8 per cent growth per year to 2012 is attractive, and the shares are yielding 6.5 per cent.
Around three-quarters of International Power's earnings are generated overseas and, as global economies recover, the pick up in electricity demand will have a positive effect on the 50 per cent of IP's generational capacity which is uncontracted or short term. Debt will be reduced by the recent £591m sale of assets in the Czech Republic, and the group is growing exposure to renewables with last week's acquisition of Canadian wind farm developer AIM. Generating the highest level of free cash flow in the European utility sphere, a 40 per cent payout ratio is targeted, equating to a 4 per cent yield at today's share price.
Scottish & Southern Energy has a well-balanced portfolio of regulated and non-regulated businesses, plus supply customer and generation assets. Boasting one of the largest renewables portfolios, a further 26 wind farms are under construction or in planning. The dividend policy of 4 per cent 'real growth' (after inflation) means a 6.5 per cent yield is forecast next year.
Finally, Centrica's ability to participate in new-build nuclear via its 20 per cent stake in EDF's takeover of British Energy is a long-term bet on the UK's nuclear future. Its more recent takeover of Venture was seen as a shrewd deal, and one that crucially increases its generation assets and reduces exposure to fluctuating wholesale prices. Having underperformed the FTSE All-|Share by 22 per cent this year, the dividend yield is close to 5.5 per cent.
