Investing in Regulated Utilities (part I, Water)

And United Utilities PLC

The visible hand of the regulator, image courtesy Wikipedia

Investors are attracted to utility companies for their steady income by way of dividend payouts. Although utility shareholders have made windfall gains from takeovers, investors expect capital gains to be modest. The FT's Gas, Water and Multiutility Index (in blue) have performed as one would expect these past 10 years. The shares that make up the Index (Centrica, Dee Valley, Igas energy, Modern Water, National Grid, Pennon Group, Renewable Energy Generation, Severn Trent and United Utilities) have proven to be less volatile and to produce less of a capital gain than the FTSE 250 (Midcap) Index (in green):

Graph courtesy of Yahoo, click to enlarge

Once the higher dividend yield of the utility companies is included (currently from 4 to 5.5%, compared to 2.7% for the FTSE 250), their overall return over 10 years is very similar to the 250 companies that make up the Midcap Index.

So far so good. But regulated utility companies are very different to non-regulated companies. Given that regulated utilities are often providing unique services to the public, government appointed regulators have extraordinary powers to ensure that the public are protected from monopoly pricing. This can be disconcerting for investors.

The water regulator, Ofwat, is in the process of determining the conditions and price controls for the water utilities from 2015 to 2020. Ofwat makes clear its main objectives:

"Our main duties are to:

• protect the interests of consumers, wherever appropriate by promoting effective competition
• enable efficient water and sewerage and water only companies to carry out and finance their functions

One of the ways we deliver our duties is to set the price, investment and service package that customers receive." (Ofwat website) 

Ofwat explains how the new price regime will take into account past efficiency gains by the water companies:

"Once price limits have been set, companies can make higher profits at no expense to the customer by outperforming the assumptions we make when we set price limits through efficiency and innovation. They earn these higher profits until the next price review, when the benefits are passed to customers through lower prices." 

In the past review, both United Utilities (by 13%) and Severn Trent (by 10%) reduced their dividend because Ofwat set prices that annulled the efficiency gains from the previous regulatory period. These gains had been passed on to shareholders. 

As each water company has to present a plan to meet Ofwat's objectives, it is impossible for the individual investor to assess how Ofwat's new price mechanism will affect the water companies' profitability. And to complicate matters, Ofwat will be setting separate prices for wholesale, domestic retail and business retail customers. 

The average dividend cover for the past three years provides some measure of the leeway the four quoted water companies have to absorb a more restrictive pricing regime:

 

Water company	Dividend yield*	Dividend cover*	Price Earnings Ratio**
Dee Valley	4.3%	1.45	16
Pennon	3.9%	1.29	20
Severn Trent	4.0%	1.33	19
United Utilities	4.5%	1.63	14

                *Average over the past 3 years. **Current price/average 3-year earnings per share 

The latest dividend cover for each company and the latest dividend shows a growing payout on a declining cover:

 

Water company	Dividend yield*	Dividend cover*	Price Earnings Ratio*
Dee Valley	4.4%	1.38	16
Pennon	4.5%	0.25**	98**
Severn Trent	4.4%	1.25	18
United Utilities	4.8%	1.26	17

                *In the latest year. **Pennon suffered losses on its non-regulatory business in 2012. 

One way that the water companies have found to improve their 'efficiency' compared to Ofwat's assumptions is to borrow at low interest rates. This reduces their weighted cost of capital. Hence, the water companies have relied heavily on loan financing to meet their capital requirements and to pay generous dividends, with the result that they are all heavily indebted:

 

Water company	Net Debt/Equity	3-year cash flow pounds mn*	Years  to pay off debt
Dee Valley	42%	6	24
Pennon	189%	(138)	n.a.
Severn Trent	528%	782	17
United Utilities	319%	89	201

                *Operating cash flow less capital expenditure for the last 3 years 

It is hard to see how these water companies will survive without issuing new equity. Some indication of the size of the equity issues that might be required to restore their balance sheets can be judged by the following table:

 

Water company Pounds mn	Net Debt	Market Capitalization	Possible capital requirement*	Possible shareholder dilution%
Dee Valley	49	66	5	10%
Pennon	2007	2840	620	22%
Severn Trent	4398	4150	910	22%
United Utilities	5972	4800	970	20%

                *New equity to reduce debt to 200% of equity and/or to cover the present cash dividend for 5 years, allowing for present cash flows. 

