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The dividend is on the line at this risk-laden utility

England's regulated water monopolies are heading for a reckoning. United Utilities might be the first in line
April 27, 2023

Predicting the outcome of the next UK election, which is likely to be 18 months away, is a bit like trying to pick a stock that will outperform the market next year. Like share prices, political races rarely follow linear trajectories and outcomes can be swayed overnight by unforeseen events. But while nothing can be assumed, if sentiment and voting intentions are an indicator of anything, the latest polling suggests Labour could form the UK’s next government.

Tip style
Sell
Risk rating
Medium
Timescale
Medium Term
Bull points
  • Stable customer demand
  • Cheap bond financing
Bear points
  • Rising interest and capital costs
  • Growing political scrutiny
  • Inflation increasing opex
  • Dividend and fine threat

Improving the health of the UK’s waterways is likely to be among the party’s top priorities should it ascend to power in 2024. Earlier this month, shadow environment secretary Jim McMahon proposed legislation that would impose automatic fines on water companies caught dumping sewage. The practice is worryingly widespread – with the environment agency reporting that raw sewage was discharged into England’s rivers and seas for 1.75mn hours last year, or an average of 825 times each day.

The vast majority of these pollution incidents were perfectly legal. This is because the country has a “combined” sewerage system, meaning wastewater and surface water flow into the same pipe system before being treated. Water companies use overflow valves called combined sewer overflows (CSOs) during periods of heavy rainfall to prevent sewage from accumulating in these pipes and spilling into homes and businesses. In theory, CSOs are only meant to be used in exceptional circumstances. But that’s evidently not the case.

 

Murkier outlook

Cheshire-based United Utilities (UU.) is the country’s worst offender in terms of hours of overflows and sheer number of spills last year. This makes it an obvious target for both political and environmental campaigners. It looks likely that the company will find itself at the centre of a regulatory storm during an era of soaring inflation. As debt gets more expensive, it’s hard to imagine United Utilities making costly, albeit necessary, improvements in infrastructure without taking a harder look at a dividend whose earnings cover looks threadbare. Shareholders should be on alert.  

 

 

Investors have long prized England’s listed water companies for their predictable, bond-like dividend yields and resilience in the face of economic turmoil. Consumers aren’t going to stop using water in the event of a recession. What’s more, because the country’s 17 water companies operate as regional monopolies, it’s not possible for a disgruntled householder to change provider. On paper, there are very few stocks as safe as an English water company. 

The long-term market record of United Utilities, whose shares’ average annual total return of 10.4 per cent over the past 13 years has comfortably eclipsed the FTSE All-Share, demonstrates this. Even today, it is a business that appears to be in rude health, particularly given the state of the wider economy. It grew both shareholder equity and earnings in the year to the end of March 2022. When it released interim figures last November, the company predicted revenue would fall 1 per cent for the full financial year due to lower-than-expected customer consumption. This £34mn impact would, however, be recovered by 2025, according to management’s forecasts. 

FactSet broker consensus puts estimated revenue for the 12 months to March 2024 at £2bn – the highest figure for more than a decade. However, the resilient top line belies some trouble brewing under the surface, particularly where leverage is concerned. The group’s average effective interest rate doubled from 4.5 per cent to 9 per cent in the six months to 30 September 2022. This is because a slug of its debt is inflation-indexed, meaning that it guarantees holders a return greater than, for instance, the retail price index (RPI). 

As of 31 March 2022, the company said it had £4.3bn of index-linked debt exposure, meaning that every 1 per cent increase in inflation equated to a £43mn higher interest charge. Although the company has since been able to tap the bond markets at cheaper rates than the retail price index (RPI), FactSet broker consensus puts the company’s interest charge for the recently ended financial year at more than £364mn – up from just £118mn in FY2022. Brokers now assume that the cost of servicing this debt will fall to £212mn for the current year (presumably due to slowing inflation). 

