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Severn Trent - dividend intact, next year more challenging

Emilie Stevens, Equity Analyst | 20 May 2020 | A A A
Severn Trent - dividend intact, next year more challenging

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Severn Trent plc Ordinary 97 17/19p

Sell: 2,484.00 | Buy: 2,486.00 | Change -19.00 (-0.76%)
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Severn Trent's revenue rose 4.3% over the year to £1.8bn with growth in both Regulated Water and Business Services. However, underlying profits before interest and tax (PBIT) dipped slightly to £570.3m, as the group increased provisions for bad debts and delayed part of their outperformance rewards to the coming regulatory period.

WaterPlus, the group's joint venture which supplies water to businesses, has been significantly impacted by UK lockdowns. As a result Severn Trent recorded an exceptional loss of £51.7m for the business for the year, which weighed on reported profit before tax.

Severn Trent announced a final dividend of 60.05p, in line with the group's policy to grow the dividend by at least 4% above RPI and bringing the total payment this year to 100.08p. The group's policy for the next five years is to increase the payout in line with CPIH - an alternative measure of inflation.

The shares were unmoved by the news.

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Our view

Under the hood of Severn Trent you'll find renewable energy and food waste recycling, but in the main, it's a straight-forward water utility. It provides water and sewerage services to over 4m customers in the Midlands and Wales.

Prices are set by the regulator, Ofwat. They're reviewed every five years and aim to make sure supply is readily available, at an affordable price, and in return efficiently run water companies can achieve acceptable financial returns.

Severn Trent has historically coped well under the system, delivering steady earnings growth and a gentle flow of dividends - characteristics which make it a popular choice for income seeking investors. This is particularly true in light of the current pandemic. While many sectors are seeing significant hits to revenue, life as a water utility is more predictable.

However, there are challenges ahead.

A new regulatory regime which lasts until 2025 has moved the goal posts. Ofwat has reduced the acceptable financial returns water utilities can make and set challenging performance targets. As with most businesses, lower earnings tend to mean less generous returns for shareholders. Cue Severn Trent's new dividend policy.

The goal is to grow the dividend at least in line with inflation - compared to 4% above the rate of inflation under the old regime - and the shares offer a prospective yield of 4.3%. Above inflation growth isn't out of the question, but coronavirus will make operational outperformance and cost efficiencies (both of which can boost earnings) harder to achieve.

The global fight against coronavirus also means interest rates are likely to stay low for a while - providing a boost to companies where income features prominently in the investment case. However, higher rates in the future would reduce the relative appeal of Severn Trent's income and will increase the group's interest cost on a debt pile.

Despite the headwinds it's important not to lose sight of the fact Severn Trent has some of the more reliable revenues out there, and a strong operational record. We think these factors, in a time of wider economic turmoil, go some way to explaining why the shares currently trade slightly above their long run average at 20.7 times earnings.

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Full Year Results

Regulated Water and Waste Water revenue rose 2.4% to £1.6bn largely reflecting inflationary rises to customer bills. Outperformance payments in the year totalled £36m, which was £21.7m lower than last year. This reduction was planned as Severn Trent deferred a significant chunk of outperformance payments into the next regulatory period. Overall for the regulatory period 2014-2019, Severn Trent earned £174m in outperformance payments.

Underlying PBIT dropped £15.5m to £511.5m, largely driven by an increase in bad debts, although higher operating, investment and depreciation also contributed.

Business Services revenue rose 19.7% to £240.4m, largely driven by the food waste energy business, which benefitted from a full year's performance of Agrivert - acquired in 2018. Underlying PBIT rose 1.2% to £64.9m thanks to higher operating costs and a lack of significant property sales this year. Severn Trent say they are still on track to deliver £100m in PBIT from property sales by 2027.

WaterPlus' losses of £51.7m reflect poor performance issues, made worse by the outbreak of coronavirus, as business customers struggle to pay bills.

Cash generated by business rose to £888.5m, and capital expenditure hit £799.5m (the groups largest spend in a decade). The net effect was an improvement in adjusted free cash flow, although it was still negative. Together with dividend payment, this meant net debt rose to £6.2bn, up from £5.8bn last year. Net debt as a proportion of the regulated asset base was 64.9%, up from 63% last year.

The group expects next year's capital expenditure to be between £430m and 510m, focussed on resilience and renewable energy projects.

Severn Trent said all future investment and cash flow needs are covered by cash or committed facilities through to January 2022. The group finished the year with £48.6m in cash and undrawn credit facilities of £755m.

Guidance for 2020/21 is for regulated water and wastewater revenue of a little over £1.5bn, a decline on this year largely reflecting impacts from coronavirus, such as reduced water use. The group also expects higher operating costs and lower outperformance payments - although it still expects these to deliver a benefit. Underlying PBIT in the Business Services division are set to rise, but Property PBIT will likely be lower.

Severn Trent expects to pay a dividend of 101.58p next year.

Find out more about Severn Trent shares including how to invest

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.