These are rough and ready numbers, but they do suggest that the new pricing review will be met with a call for new equity and/or a cut in the dividend payout.  

Investors should be very cautious when assessing these water companies. It would be wise to wait. Consider: 

1. Possible rights issues or placings will reduce the earnings per share and value of these companies' shares. 

2. Dividend payouts are likely to fall. United Utilities and Severn Trent reduced their dividend payouts by 13% and 10% respectively after the last Ofwat review. All four water companies will have great difficulty in maintaining their payouts. 

3. The uncertainty over the 2014 Ofwat review will depress water company prices. 

4. Against this, the recent (rejected) bid for Severn Trent valued the company at a 15% premium to the present price. This will help to sustain present prices. 

The water companies have until December 2013 to submit their plans to Ofwat. Ofwat will announce its new price mechanism during 2014.

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United Utilities PLC

Tap water, image courtesy Wikipedia 

United Utilities (UU) shed its electricity business and a series of other businesses by 2008 and returned 1.5 billion pounds to shareholders. Since then, UU is a pure water and waste water business that covers the North West of England. All its business is subject to the price controls, capital commitments and other requirements of the regulator Ofwat.  

UU's large capital expenditure, amounting to 3.5 billion pounds in 2009-14, is the equivalent to more than 2 years revenues. Hence, UU's management are as much engaged in managing new plant and infrastructure as they are in the sales, service and maintenance side of the water business. 

UU's share price (in blue) is back where it was 5 years ago:

 

Graph courtesy Yahoo, blue line for United Utilities, green line for the FTSE 250 Midcap, click to enlarge. 

Investors often see utility companies like UU as an alternative to bonds. The Ontario Municipal Employees Retirement System, the Kuwait Investment Office and the Universities Superannuation Scheme of the UK bid for Severn Trent. Two of the three bidders are in need of long-term income, which is something that water utilities can deliver. If necessary, these institutional investors can assume the utility's debt, which would be another source of income for their members. But the same conditions do not apply to individual investors.  

UU shareholders face an unappetizing future: 

1. In the latest Annual Report, management refers to the decline in both the retail and commercial demand for water.  

2. This year UU increased its dividend payout, but this just brings it back to where it was in 2009. 

3. Earnings per share have shown no consistent increase in the last 5 years. 

4. Net debt stands at 319% of equity and, in the last 5 years, operating cash flow (including capital expenditure) of 380 million pounds has failed to cover dividend payments of 1,235 million pounds. 

5. For a company that relies so heavily on debt, UU cannot be happy that S & P rate their long-term debt as BBB-. This is the lowest investment grade rating.  

6. In the current climate of austerity, it is unlikely that Ofwat will look favourably on improving the returns to investors. To the contrary, Ofwat has stated that, "These separate price controls will create stronger and more targeted incentives on the customer facing services companies provide. This will drive companies to deliver better customer service at a lower cost." (Ofwat's website). 

7. Rising 10-year gilt yields hit UU in two ways. They increase UU's cost of debt and they shrink the difference between what investors can earn from AA government debt and what they receive from UU in the form of dividends.

 

Assuming that UU does not reduce its dividend and that trading results remain about where they are gives, according to my valuation model*, a value of around 600p for UU's shares. They currently trade at 711p. *Assumptions: no earnings per share growth, 15% return on equity as now, dividend yield as now (4.8%), equity per share continues to increase by about 6% p.a., and the stock market values UU on an average P/E ratio of 16.5. Discount rate used is 11.3% - UU's cost of debt is 4.3%, 2% for operating risk and 5% for a margin of safety.  

Even at 600p, the prudent investor will consider: 

1. The possible repercussions of a reduced dividend and/or share issue on UU's share price. 

2. A possibly unsatisfactory price regime imposed by Ofwat for 2015-2020. 

3. Defined pension scheme assets and liabilities, each valued at 2.4 billion pounds, are large in the context of UU's business. Adverse changes in assumptions would cause a further draw on UU assets.

Dealing with the Time Value of Money

And J P Morgan Global Emerging Market Income Investment Trust

The Persistence of Memory, Salvador Dali, courtesy Wikipedia

Man has been charging interest, the time value of money, on loans for at least 2,700 years (it is recorded in Deuteronomy). Roman lenders charged from 4 to 48% p.a. depending on the credit worthiness of the borrower and the availability of credit. The same principles apply to the rate of return required for making an investment, only the starting point is much more complicated for an equity investor seeking a long-term investment.

