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Severn Trent - Opening up the dividend taps

George Salmon | 23 May 2017 | A A A
Severn Trent - Opening up the dividend taps

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Severn Trent plc Ordinary 97 17/19p

Sell: 2,036.00 | Buy: 2,038.00 | Change 35.00 (1.74%)
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As expected, Severn Trent has increased the 2016/17 full year dividend in line with RPI inflation to 81.5p per share. However, the group has adopted a more ambitious policy of increasing the dividend by 'at least RPI +4%' out to 2020. The shares rose 2.1% on the news.

Our View

Severn Trent is a straight-forward water utility, providing water and sewerage services to over 4m customers in the Midlands and Wales. While it also provides commercial services across the UK and internationally, it is the regulated utility division that generates the lion's share of group profits.

In the UK, water and sewage prices are regulated, with Ofwat setting price limits every five years. The regulator has a track record of setting tough, but achievable limits that allow efficiently run water companies to achieve acceptable financial returns. Severn Trent has historically coped well under the system.

With revenues that are linked to inflation by Ofwat's price formula, Severn Trent has a relatively predictable level of real income. That visibility of income has previously attracted outside interest from major pension and infrastructure funds, interest that could be renewed in future.

For now however, the main attraction of Severn Trent, like most utilities, is the dividend. In a world of ultra-low interest rates and depressed bond yields, these stocks have become a more attractive option for income-seeking investors.

This has seen Severn Trent's shares rise in recent years, and they currently trade well above their historic average price to earnings ratio. While we don't see a sharp reversal of current economic conditions in the near-term, this higher rating could be vulnerable if the Bank of England raises interest rates earlier, or faster, than expected.

Whatever the future holds for the UK's economy, the group's regulated revenues mean that its earnings are unlikely to fluctuate much, which should underpin confidence in the dividend. The shares currently offer a prospective yield of 3.4% and the group has announced a more generous policy, to increase the dividend by 4% above the rate of RPI inflation.

Full year results

Group revenue for the year to 31 March 2017 was £1.8bn, up 3.7%. Growth of 11.9% in the business services division augmented a 1.5% increase in pricing in the Regulated Water and Waste Water businesses.

Underlying profit before interest and tax came in at £525 million, up 4.3%. Regulated Water and Waste Water remains responsible for around 95% of group profits.

Severn Trent achieved Customer Outcome Delivery Incentives from the regulator (Ofwat) of £47.6m, which reflect a strong operational outperformance and a milder winter. This helped the group deliver a return on regulated equity of 11%, up from 9.7% for the current regulatory period to date.

On 15 February 2017 Severn Trent completed the acquisition of Dee Valley Water for £84m. Progress in integrating the acquisition into the regulated business is said to be progressing well, with synergies set to be realised from 2017/18.

A further £100 million of extra total expenditure savings have also been identified. The group is now expecting to achieve £770m of efficiencies in the 2015-2020 regulatory period. £610m of these efficiencies now locked in, including a further £70m identified in H2 2016/17.

Net debt is £5.1bn, up £259m year-on-year, however debts as a percentage of regulatory capital have remained stable at 61.6%. The group's effective interest rate reduced year-on-year by 10 basis points to 4.4%, despite rising RPI inflation.

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. 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.