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Utilities shares sector update – insulated not immune

Emilie Stevens, Equity Analyst, takes a closer look at what the pandemic has meant for some of the FTSE 100 utilities.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

We asked clients which topics they'd like to hear more about. This article's been written based on what they told us.

Defensive sectors provide investors with a degree of shelter when the economy hits a rough patch. And as sectors go, it doesn’t get much more defensive than utilities.

Demand is steady as electricity and water aren’t things we typically choose to cut back on. In return for providing a reliable and affordable service, the regulators Ofwat (for water) and Ofgem (for gas and electricity) allow companies to earn an ‘acceptable’ income. This is agreed in advance as part of different price or regulatory periods.

With lots of businesses, particularly those that rely on us leaving the house to spend our money currently facing dramatic falls in revenue, it’s perhaps no surprise utilities stand out. On the whole utilities have fared much better than the wider stock market.

Line chart showing the performance of utilities vs the stock market

Scroll across to see the full chart.

Past performance isn't a guide to the future. Source: Refinitiv, 01/05/20.

But utilities face challenges from COVID-19 too. As the graph above shows, not all utilities are faring equally well in the current climate.

Water – a clearer picture

Water companies have just started their next regulatory period which lasts until 2025. This means price controls have been set, financial plans agreed and work to improve our water supply started.

This provides a nice degree of predictability for listed water players – United Utilities (UU), Severn Trent (SVT) and Pennon (PNN). But the next five years is not without challenge.

Ofwat has reduced the financial returns companies can earn and increased other performance targets, like reducing leakage. As with other businesses, lower earnings tends to mean less generous returns for shareholders. And that’s seen SVT and UU reduce the generosity of dividend policies for the next five years, we’ve yet to hear from Pennon.

For workers, the day job is harder at the moment too. Social distancing is adding a logistical challenge to keeping up the same service, and all our hand washing is putting a strain on supply (one hand wash uses as much as two litres of water).

And it’s not just households that might struggle to pay bills but businesses too, which make up around a third of revenues.

While we haven’t heard anything yet, these challenges might come at the cost of service performance improvements and cost savings in the short term – two ways water companies can boost earnings.

But despite the uncertainty water companies are a resilient bunch – so far all three remain on track for the full year. They’re in good shape financially with debt under control and earnings stable. That could bode well for dividends – although no dividend is guaranteed.

Power – a mixed picture

There are more moving parts in the power sector, and the big players, National Grid, SSE and Centrica have a bit more going on under the hood like renewable energy, retail supply and nuclear.

Coronavirus restrictions are expected to see power demand and prices drop, largely driven by reduced business activity. This is expected to impact earnings, particularly for those companies like SSE and Centrica who are involved in the generation as well as distribution of electricity.

As the owner and operator of essential electricity and gas infrastructure across the UK and North-eastern US, National Grid will feel it too. But delivering power to homes and businesses is a regulated affair both here and in the US, so it will be able to recoup lost earnings in the future. Despite additional challenges presented by COVID-19, National Grid says full year expectations remain unchanged.

National Grid operating profits (£bn)

Source: National Grid Annual Report 2019.

For SSE delivering electricity to homes and businesses is only part of the story. Renewable energy like wind farms and hydropower make up just under a third of profits and is a big part of SSE’s future. While it has the potential to boost earnings, returns are dependent on the unpredictable British weather and the wholesale energy price – making them less stable.

This together with a significant debt pile, means the dividend doesn’t look so comfortable. SSE still intends to pay a dividend this financial year, but that could be subject to change if the impact of coronavirus is greater than expected – so we’d suggest an air of caution.

Centrica looks set to wear the current crisis the worst. Its uphill battle in the Consumer and Business divisions, while also trying to exit oil & gas and nuclear operations, has been rumbling on for a while. The pandemic and oil price crash look set to make things even worse. Lower demand, particularly from businesses, and increased bad debts, is expected to knock earnings in the near term. These conditions led Centrica to cancel last year’s final dividend at the beginning of April and the outlook for future payments remains unclear.

The power sector is not without opportunity for investors but performance varies significantly among companies. It’s important to be selective and know exactly which parts of power, whether that be networks or nuclear, you’re exposed to.

Things to think about

On the whole utilities have unrivalled reliability when it comes to earnings, which is particularly valuable at times like this.

Although the sector isn’t one that typically offers rapid growth, more predictable earnings has traditionally meant good news for dividends. But, the sector isn’t completely insulated from the current challenges and there are several company specific issues. Dividends are variable and not a reliable indicator of the income you’ll receive in future.

When thinking about investing in utilities we think there are two important questions to ask.

Is dividend income what I’m looking for from an investment? And if it is, can this company afford to keep paying it?

Keep up to date with developments in the utility sector by signing up to our Share insight email.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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