Some of the most defensives companies in the market, and old favourites for pension funds, self-invested personal pension (Sipp) investors and private shareholders alike, could soon be removed from the reach of investors. UK-listed utility companies provide inflation-linked income just when we need it most in our portfolios. The problem is they have attracted the attention of overseas investors precisely for their defensive qualities and strong cash generation.
This isn't a new problem for UK investors, but more takeovers are on the cards. Last year Northumbrian Water was snapped up by Hong Kong-based businessman Li Ka-shing and London-listed International Power has just been swallowed up by French giant GDF-Suez. Investors should take advantage while they still can, because if a takeover happens, you could benefit from a cash windfall.
A mouth-watering opportunity
The message was clear in a recent research note from analysts at Deutsche Bank: "Don't miss the opportunity to invest in UK utilities". They reviewed the changing market landscape from 1995 post privatisation to the present day and their findings display a clear trend. In the post privatisation period there were 29 listed UK utility companies with household names such as Yorkshire Electricity, London Electricity and Thames Water. Up until 10 years ago there were still 14 listed names. However, if shareholders accept the revised GDF-Suez bid, which is all but guaranteed, then there will be only seven listed UK utilities left.
One of the factors that has contributed to the dwindling number of listed utilities is that the UK is peculiarly open to foreign investment. The UK has no state control of utilities, and usually has very limited 'strategic holdings' which have proved a stumbling block to deals elsewhere in Europe.
What kind of price can shareholders expect when overseas investors come calling? The key to a valuation for utilities is something called the regulatory asset base or RAB; simply put, this is the value of reservoirs and treatment plants in the water utilities sector or power stations and gas assets in the power sector.
Deutsche Bank analysed utility deals over a 10-year period and found that the prices paid have ranged from a 10 per cent discount to RAB back in early 2000, to a 50 per cent premium in 2006. The average over the last 10 years has been around a 25 per cent premium, which is in line with both the Northumbrian Water deal and more recently the revised GDF-Suez offer at 418p for International Power. The table below provided by analysts at Investec Securities shows the current opportunities.
Current opportunities in the UK utilities sector
| Company name | Current price (p) | Price with 25% RAB Premium | Upside (%) | 5% RAB Discount | Upside (%) |
|---|---|---|---|---|---|
| Centrica | 319 | * | * | ||
| Drax | 540 | * | * | ||
| Int’l Power | 417 | * | * | ||
| National Grid | 646 | 660 | 2% | 476 | -26% |
| Pennon | 731 | 896 | 23% | 649 | -11% |
| Severn Trent | 1,600 | 2,227 | 39% | 1,272 | -21% |
| SSE | 1,360 | 1,278 | -6% | 1,185 | -13% |
| United Utilities | 604 | 989 | 64% | 563 | -7% |
| *No RAB data Source: Investec Securities | |||||
Sovereign wealth and infrastructure funds are willing to pay these prices because UK utilities represent relatively safe asset-backed investments. Quite apart from the returns on offer, the UK has a legal structure that is supportive of foreign investment and a government keen to encourage long-term investment. Over the next decade massive reinvestment is required to replace Britain's ageing infrastructure.
As with all investments there are some risks to UK utilities. The shares are not immune from a market crash, and when energy and water prices rise, consumption falls. But in the latest round of results the utilities reported strong results. There is also always the risk from government regulators keen to introduce more competition, but for now it looks like the priority is supporting further capital investment. The regulatory environment is fairly benign and this has been further boosted by the perverse macroeconomic conditions prompted by the global debt crisis.
As governments around the world put their printing presses into overdrive, elevated inflation looks here to stay. The prevailing high inflation and low interest rates is almost tailor made for utilities to prosper.
Calm waters
Water companies are yielding up to 4.5 per cent; the shares are defensive in a downturn and the dividend increases are inflation linked. The water industry, in stark contrast to the UK's power generating utilities, is in much calmer waters at the moment, as it is halfway through Ofwat's 2010 to 2015 pricing regime.
In fact, the sector has guaranteed dividend growth targets for the five-year period at retail prices inflation (RPI) plus 2 per cent for United Utilities, plus 3 per cent for Severn Trent, and plus 4 per cent for Pennon. Capital investment plans have been set for the five-year period as have the costs of debt. The water utilities have used their size and cash generation to lock in record low borrowing costs. Just as savers are getting punished by high inflation and low interest rates, water companies will benefit.
