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Utilities - coming off the boil?

Utilities - coming off the boil?

19 April 2018

No news or research item is a personal recommendation to deal. All investments can fall as well as rise in value so you could get back less than you invest.

Shares in the utilities sector have come under pressure in recent months, with many major players falling by over 20%.

Here, I explore three reasons behind the sell-off, and share our view on the sector.

Nationalisation

“Rail, water, energy, Royal Mail – we’re taking them back”. These words from shadow chancellor John McDonnell have brought the question of nationalisation back to the surface for the first time in a generation.

The Labour Party thinks bringing the utilities sector back under government ownership is in the national interest. Whether that’s the case is more Question Time than Investment Times, but given the uncertainty for shareholders, we can’t ignore this issue.

There’s not much separating Labour and the Conservatives in the polls, and Theresa May’s slim majority evaporated in the 2017 election. Strong and stable doesn’t exactly describe the political landscape.

It isn’t clear how Labour plans to deliver its promise if it wins the next election, whenever that may be. The most obvious route would be to simply buy the shares in the open market. Another would be to pay a premium to the prevailing market price in much the same way a private takeover works. In this situation, being bought is usually no bad outcome for investors. But nationalisation is no ordinary takeover.

Labour has itself acknowledged that the equity could effectively be seized with no compensation paid to shareholders. Plenty of dominos would need to fall in just the right sequence for shares to see significant falls in value, but in a world of political surprises, it’s easy to see why this is weighing on sentiment.

Regulation, regulation, regulation

It’s not just the Labour Party that’s adopted a tougher rhetoric.

The Conservatives’ price cap on energy bills, and a tougher stance on allowed returns for water companies, have also weighed on the sector.

Ofwat has a record of setting challenging but achievable goals, but Pennon, United Utilities and Severn Trent have all acknowledged the next regulatory period will likely be tougher, with lower rewards and payments from Ofwat both possibilities.

Interest rates

Income-seeking investors face a choice between the equity and bond markets.

Low interest rates have depressed bond yields. That means for bond investors, the well has been running dry for some time. In widening their search for income, some bond investors switched out of low-yielding bonds into utility shares, which have a reputation for reliable revenues, profits and dividends.

Up until not so long ago, it had looked as though utility companies were set to serenely sail through the calm waters of sub 1% rates for many years. However, the Bank of England looks to be eyeing higher rates.

Mark Carney has indicated a sharper than expected rise from the current 0.5% could be on the cards, and a rise in May is now widely anticipated.

This means we’re seeing cash flow back out of the utility sector, which has had negative effects on share prices.

Our view on the sector

All three of the above are risks that simply weren’t there 12 months ago.

However, we don’t think it’s time to write off the sector.

Higher interest rates may weigh on capital values, and could increase interest obligations as debts are refinanced but analysts don’t expect this to have a big impact on companies’ payout potential.

The question of nationalisation brings a new level of uncertainty. But as 2016 proved, predicting politics is difficult. Even if investors can predict the outcome of an election, they also need to foresee what change looks like. As a general rule, we feel politics and investing decisions should be kept at arms length where possible.

That leaves regulation. Upcoming regulatory changes mean stricter guidelines on what consitutes an acceptable return, and potentially higher investment requirements. Both will likely have an impact on profitability and cash flows, two of the pillars that dividend increases are built on.

Therefore it’s possible some of the more generous dividend policies in the sector could be reassessed. However, we feel any changes to dividend policies will be more tweaks than re-writes.

For example, Pennon and Severn Trent, which both target paying dividend increases four percentage points above the rate of RPI inflation, could move to a less ambitious goal. At the start of the next regulatory period they may adopt something more akin to the strategy of United Utilities, namely paying increases in line with RPI.

Again, taking the water companies as an example, Pennon, Severn Trent and United Utilities are all trading well below the more lofty PE Ratios of recent years, with dividend yields also looking more generous.

We think utility stocks could still form part of a diversified portfolio for income-seeking investors, but there are clearly a few dangers lurking.

Severn Trent share prices, charts and research

Pennon share prices, charts and research

United Utilities share prices, charts and research

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. The author holds shares in Pennon Group.

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    • 19 April 2018
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    Investment notes
    No news or research item is a personal recommendation to deal. All investments can fall as well as rise in value so you could get back less than you invest.

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