UK water utility stocks: are Severn Trent, United Utilities and Pennon still worth a tap?

Water companies have long been an anchor of stability and a staple for anyone looking to make an income-boosting addition to their portfolio. They each have a monopoly over the regions in which they operate, returns are regulated, and the critical service they provide often shields them from the external blows that impact most other stocks.

But the attractiveness of the three remaining water companies listed on the London Stock Exchange – Severn Trent, United Utilities, and South West Water-owner Pennon Group – is waning and the risks are rising. The industry has faced years of criticism and accusations that it has favoured shareholder payouts and executive pay at the expense of customers, and the industry’s debt burden is only continuing to grow.

This has sparked a backlash against the industry, enough so that Labour has promised to renationalise the industry if it is elected - by paying existing investors below market value. The water companies have promised to raise investment and improve their performance in an attempt to stave-off the political pressure but, with the Water Services Regulations Authority (Ofwat) also pressuring them to lower prices for consumers, questions remain whether they can meet that demand without making sacrifices elsewhere.

UK water privatisation raises investment but also brings dividends and debt

The UK water industry was given a clean bill of health when it was privatised in the late 1980s. These newly structured companies were given tax breaks, issued one-off grants and had nearly £5 billion worth of debt written off by the government. Further fresh capital followed once they were listed.

Nearly 30 years on and the debate over the effect of privatisation is far from settled. Ofwat and the industry argue it has allowed significantly more money to be invested than would have been possible in the hands of taxpayers and meant lower prices for customers. Critics respond by pointing to the huge sums spent on dividends and the fact most have plugged holes in their budgets by gradually racking up debt over the decades.

While the industry argues over £140 billion has been invested in improving infrastructure and service since privatisation, others argue it could be considerably more if it had chosen to divert the £60 billion-plus paid out in dividends over the same time frame, or the £2 billion being spent each year servicing the industry’s £50 billion-plus worth of debt. Dividend payments are far from their peak, but they are still substantial, and debt sits at an all time high. This situation has been primarily caused by the water companies regularly plugging spending shortfalls with debt rather than looking to make savings elsewhere in the business, such as by adjusting the dividend.

All three stocks have been prime examples of this. Severn Trent generated £826 million in net operating cash flow in its recently ended financial year, not enough to cover its £769 million net capital expenditure (capex) budget and the £161 million needed to service its debt, let alone the additional £212 million spent on dividends. United Utilities’ £823.3 million of net operating cash flow did manage to cover its £625 million of net capex and £136 million of interest payments, but £274 million of dividends caused a shortfall. Similarly, Pennon’s cash flow failed to cover all its spending.

Consequently, Severn Trent’s net debt rose almost 9% year-on-year to £5.8 billion at the end of March 2019 while United’s net borrowings climbed 3% to over £7.0 billion, and Pennon’s jumped 10% to £3.08 billion. In fact, over the last five years United’s net debt has increased over 19% and Severn’s has jumped by almost 23%, but those increases are tame compared to Pennon’s 40% increase.

Severn Trent

Severn Trent is the largest listed UK water company serving around eight million people across the Midlands. Revenue has fluctuated over recent years, but profitability has improved significantly because the company has focused on finding savings and earning rewards from the regulator by beating targets.

Severn Trent’s capital expenditure budget was the highest on record in the financial year to the end of March 2019, but it has kept bills down and has boasted the lowest prices in England and Wales for the last decade. It has made a commitment to lead the way on pricing until at least 2025. This has been offset by outperformance rewards paid by the regulator, which have totalled £138 million since the start of the current regulatory price period running from 2015 to 2020. That sum would have been £234 million if the firm had not hit the cap in place and was the best on record.

The company has pledged to reduce customer bills by a further 5% during the next regulatory period running from 2020 to 2025, with Ofwat having already approved its business plan. It has already got a head start and appointed partners for £1.5 billion of its £2 billion capital programme for the five-year period (known as AMP7) and said it has broadened access to expertise by using up to 20 partners compared to the six it currently works with. Severn Trent has said it expects to earn a higher amount of outperformance payments in AMP7 versus AMP6, with a target of at least £177 million.

