The safety and value of water company dividends

That said, if you look at the profits and cash flows of water companies, you could be forgiven for thinking that the dividends look unsustainable. They are thinly covered by profits, uncovered by free cash flows and have to be paid after large chunks of debt. The truth is that they are perfectly affordable for now, but maybe not for very long. More on this shortly.

Britain’s water companies were privatised nearly 30 years ago and have paid out chunky dividends to their shareholders. Those dividends have also proved to be very popular with corporate buyers. Of the 10 big water companies that floated on the stock market 30 years ago, only three remain. So let’s have a look at what’s been going on with water company dividends.

Water company dividends over the past 10 years

At first glance, water companies seem one of the safest homes for your money on the stock market. After all, everybody needs and uses water regardless of what’s going on with the economy. This means that the profits and cash flows of water companies should be relatively easy to predict. They should be relatively stable and are unlikely to bounce up and down a lot.

And in general they are. However, because water companies are natural monopolies and face no competition, the amount of money they can ultimately make is controlled by an industry regulator, Ofwat.

Every five years, Ofwat takes a good hard look at how good a job the water companies have been doing in delivering water and sewerage services to customers (known as a periodic review). It also looks at how much money they have been spending and how profitable they have been. It then puts together a plan for the next five years.

It tells the water companies how much money they should be spending on maintaining and replacing some or all of the pipes, sewers and reservoirs that they own and how much they can spend on expanding their networks.

If Ofwat gets its sums right then customers should get a reliable source of clean water without their bills going up too much. In return, the water companies will be able to earn a reasonable profit on their assets. After spending money keeping those assets in good working order, they should have enough money left over to pay the interest on their substantial borrowings, tax and those all-important dividends to shareholders.

During the early years after privatisation, water companies were able to pay big dividends that kept increasing every year as they cut more costs than Ofwat expected them to. Ofwat eventually wised up to this and started setting very tough efficiency targets on spending and even cut customer bills.

On top of this, as interest rates and the cost of borrowing money has come down in recent years, Ofwat has ruled that water companies don’t need to be as profitable as they were in the past – they can get by with lower profits and a lower return on their assets.

As a result, it has become more and more difficult for water companies to keep on increasing their dividends. Some dividends have even been cut.

If you look at the chart below you can see that the dividends paid by the three remaining water companies have been through a bit of a rocky patch during the past 10 years. Both Severn Trent (SVT) and United Utilities (UU.) have had to cut their dividends, whereas Pennon (PNN), which owns South West Water, has been able to keep on increasing its payouts.

During the previous Ofwat price-setting period between 2010 and 2015 all three companies were able to pay a rising annual dividend to their shareholders. For the current period, 2015-20, Severn Trent had to slightly cut its dividend while United Utilities has had very weak dividend growth. Pennon has remained the star dividend payer of the three.

But on a close inspection of their profits and cash flows you could be forgiven for asking how on earth they have been able to do this.

Source: SharePad. FCF = free cash flow.

Without doing any further research, just looking at the numbers in the table above it could easily lead you to worry about the safety of water company dividends.

Why do I say this?

Well, for starters, the forecast dividends are barely covered by profits (in this case earnings per share, EPS) as the forecast dividend cover ratios are hovering at around 1.3 times. This does not offer much in the way of a protective buffer against possible price cuts by the regulator. However, in reality, dividends are not paid from profits but from cash flow. The past history of water companies’ cash flow makes for very grim reading.

During the past 10 years, water companies have spent a lot more money on assets than the depreciation charge in their accounts. This has meant that there hasn’t been much in the way of free cash flow produced – certainly nowhere near enough to fund the total dividends paid to shareholders.

Water company capex spending vs depreciation

Source: SharePad

So what’s been going on? Have the water companies been pulling the wool over investors’ eyes and been borrowing money to pay dividends as some investors might think? Or is there a clearer explanation?

