Utility Week

UTILITY WEEK | 18TH - 24TH OCTOBER 2019 | 21 Finance & Investment Analysis F inancial markets generally dislike uncertainty. Yet within the UK utility sector, and also for many quoted com- panies outside it, real uncertainty prevails. A•er all, the UK seems to be on the cusp of another general election, with the Labour Party proposing wide-ranging utility rena- tionalisation. And, more than three years a•er the European Union referendum result, an exit strategy remains elusive. More specifically, utility sector investors have several key regulatory reviews looming large, such as PR19 for the water sector and National Grid's periodic price review for its UK operations. Investing prudently against that back- ground is very challenging. It resurrects memories of some fund managers' views, post the 2008/09 financial crisis, that UK banks were essentially "uninvestible" – a stance vindicated by their subsequent lack- lustre performance. The same "uninvestible" policy should not apply to UK utilities, although their risk exposure is considerably higher now. For UK fund managers, careful analysis is needed across several fronts. A•er all, the outcome of the expected general election will impact many sectors beyond the traditional utilities. Downward pressure Aside from raising the threat of their renationalisation, a substantial majority for an incoming Labour government would, in all probability, put immense downward pressure on the pound sterling and push up interest rates; leading exporting companies would be heavily affected. The contentious Brexit issue also goes way beyond the utility sector. Quoted airlines such as IAG, the owner of British Airways, and easyJet have seen their shares fluctuate according to the latest Brexit developments. The ratings of housebuilders, too, have been badly unsettled by the continuing Brexit saga as many potential buyers wait. More specifically, within utilities, key price reviews are well advanced. In particular, the water sector will learn of Ofwat's Final Deter- minations for PR19 within two months. Only three of the original ten privatised water stocks remain publicly quoted – Severn Trent, United Utilities and South West Water owner Pennon. For the remaining seven, some of which are very highly geared, the final determination figures will be pivotal. On the electricity front, the risks are less near-term. Nonetheless, National Grid – the UK element of which is included in Labour's proposed renationalisation portfolio – faces real regulatory risk. A new RIIO-2 pricing regime will be applied to its cash-generative UK electricity transmission and gas transpor- tation businesses in April 2021. Furthermore, while ownership of the electricity distribution companies, floated in 1990, is now well dispersed, they are all subject to periodic price reviews, which seem certain to be based on a lower weighted aver- age cost of capital (Wacc) – and will there- fore squeeze investor returns. Assessing stocks Important though these issues are, dis- cerning UK fund managers will be assess- ing them, along with their base investment assumptions, against other UK equities and bond returns. Relative dividend yields will be crucial, especially since most utility stocks are still held for their dividend payment capacity. Assumptions about whether dividend cuts will be imposed a•er a pricing review and their growth level therea•er are pivotal. Two UK utility stocks neatly illustrate this point. Severn Trent, based on a 2019/20 dividend of £1 per share, is currently yielding a pro- spective 4.5 per cent. With about £177 million of outcome delivery incentives in hand, it should be able to avoid a dividend cut. Hence, short of renationalisation, ongoing annual returns of 4 to 5 per cent look reasonably assured – a very competi- tive return against ten-year gilts, which are currently yielding well below 1 per cent. By contrast, Centrica's investment returns have been depressing. July's announce- ment of a 58 per cent dividend cut caused its shares to plummet. It will take time – or an opportunistic bid – for them to recover. Most overseas fund managers can take a rather different view. Some will have fol- lowed the mind-boggling shenanigans of the Brexit issue and found it near impossible to ascertain how it will all end. Add to that a likely general election, pos- sible renationalisation and the uncertainty of periodic price reviews, and many will sim- ply conclude that other stock markets offer clearer opportunities for utility investors. Target markets Within the EU, Germany and France would be two obvious target markets. Yet investor returns from Eon and RWE have been dread- ful, with share price falls exceeding 80 per cent of their peaks shortly before the finan- cial crisis of 2008/09. Furthermore, the latest German economic data suggests recession there is now proba- ble. And, in France, EDF's share price perfor- mance has been shocking – down by about 75 per cent over the past decade; shares in Engie (formerly GDF Suez) have halved over the same period. Only the renewables-orientated Iberdrola and Enel have bucked this dire trend. Other smaller EU electricity stocks, with a renewable generation focus, are prosper- ing, including Denmark's two sector leaders, Ørsted (formerly DONG Energy) and Vestas. However, in terms of identifying substan- tial EU-based utilities with solid prospects and assured dividends, any overseas fund manager may be hard-pushed. Of course, it can be argued that the cur- rent low share prices more than reflect the material risks. But many overseas fund man- agers may be persuaded to invest in coun- tries where economic growth prospects are brighter and energy use is expected to rise. It may be that utilities have had their day – at least for the moment. But for those seek- ing yield, they still have their attractions. The investment priority, though, is to avoid major dividend cuts and capital losses – the recent profile of the embattled Centrica. Nigel Hawkins is the utilities analyst at Hardman and Co and a Utility Week correspondent Uncertain times for investors With Parliament requiring a Saturday sitting, a general election looming and ongoing regulatory price reviews, utilities investors can only watch and wait for market certainty, says Nigel Hawkins.

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