Severn Trent is expecting revenue from its core water and sewerage business to rise to £1.61 billion to £1.64 billion in the current financial year from the £1.58 billion delivered in 2019. The unit’s operating costs are expected to rise from the £600 million recorded last year, although efficiencies and a net reward of £25 million (versus a net £5 million penalty last year) should provide enough of a cushion to offset it. Its business services division is expected to see profit fall after it sold surplus land for a £19.9 million profit last year, which won’t be repeated.

Severn Trent’s dividend policy is to grow its payouts by retail price index (RPI) inflation plus 4%, which it has stuck to over the current regulatory period. This compares favourably to United Utilities, which grows its dividend in line with RPI inflation. Severn Trent has already said the dividend for the new financial year will be 100.08p.

United Utilities

United Utilities serves three million homes and 200,000 business in the North West of England. Despite reporting higher revenue in recent years the bottom line has not followed, with operating profit falling in the recently ended financial year. Pre-tax profit did nudge higher but was ultimately below what it delivered two years beforehand.

The company reported its best year for outperformance payments last year, booking £19.2 million. That represents the bulk of the £21.4 million earnt in total since the start of 2015 and ahead of United’s expectations. It expects to have received cumulative net payments of £30 million by the end of the current financial year, which also marks the end of the current regulatory period.

United said it was increasing spending by £100 million in the current financial year to get a head start on AMP7. That represents a big jump, taking its total budget over AMP6 to £350 million from £250 million beforehand. United’s business plan for AMP7 has also been approved by Ofwat, which said United had put forward the best quality plan in the industry. That is a great sign operationally but points toward lower income and higher spending on the financial front, both of which will not necessarily welcomed by investors. The policy to grow dividends in line with RPI inflation is already behind the policy in place at both Severn and Pennon to grow payouts at RPI plus 4%, so further pressure on margins could be a concern. Like Severn, United will need to deliver the efficiencies needed to please the regulator, customers and investors.

Pennon Group

Pennon Group is the smallest but most diverse of the three listed stocks. It’s core water and sewerage businesses are offered through South West Water and Bournemouth Water and serve about 1.7 million people (mostly in Cornwall, Devon and Dorset) and 160,000 businesses. However, it also owns Viridor, a recycling business that manages about 7 million tonnes of waste each year, which it either recycles or sends to its energy recycling facilities that turn it into electricity.

Viridor is the unique gem in the Pennon crown. The business serves over 150 local authorities but is nowhere near as regulated as the core water unit, meaning Pennon has better growth opportunities through recycling and a very reliable water business acting as a backbone. Water still drives earnings but Viridor is growing at a much faster rate – with profits having doubled over the last four years - and it will contribute more toward Pennon’s overall profits going forward. The company has already pledged to invest £65 million in a new plastics recycling facility in Avonmouth and has already seen increased demand thanks to greater awareness over the use of plastics in the UK. Pennon has spent around £1.2 billion on building out its recycling and energy recovery facilities but is still looking for new opportunities, with another three facilities currently under consideration.

Pennon has delivered £237 million in efficiencies during AMP6 so far and aims to deliver £300 million in total over the five-year period. It has also said ‘South West Water has the highest outperformance potential for the next regulatory period [2020-2025] and we are confident in delivering outperformance across all areas.’

Pennon has said spending will fall this year and that earnings from Viridor should rise as operations ramp up. It has also committed to grow its dividend by RPI plus 4% once again this year.

Severn Trent vs United Utilities vs Pennon Group

Each of the water companies has shown strengths and weaknesses. Severn Trent was by far the best performer in the last financial year when it came down to improving profit, cash flow and its dividend but it also added more debt and share price growth lagged its peers. United Utilities was the only company to report growth across the board, albeit in the low single digits, and while Pennon’s dividend and share price both improved it also saw cash flow and profitability come under pressure.

Below is a comparative table outlining the performance of each stock in the most recent financial year and over the last five financial years:

Another metric worth tracking is Return on Regulated Equity (RoRE), which can be viewed as a measure of profitability within the core water and sewerage businesses. While Severn Trent and United Utilities delivered similar RoRE in the last financial year the latter is behind the former when you look at what has been delivered over AMP6 so far. However, both have significantly lagged Pennon, which has delivered sector-leading RoRE that is in line with Ofwat’s recommendation.