The truth behind water companies’ profits and cash flows

One of my favourite – and most challenging – parts of investment analysis is trying to work out how much a company has to spend to stay in business and keep its existing assets in good working order.  This is known in professional investment circles as maintenance or 'stay-in-business' capex and can be a lot different from a company’s depreciation expense.

You need to try to get a feel for what this number is if you are to work out what a company’s true profit really is. The bad news is that it is virtually impossible for a private investor to do this with any accuracy.

The good news for investors in water companies is that you can find out what this number is. Don’t bother looking at a company’s stock exchange news releases or annual report, though, you are unlikely to find it there.

Water companies produce two sets of accounts. One for their investors and one for their regulator. You need to ignore most of the numbers in the annual report and instead get your hands on a copy of a company’s regulatory accounts, or the annual performance report for the water company rather than the plc. You can find these valuable reports quite easily on company websites.

Getting valuable information out of regulatory accounts

Stay with me on this one. You are about to learn why the numbers in regulatory accounts are extremely useful. Things have changed slightly since 2015. Before then, companies used to produce regulatory accounts based on current costs. Today, they present numbers in an annual regulatory performance report.

Standard company accounts are based on something known as historic costs – what was actually paid or received at the time of a transaction. Some water company assets can last for more than 30 years, which means that the depreciation charge in the accounts might be based on the cost of something 30 years ago. That asset will probably cost a lot more to replace today.

Current cost accounts adjust costs for inflation so that the depreciation charge is a more realistic estimate of what a water company needs to spend to maintain its assets. In current cost accounts before 2016 you will have found two key numbers:

• Current cost depreciation
• Infrastructure renewals charge

If you added these two numbers together you would get close to having a true and accurate figure for stay-in-business capex. You could use that figure to work out a water company’s real profits and the cash flows available to pay dividends.

In the annual regulatory performance accounts from 2016 onwards, the numbers that you need are set out a little bit differently:

• An infrastructure renewals charge that is expensed against revenues and therefore reduces operating profit.
• The cash spent to maintain the capability of non-infrastructure assets – found in the cash flow statement.

Essentially, if you take a water company’s operating cash flow – which has a deduction for infrastructure renewals – and take away the maintenance capex in the cash flow, you will have the basis for a proxy for cash-backed profits that can be used to pay dividends for shareholders.

How water companies have paid for their dividends

Taking these numbers, we can see how the three listed water companies paid their dividends from their cash flows in the last regulatory period and in the current one.

Let me explain what’s going on here. In the top half of the table, you have a standard calculation of free cash flow where total capex is subtracted from operating cash flow. Below is a figure for maintenance expenditure or stay-in-business capex. To calculate adjusted free cash flow, we add back total capex to our standard free cash flow and take away stay-in-business capex.

You can also see the dividends paid by the water company back to the parent company – the plc. The other thing to bear in mind is that the company’s cash flows over a five-year period can be quite lumpy – as capex spending and revenues can be subject to phasing – so focus on the cumulative figures instead.

If we look at United Utilities on the basis of standard free cash flow and compare it with the cash dividend paid to shareholders then it seems there is a problem. It only produced £238m of free cash flow over five years to 2015, but paid out just over £1.1bn in dividends to shareholders – a free cash flow dividend cover of just 0.21.

However, if we look at adjusted free cash flow then it virtually matches – it is slightly more than – the amount of money paid out in dividends. In other words, the dividends paid have been perfectly affordable. This remains true for the current regulatory period so far.

The company has then borrowed money to expand its asset base (the portion of capex greater than maintenance capex).

The same story is true for Severn Trent and South West Water (Pennon) as shown in the tables below.

Source: Company reports

Source: Company report

What about dividends after 2020?

The water companies have had detailed spending plans for the period 2015-20 given to them by Ofwat. This means that they have a very good idea how much money will be coming into the business and how much will be going out. This in turn means they also have a good idea of how much free cash flow there will be and the size of dividends they can pay. These are probably reflected in current analysts’ forecasts.

