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United Utilities - earnings dip under new regulatory regime

Emilie Stevens, Equity Analyst | 24 September 2020 | A A A
United Utilities - earnings dip under new regulatory regime

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United Utilities Group Plc Ordinary 5p

Sell: 1,010.50 | Buy: 1,011.00 | Change 31.00 (3.16%)
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United Utilities (UU) says the first half has been in line with expectations. Revenue is expected to be around 5% lower than last year's total of £935.5m - reflecting the lower allowed revenue return under the new regulatory regime and lower business consumption. Together with increased infrastructure spending that means underlying operating profit is also expected to be lower than last year.

The shares rose 0.6% on the news

View the latest United Utilities share price and how to deal

Our view

United Utilities (UU) is a utility as pure as the water that flows through its pipes. In return for providing a reliable and affordable water supply to North West England, Ofwat (the regulator) allows UU to earn an acceptable financial return.

With prices set by the regulator and reviewed every five years, utilities' earnings have tended to be stable and predictable - not to mention inflation linked. That means they can provide a steady income.

The current pandemic acts a strong reminder of these qualities. While many companies face significant earnings uncertainty, UU's unlikely to see dramatic revenue declines.

But while insulated, UU is not immune.

Businesses and homes are under strain and that's impacting their ability to pay their water bills. UU expects this to increase as the government furlough scheme tails off - although reassuringly non-payments have been no worse than expected so far.

This comes at a time when life has already got slightly tougher. A new regulatory period is underway and the regulator's reduced the level of financial returns UU and its water peers can earn, and increased performance targets.

This isn't good news for investors, as anything unexpected could mean a less generous dividend policy. And that's already something UU is reviewing. Prior to the pandemic it announced plans to grow the pay out by at least inflation over the next five years. But as coronavirus took hold, UU put the policy under review.

No news is good news here and we think it would be wrong to interpret it as anything other than prudence. UU has enough cash to pay the dividend a few times over, so it's not an issue of can't afford. But the group will lose around 2/3 of its £1.2bn liquidity this year, which suggests a short term liquidity crunch. Plans are in place to raise more funds this year, so we'd hope to see the previous dividend policy reiterated if and when additional funding is secured.

Despite the challenges from the new regulatory regime and caution over coronavirus, UU has some of the more reliable revenues out there. We think this goes some way to explaining why the shares currently trade at 18.4 times expected earnings, comfortably above the longer run average. The prospective yield is 5.1%, but given the ongoing review that should be treated with a degree of caution.

United Utilities key facts

  • 12m forward Price/Earnings ratio: 18.4
  • 10 year average 12m forward Price/Earnings Ratio: 13.6
  • Prospective yield: 5.1%

Please remember yields are variable and not a reliable indicator of future income. Keep in mind key figures shouldn't be looked at on their own - it's important to understand the big picture.

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Half Year Trading Details

UU's first half has been in line with its plan for the regulatory period (2020 - 2025), although the group's accelerated its capital expenditure plans. UU continues to expect to receive outperformance payments this year.

Cash collection from customers has been in line with UU's targets set before the pandemic. The group still expects bad debts to increase as government support measures tail off but won't exceed the value of existing provisions.

Finance costs for the first half are expected to drop by around £30m, due to lower inflation.

As a result of continued capital expenditure, net debt is expected to have risen above £7.4bn as of March 2020. Although gearing (net debt as a proportion of its regulatory asset base) remains within the target range of 55 - 65%.

Find out more about United Utilities shares including how to invest

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. 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 for more information.