Safety in a market meltdown
| 01-Apr | 21-May | Dividend yield | RPI + Dividend increase | ||
|---|---|---|---|---|---|
| FTSE 100 | 5,874 | 5,294 | -9.90% | ||
| Utility Sector Average | 0.80% | ||||
| Pennon | 719 | 718 | -0.10% | 3.80% | 4% |
| Severn Trent | 1,570 | 1,648 | 5.00% | 4.50% | 3% |
| Centrica | 323 | 312 | -3.40% | 5.00% | |
| Drax | 548 | 557 | 1.60% | 5.00% | |
| United Utilities | 614 | 620 | 1.00% | 5.10% | 2% |
| National Grid | 644 | 668 | 3.70% | 5.90% | |
| Scottish & Southern | 1,355 | 1,326 | -2.10% | 6.10% |
Power to the people
The UK power sector is facing huge changes in the coming decade. Regulator Ofgem estimates £200bn is required to replace ageing infrastructure in the network or the lights will quite literally go out. To fund this prices will have to rise, but the regulator is keeping a lid on increases through a price control scheme called RIIO (Revenue = Incentives + Innovation + Outputs). National Grid is expecting the results of the first proposals in July with a final determination in December; these will be key dates for shareholders. Analyst Mark Freshney at Credit Suisse points towards recent RIIO consultation decisions for Scottish power and Scottish Hydro which supported shareholder returns while keeping price hikes to a minimum, and thinks this is favourable for companies such as National Grid.
Liberum estimates we will see 70 per cent price rises in energy bills by 2020 as chancellor George Osborne introduces a carbon floor price from 1 April 2013. This will make some ageing gas power stations in the UK, which are already struggling from high gas prices and paper thin margins, uneconomic to run. In addition, coal-fired power stations that spew out carbon will have to switch to biomass or close. There is a huge amount of investment being undertaken by UK power companies and further progress relies on state guidance.
The imminent release of the UK Government renewable banding review (ROC) will outline the level of support for electricity produced from renewable sources. This will stimulate the next phase of investment in the industry. Drax will be looking for a ROC subsidy of 1 per megawatt hour (MWh) for co-firing coal and biomass - support at this level will fund investment to get co-firing up to 50 per cent, anything below 1 will hit shares. Scottish & Southern Energy has invested heavily in wind and hydro generation and its shares will be well supported if the banding for wind is 1.8 times per MWh for offshore and 0.9 times per MWh for onshore as expected.
MAGNIFICENT SEVEN
Centrica is a well diversified mix of a downstream gas and electricity retailer combined with an upstream oil and gas extraction business. The most recent set of results showed that a mild winter and soaring gas prices had caused profits to slump in the British Gas retail arm. But Centrica more than made up for this with bumper profits in the upstream division as it benefited from record wholesale gas prices.
Centrica has also been making big investments in new gas fields as elevated prices create attractive returns. The shares, at 318p, trade on a forward PE ratio of 14.2 times and the utility has been linked with bids from Russian state gas giant Gazprom in the past.
As the largest listed utility with a market capitalisation of £22bn, it would take someone with extremely deep pockets to tackle a deal of this size.
What is attractive about Grid is its exposure to the US recovery through its retail arm there. Analysts at Deutsche Bank see a more likely scenario as a sale of its UK or US gas distribution business or the sale of a strategic stake in the UK transmission business to fund much-needed investment. The shares, at 647p, trade on an undemanding forward PE ratio of 12.4 times.
SSE – Scottish & Southern Energy
Is well diversified across generation types having invested in hydro and wind. It is therefore well placed to benefit from this renewable energy source when electricity prices rise.
Its first-half results were hit by high wholesale gas prices as it was unable to pass these on to customers and analysts expect most of the profits to be made in the second half of the year. Analysts at Deutsche Bank point out that Spanish utility Iberdola owns Scottish Power, which would have some synergies in a deal with SSE. The shares, at 1,323p, and on a forward PE ratio of 12.6 times generate a yield of 6 per cent.
The largest coal fired power station in Europe - is currently enjoying low coal prices, cheap carbon permits and high electricity prices. This situation won't last as the government is bringing in a carbon floor which will eat into Drax's margins. Drax has plans to greatly increase the amount of biomass, but further investment will depend on government support when the ROC banding is announced shortly. It is a strategic power asset fulfilling 7 per cent of UK power demand, so with the shares at 562p and on a forward PE ratio of eight times, they remain a buy. Analysts think that once support for biomass is clarified it could invite a bid from Centrica.
The largest of the listed water utilities by market capitalisation - is also the purest way to get exposure to the sector, with 99 per cent of the business being the regulated water industry. Like all the other water utilities, United has an inflation-linked annual dividend increase set at RPI plus 2 per cent. At 621p and on a forward PE ratio of 11.3 times, the shares remain a solid buy.
This water utility offers something a little extra for investors by way of its fast-growing waste management arm Viridor. Proving that where there's muck there's brass, Viridor looks well-placed as councils around the country outsource waste collection.
The waste management arm produced over half the group's pre-tax profits in the half-year results and the regulated business South West Water announced a strong performance as it grapples with record low rainfall. Management said it was confident the group would meet expectations in the February update.
Pennon is the smallest of the water utilities and as such could be attractive to sovereign wealth funds. The shares, at 725p with a forward PE ratio of 16.2, price in much of the growth from Viridor already.
All the water utilities are attractive targets for infrastructure funds searching for inflation-proofed income in defensive industries. Severn Trent's most recent half-year results reported a profit slip on exceptional charges relating to assets in Italy that had been hit by the debt crisis.
The core water business is more stable and this generated solid underlying earnings. In a February trading update, Severn Trent said it expected a better second-half performance and that trading was in line with expectations. The shares, at 1,594p and on a forward PE ratio of 15 times, are still a buy.
