Severn Trent (SVT) and United Utilities (UU.) were far from bullish when they recently revealed their March year-end figures, but they still felt able to crank-up their share-based returns when many other top-tier constituents were busy squirreling away the cash.
If you take the view that we are staring down the barrel of a lengthy recession, it is not surprising that many investors might seek shelter in alternatives to cyclical stocks, whose performance is entwined with economic growth rates.
Utilities offer relative predictability. Slow growth combined with regular cash flows and regulated markets. They are effectively unassailable given the high fixed costs of distribution in the power and water industries.
It is these sunk costs which would deter not only competition, but any prospect of withdrawal from these markets – even before you consider the ineffectual regulatory framework foisted upon these natural monopolies, post-privatisation. You get the impression that ministers were never quite sure how to square the demands of shareholders with those of customers. So we have been lumbered with a halfway house; privatised monopolies operating within the public sphere. The Labour Party’s renationalisation policies may have been wholly unpalatable to many people in the country, but is doubtful whether they cost it the last election.
Although we are left with an imperfect system, we have been prepared to pay high multiples for the utilities in expectation that they will outperform the wider market during economic downturns, while providing a regular income stream. If this represents an easy assumption, it is not difficult to understand why we may have become complacent about whether the utilities can keep on delivering on both fronts, even though the former could well depend on the latter.
The trouble is that the demands of customers and shareholders may not be reconcilable, at least in regulatory terms. Last year, Centrica swung from a £987m statutory operating profit to an £849m loss following the introduction of a price cap on UK energy bills. Theoretically, demand for energy is inelastic, in that it is relatively stable in response to price variations, but that is moot in view of Ofgem’s statutory intervention in the market.
They may have a captive market, but the only way utilities can grow is through acquisition. That helps to explain why English water companies have amassed around £50bn in aggregate debt since they were privatised 30 years ago. But share-based returns have also served to bump-up leverage, even though utilities are highly cash-generative businesses. Then there is the perennial issue of infrastructure renewal. Ofwat recently challenged the UK’s water companies to spend an additional £13bn on infrastructure investment over the next five years, while reducing household bills.
Under the Water Industry Act 1991, it is Ofwat’s responsibility to make sure that water companies can finance their planned operations. Given the absence of a conventional market, the key metric in utility pricing is known as Regulatory Capital Value (RCV). It is a measure of a utility’s assets by which the regulator bases the regulated rate of return – and prospective distributions. But some analysts now question the efficacy of this mechanism because of the scale of the debts now carried by the utilities.
United Utilities signalled that it was re-examining its dividend policy for the new regulatory period, AMP7, which commenced in April. This is probably just as well given that its debt interest and principal repayments, combined with its dividend commitments, were equivalent to 97 per cent of operating cash flow in FY2020 – not much wiggle room there. Severn Trent’s ability to meet its immediate obligations could also be brought into question given a quick ratio of 0.54 and net debt representing 5.1 times shareholders’ funds.
Utilities are capital intensive by nature, so you would expect them to have higher debt-to-equity ratios than many other sectors, but there must be a limit. The existing regulatory regime has proved favourable for income seekers, but there is a chance that the industry watchdogs may soon be compelled to prioritise capital adequacy over distributions.