Focus is now turning to the ability of companies to pay growing dividends after 2020. This will be determined by four main factors:

1. The allowed return on regulated equity (RORE).This is set at an average of 5.65 per cent in the current 2015-20 regulatory period.
2. Outperformance on financing and spending costs.
3. Outperforming service and output delivery targets.
4. Increasing leverage and paying it to shareholders.

The RORE is where the key threat rests. Companies essentially pay a base dividend based on the RORE and then adjust it based on the other considerations above. So if a company has regulated equity of £1bn and the base RORE is 5 per cent, its base annual dividend will be £50m.  The regulator will set customer bills and spending targets to allow companies to meet a target RORE.

The other challenge is that customer bills and company revenues will be linked to consumer price index (CPI) inflation rather than the higher retail price index (RPI) inflation. This may also have the effect of bringing down future profitability and returns

The chances are that the target RORE is going to come down and possibly by quite a lot. Companies are currently smashing their target returns and are financing themselves with very cheap debt. The regulator has a strong case for telling the water companies that some of these extra profits are going to have to be given back to customers in the form of lower bills.

Source: Company reports

Leverage is unlikely to go much higher, but companies could still have the chance to make extra profits from delivering better services and outputs.

What dividend outlook is factored into current share prices?

As adjusted free cash flow and dividends are likely to be very similar over a control period, you can attempt to value water shares using a dividend discount model (DDM). This is based on using an interest rate to discount the value of future dividends back to a present value today.

Estimated value of water company shares based on future dividends

Source: SharePad/My calculations

Here are some estimated values for each water company. They are based on the expected final dividend for 2019 and the full-year dividend for 2020. After 2020, a long-run growth rate of zero and 2 per cent (growing with CPI inflation) are used to get terminal values. All values are then discounted back to a present value using a discount rate of 7 per cent.

Remember the lower the interest rate and the higher the growth rate of dividends assumed, the higher the value of the share will be. Water companies are seen to be quite low-risk investments hence the choice of a relatively low interest rate of 7 per cent.

Based on these assumptions, it seems that water companies are going to have to grow their dividends by more than 2 per cent per year after 2020 in order to be seen as good value today. Out of the three, perhaps Pennon, which has a significant source of additional profits coming from its Viridor Waste business, has the best chance of doing this.

Enterprise value (EV) to regulatory capital value (RCV) multiples

Another useful number in the regulatory accounts is something known as the regulatory capital value (RCV). This is the total value of the water company’s assets and is used by the regulator to set a company’s allowed profits. RCV is sometimes referred to as regulatory asset value (RAV) of regulatory asset base (RAB).

RCV is also seen by City analysts as an estimate of the market value of the water company. To see if a water company’s shares are cheap or expensive the company’s enterprise value (the market value of shares plus net debt) is often compared with its RCV.

Here are some rough rules of thumb for using this method:

• EV should be more than RCV if a company can make more money than the regulator has assumed – known as a premium.
• EV should be less than RCV if the company will make less money than the regulator has assumed – known as a discount.

A premium should be biggest at the start of a price review period to reflect the size of any extra profits expected to be made. As the next price review approaches (in 2020) the premium should be very small and could even move to a discount as the regulator shares any gains made with customers by lowering prices in the future.

Some water companies have been taken over for as much as 40 per cent more than their RCV in the past. These takeover prices have been mainly explained by the buyer being able to stuff the company with lots of cheap debt and therefore make more money than the regulator had assumed. 

Source: Company Reports/My calculations 

Pennon and Severn Trent have non-regulated business that will have a value implicit in their EV. This has to be estimated and deducted from the company EV to get an EV of the water business to be compared with the RCV.

On this basis, water companies are currently trading at a reasonable premium to their RCVs, indicating that they are not particularly cheap at this late stage of the regulatory cycle.

The analysis of water companies is quite involved, but hopefully you can see that a bit of extra effort helps you to learn a lot more.