Once the preliminary analysis of a company is complete and the investor is satisfied that it merits further study, he will require a methodology to help him find what might be its intrinsic value.

According to Mary Buffett (Buffettology, 1997), Mr Buffett projects a company's earnings per share for 5 or 10 years and no further. As the accuracy of any projection declines rapidly over time, this cut off has the advantage that it limits the enormous variations that can occur when projecting earnings for longer periods

But to call a stop at such a short period requires some further assumptions on the part of the investor. These further assumptions have the advantage of making explicit assumptions about a company's return on equity, dividend yield and payout ratio, the market's price earnings ratio and the growth of earnings per share and equity per share. All factors relate to the value of a company. They can be combined as follows.

Three simple models provide a contrasting source for the value of a company's share price 5 or 10 years hence.

1. A first route is to Project earnings per share for 5 or 10 years. Adding a multiple (say an average historical Price Earnings Ratio (PE) for the company's share price) to the resulting earnings per share gives a notional share price for that company in 5 or 10 years time.

2. A second route is to project the growth in the company's equity per share. Then multiply it by a selected Return on Equity and this gives a value for the future earnings per share. Repeat the PE multiple in 1 above to give another notional value for that company's share.

3. A third route is to apply a selected return on equity to the present equity per share, adding the earnings per share that is retained and not paid out as a dividend for each year. This model generates a notional earnings per share for the company concerned at the end of the 5 or 10-year period. Repeat the PE multiple in 1 above to give a third notional value for that company's share.

Changing assumptions and watching the resulting change in value, gives the investor a feel for the sensitivity of a company's share price to specific factors.

Purists will object that this method does not use cash flow. But before the investor uses these models, he will have satisfied himself that the company is generating cash in line with earnings. In any event, the only cash flow an investor will normally see is the dividend, and this depends greatly on the company's earnings per share.

All of the above valuations require a discount rate to allow for the time value of money. Mr Bearbull, columnist of the Investors Chronicle, uses 8.5%, because that is what he requires from his equity investments. This is a common approach, but as Seth Klarman (Margin of Safety, 1991) writes:

"The appropriate discount rate for a particular investment depends not only on an investor's preference for present over future consumption but also on his or her own risk profile, on the perceived risk of the investment, and on the returns available from alternative investments."

The required rate of a return on an equity investment is not the same when 10-year Gilts yield  2% than when they yield 17%, as they did in 1974. Equally, the required rate of return for a company such as Unilever, with an A+ long-term credit rating, will most likely be lower than for a company with no credit rating at all.

Similarly, the investor in foreign markets should be aware of the credit rating of those countries where the investment is located. Standard & Poor's country ratings are currently as follows:

Map courtesy of Wikipedia, click to enlarge

The return required from investments based in BBB and below rated countries should be higher than investments based in investment grade rated countries. The grey area, where there is no credit rating at all, indicates that any financial investment is subject to great risk. These countries are best avoided by the individual investor.

To summarise, the diligent investor will develop a tailor-made approach to arrive at the required rate of return (or discount rate) for a particular investment to discount it back to its present value. One possible method is:

1. Use the average cost of debt of a company as a base, for this does take into consideration the risk of company default. The mail order and internet clothing retailer N Brown's average cost of debt, for example, is 4.3%. Where a company has no debt, one can use investment grade corporate bonds as a proxy. The ETF SLXX, a fund that only invests in such bonds, currently yields 4.1% to redemption.

2. Add an amount for execution risk. The more ambitious the growth in earnings assumptions, the greater the risk of failure to meet them. In the case of Unilever, I use fairly conservative assumptions and add 2% as a risk factor.

3. Add an amount for profit and a margin of safety. I use 5% for all stocks.  

This approach habitually results in a discount rate of between 9 and 13% in the current low interest rate environment. To allow for the dividend payout of companies, which should reduce their growth in earnings and equity, the investor deducts the current dividend from the required discount rate. Or, to look at it from another viewpoint, if the investor requires 10.8% from Unilever and it regularly pays out a dividend equivalent to 3.1% at the present price, then the required capital gain from future earnings will be 7.7% p.a. 7.7% becomes the discount rate.