 

Search for clarity

However, this doesn’t change the fact that the company is heavily geared and perhaps more exposed to interest rate risk than its ‘bond proxy’ status might lead investors to believe. By September, the group’s net debt to Ebitda ratio – a measurement of a company's ability to pay down its liabilities – was 7.83. The lower this ratio, the higher the chances are that a firm can successfully lower its debts and take a more flexible approach to the way it deploys cash.

While United Utilities’ leverage is comparable with sector peers Severn Trent (SVT) and Pennon (PNN), which clock in at 7.3 and 8.1, respectively, it’s worth remembering that United Utilities is England’s most prolific sewage spiller. This leaves it most exposed to political backlash. “With Labour now materially ahead in polling… we think the market should start to price in a more adverse regulatory environment,” cautioned Jefferies analysts in a recent note on the listed sector. 

The broker sees revenue growth being outpaced by cost pressures across the sector this year, and cut its Ebitda forecasts for Severn Trent and United Utilities by 7 per cent and 6 per cent, respectively. Against these operating challenges, investors also need to keep an eye on the rollout of new dividend payment restrictions by Ofwat. As of 17 May, the regulator has said it will stop the payment of dividends if they risk a firm’s financial resilience, and force companies to take account of environmental and customer performance as part of their shareholder rewards.

 

 

Whether this is just strong rhetoric from the regulator, or a precursor to genuine punitive action, is yet to be determined. It’s also important to state that United Utilities’ combination of guaranteed water sales and largely long-dated and cheap debt do not raise imminent questions about its capacity to meet its liabilities.

But that doesn’t mean the shares’ investment case is resilient, particularly amid a government consultation on whether the Environment Agency should have greater powers to levy fines on polluting water companies. The profits and payouts of water companies are clearly under the microscope like never before – and current investors should be aware that this may have share price implications. 

Growing political risks and scrutiny of sewage dumping, together with the prospect of uncapped civil fines and new regulations on dividends collectively amount to a “close-to-nil premium” valuation for the shares, in the eyes of Jefferies’ analysts. With United Utilities’ shares priced at 35 times adjusted earnings for the next 12 months, investors seem to have taken a generous view of the company’s many acute risks and anchored their valuations to Pennon and Severn Trent’s similarly toppy forward earnings multiples of 48 and 33, respectively.

Markets, it would seem, still have the water companies’ historically reliable performance at the forefront of their minds. However, analysts at JPMorgan recently dubbed National Grid (NG.) the top bond proxy among UK utilities. Its reasoning? Greater regulatory clarity and a better growth profile than the water and sewage providers. Critics of the sector have argued that water infrastructure has been neglected in favour of paying dividends and awarding bonuses to c-suite executives. United Utilities has become the poster company for this variety of mismanagement. Shaking that reputation is not going to be quick – or easy.

Company DetailsNameMkt CapPrice52-Wk Hi/Lo
United Utilities (UU.)£7.37bn1,082p1,173p / 813p
Size/DebtNAV per share*Net Cash / Debt(-)Net Debt / EbitdaOp Cash/ Ebitda
434p-£7.73bn7.3 x135%
ValuationFwd PE (+12mths)Fwd DY (+12mths)FCF yld (+12mths)P/Sales
354.6%2.3%4.1
Quality/ GrowthEBIT MarginROCE5yr Sales CAGR5yr EPS CAGR
30.8%5.7%1.8%-
Forecasts/ MomentumFwd EPS grth NTMFwd EPS grth STM3-mth Mom

3-mth Fwd EPS change%

-64%2.2%

32.7%

Year End 31 MarSales (£bn)Profit before tax (£mn)EPS (p)DPS (p)
20201.8643663.042.6
20211.8145756.243.2
20221.8634253.843.5
f'cst 20231.83-42-3.946.0
f'cst 20242.0125230.149.8
chg (%)+10--+8
source: FactSet, adjusted PTP and EPS figures
NTM = Next Twelve Months
STM = Second Twelve Months (i.e. one year from now)