Investing in UK water stocks: what to watch out for

The environment for utilities is usually far more stable than it is for other industries, particularly for water companies. However, there are several major potential catalysts that those trading or investing in the industry should watch out for going forward.

General Election

British politics is currently fragile. The Conservative government – the party traditionally in favour of free markets and the one to privatise the industry in the first place – has been in power for nine years but the turmoil of Brexit has taken its toll. It has sealed the fate of Prime Minister Theresa May and split both the Conservatives and the opposition Labour party that have started to lose votes to parties with more straightforward stances on the matter, like the Brexit Party or the Liberal Democrats.

While the continued uncertainty over Brexit has not impacted the water industry in the same way as the rest of the economy the potential political ramifications of it could cause upset. The big threat comes from Labour, which is reportedly looking to spend just £20 billion on renationalising water companies. That is less than half their current combined value and well below the £90 billion-or-so valuation when debt is included. Labour has since said the actual outcome would depend on many factors like the state of each company’s pension or the number of subsidies they benefit from, but ultimately the warning stays the same: shareholders look set to lose out substantially should Jeremy Corbyn get into government. Both United Utilities and Severn Trent have listed renationalisation as a new major threat to their businesses and warned of the potential implications.

Other parties, including the Conservatives, have been so wrapped-up in the Brexit debate that many haven’t considered a policy on the water industry, let alone one as radical as Labour’s. But investors should be wary that any non-Conservative government will bring new policies and attitudes to the table, and ones that are likely to be less favourable to shareholders.

Water stocks started to suffer heavy losses in June 2017, when the Conservative government’s power was weakened, and it lost its majority. Although they have rebounded somewhat they are far from recovering in full as investors have attached a discount to the industry in fear of another general election in the near future.

New regulatory price period 2020-2025

Regulator Ofwat lays out the regulatory setting for the water industry every five years. Each company puts forward a five-year business plan outlining how much they intend to charge customers and the amount they plan to invest before the regulator makes a final decision.

The next regulatory period, AMP7, runs from 2020 to 2025 and companies have already submitted their proposals to Ofwat, which will intervene if any of the plans submitted fail to meet its standards and possibly lead to lower returns for the business, and therefore its shareholders. Severn Trent, United Utilities and Pennon Group were the only three water companies to have already had their plans accepted under the regulator’s ‘fast-track’ plan, meaning they have been conditionally approved.

Ofwat has said it expects all three companies to cut bills for customers over the period, with early draft determinations suggesting Severn Trent bills will fall by £16, United Utilities by £49 and Pennon £77. ‘By becoming more efficient and embracing innovation, Ofwat found these companies can continue to keep bills down while delivering the investment needed to make sure there is enough water for everyone,’ the regulator said in April. All in all, Ofwat wants the trio to spend £1.2 billion on improving the environment and investing in infrastructure over the five year period and told them to reduce leakage by 15% and assist up to 300,000 customers in financial difficulty.

Nothing is final yet. Ofwat won’t release its final determinations until December 2019 and they won’t come into affect until April 2020.

Higher interest rates

Interest rates have remained at record lows but look set to start rising in the coming years based on signals from the Bank of England. There is higher demand for utility stocks when interest rates are low but that tends to tail off when interest rates rise and alternative investments, like bonds, become more attractive to income investors.

Higher interest rates could also spell bad news for the industry’s bulging debt pile by making it more expensive to service, although all three stocks have taken efforts to mitigate this threat by refinancing debt to fixed rates from variable ones.

How to trade Severn Trent, United Utilities and Pennon Group

There is a cautious view on the water industry at present with a Hold recommendation on all three stocks, although there does seem to be a slightly more bullish stance behind United Utilities compared to Severn Trent and Pennon Group.

UK water utility stocks: are the taps running dry?

UK water stocks are traditionally viewed as reliable investments that offer consistent dividend growth for income investors. However, the investment case is facing several threats. Calls for renationalisation represents one of the most significant threats to the industry since it was privatised 30 years ago, criticisms over bumper dividend payouts and executive pay continue, and higher interest rates could see their attractiveness wane. And, even if none of those threats comes to fruition the industry still has to find a way to cut prices and raise investment going forward without upsetting the regulator, customers or investors. Efficiencies can only go so far, debt can’t plug shortfalls forever and investors are aware that the risk of dividends being cut and rebased is higher than normal.