Given the uncertainties in any forecast, the resulting valuation is but an indication of what a company's share might be worth. A benchmark is most useful, but it is not a substitute for understanding the quality of a company's management, its market position and potential threats to its business. 

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J P Morgan Global Emerging Market Income Investment Trust (JEMI)

Courtesy Financial Times 29 June 2013, click to enlarge

This graph compares the price to book ratio* of emerging markets to developed markets since 1996. On this basis, emerging markets are at their lowest level since 2005 and stand at a 20% discount to developed markets. *Market capitalization/Net asset value for all companies. 

John Authers of the Financial Times (29 June 2013) concludes,

"There is no great case for buying emerging markets en masse, as an asset class. That is the way the sector pumped up over the past decade, as investors poured into passive funds that tracked emerging market indices.  But not all countries or companies deserve to be trading at the sector’s biggest discount in eight years. The job is to identify them."  

Quite so. Stock and country picking is the order of the day, and this eliminates the use of Exchange Traded Funds. The investment trust J P Morgan Global Emerging Market Income (JEMI) is one of the few such GBP trusts that cover this area and are income oriented. JEMI (price in blue, net asset value in red) has a superior performance to the MSCI Emerging Market Index (in green):

Graph courtesy of the Investors Chronicle, click to enlarge. 

JEMI, which yields 4.4%at 123p, is invested in emerging markets with a BB or better credit rating:

 

Country	Percent of portfolio	Credit Rating
South Africa	15%	BBB
Brazil	12%	BBB
Taiwan	12%	AA
China	12%	AA
Hong Kong	7%	AA
Turkey	6%	BB
Russia	6%	BBB
Other*	30%	BB or better

*South Korea, Poland, Indonesia, Thailand, India, Saudi Arabia, Kazakhstan, Qatar, Philippines, Mexico, Malaysia. 

By sector, JEMI is mainly invested in consumer goods (22%), financials (16%), telecommunications (16%), information technology (11%) and general industrials (10%). 

JEMI is well diversified and by the standards of emerging market investments low risk. Not only is the fund invested in a wide range of better quality markets, but also no single company accounts for more than 2.2% of the portfolio. And: 

1. Though the statutes permit JEMI to borrow up to 30% of the value of the fund, currently JEMI is fully invested and it holds 9% debt. 

2. Though the statutes permit JEMI to invest in a wide range of financial instruments, the 30 largest holdings, accounting for 51% of the fund, are all in equities. 

3. JEMI is capitalised at 283 million pounds, which is big enough for a fund investing across so many markets. The investment trust has a policy of issuing new shares to keep down the price premium to net asset value. This currently stands at 1.8%. 

4. Revenue earnings per share after charges more than cover the dividend payout, currently 4.4%. However, as 70% of the fund's charges for commissions and the cost of debt are charged to the capital account, 15% of dividends were, in practice, paid from the capital account.  

5. The total cost of operating JEMI, including the cost of debt, a 1% annual commission on net assets, a 1% performance fee on the fund's outperformance of its benchmark index and all other administrative and trading costs amounted to 3.3% of the value of the fund in 2012. From April this year the performance fee is capped at 0.75% of net asset value; in practice, this is unlikely to make any difference to management charges. 

It never hurts to pick the best fund managers and the best performing funds, though both can suddenly change. City Wire rated J P Morgan as the best fund manager in the UK in 2012. JEMI is managed by Richard Titherington since its launch in 2010. He has a staff of 38 professionals, who work on this and other emerging market funds at J P Morgan, at his disposal. With 14% of global market capitalization, up from 5% in 1992, emerging markets are a worthy part of an investor's portfolio. 

The cautious investor will note: 

1. The risks mentioned in JEMI's 29 June 2013 prospectus for its latest share issue. It is available from the internet. 

2. Emerging markets are more volatile than developed markets, though JEMI is less so. JEMI's share price reached a 12-month low of 110p in July 2012 and a high of 140p in May 2013. 

3. Emerging markets have gone through phases of exceptionally good performance followed by catastrophic falls, and there is no guarantee that this will not recur. So it is wise not to commit more than 5 or 7% of a portfolio to this area. 

4. Unlike an open-ended fund, JEMI, as a close-ended fund can and does leverage its portfolio. This increases the funds volatility.

5. JEMI's share price is currently at a small premium to net asset value. If emerging markets go out of fashion, this could turn to a discount.