Utility Week

Comment Utility Week expert view Nigel Hawkins "For institutional investors, dividend flow is paramount. They want it assured and durable – and not subject to the whims of government, regulators or the market." H istorically, dividend payments have been the prime attraction of utility stocks. With solid income, decent cash flow and few surprises, the traditional utility stock should offer the risk-averse investor real security. Despite all the publicity generated by other utilityrelated issues, this philosophy still underpins investment in UK utilities. Almost 25 years ago, the English and Welsh water sector was privatised. However, two months or so before flotation, City enthusiasm was distinctly lukewarm. In a shrewd piece of imaginative PR, senior Labour Party politicians somehow came across summarised copies of the spreadsheet cash flow models for the water companies. They lambasted the seriously aggressive dividend projections; the subsequent political row acted as a wake-up call for sceptical City – and overseas – investors. In the event, the flotation process went swimmingly, with heavy over-subscription. Cynics would argue that, if you offered an 8.61 per cent yield on a debt-free, monopoly water stock with scope to increase prices by more than 6 per cent in real terms annually for the next five years, this was a nobrainer for dividend seekers, especially since the stock was part-paid so the running yield was far higher, as was the case with South West Water. Nowadays, the water sector has settled down, but the ongoing periodic review will still be critical for the water companies and especially the three remaining quoted stocks – Pennon, Severn Trent and United Utilities. The outcome will drive their future cash flow – and their scope to grow their dividends. After the previous review, Severn Trent and United Utilities cut their dividends; not massively, but enough to affect their share price rating. That is why any pronouncements from Ofwat, especially on the Weighted Average Cost of Capital (Wacc), are so price-sensitive – as was the case last month. With none of the privatised regional electricity companies still quoted, the electricity sector is now less driven by dividends. Unlike distribution, generation returns are less predictable and investors expect genuine earnings growth. The UK's largest utility, National Grid, is an exception in that its core UK businesses operate under an unprecedented eight-year regulation settlement, which started last April. Based on a projected dividend of 42p for 2013/14, the stock is currently yielding over 5 per cent – well above the yield on government gilts, a parameter that is very relevant for long-term utility investors. For SSE, its hitherto formidable dividend payment ability is coming under real pressure. With a forecast 2013/14 dividend of around 87p, dividend cover is set to be below 1.4x. Given the uncertainties affecting the stock – generation returns, distribution reviews, the Miliband 20-month price freeze pledge, the durability of renewable subsidies and even the Scottish independence referendum – it is no surprise that investors are nervous. The sustainability of SSE's dividend flow is a key question for long-term investors – and a complex one since many factors are at play. With SSE's current yield of about 6.5 per cent, based on this year's projected dividend, the market message is: "We have doubts." Remember, too, that SSE's share price peaked last summer at about 25 per cent above the current price. Centrica's cash flow and, implicitly, its dividend-paying capability, has also come under scrutiny. Its core UK gas business is very vulnerable to margin erosion, most obviously if the Labour Party prevails in next year's general election and implements its price freeze pledge. Given that Centrica's dividend is very dependent on its UK gas profits, this has undoubtedly impacted the share price. And the uncertainty about the price freeze pledge will last for at least another 18 months. Centrica has aggressive expansionary plans in North America – and a strong balance sheet to finance them – but this does not necessarily equate to a capacity to finance robust dividend growth. Previously, UK utility share prices have been driven partly by takeover speculation, notably during the late 1990s when the electricity supply industry was "up for grabs". More recently, the water sector has been subject to intense takeover speculation; the high point last summer was the £22 per share bid that Severn Trent – bravely or foolishly – turned down. If Severn Trent is fast-tracked by Ofwat – with a consequent dividend cut a highly unlikely outcome – it may well have the last laugh. But for most long-term institutional investors seeking to raise funds to discharge their pension liabilities, the dividend flow is paramount. And they want it to be assured and durable – and not subject to the whims of the government, regulators or even, heaven forbid, the market. They also want the maintenance of a sizeable yield premium over government gilts. As such, for many institutional investors, utility dividends help pay the rent – and to meet their other long-term liabilities. Nigel Hawkins (nigelhawkins1010@aol.com) is a director of Nigel Hawkins Associates, which undertakes investment and policy research UTILITY WEEK | 31sT JanUarY - 6Th FEbrUarY 2014 | 7

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