Henk Potts cautions investors considering what is usually a defensive sector

Amid the current market turmoil, it is little wonder that investors have been looking for ‘safe havens’. Traditionally defensive names have held up in recent weeks, while financials and sensitive stocks have suffered a brutal sell-off.

However, investors need to choose their safe havens carefully. Water utilities – an ostensibly safe area – are a case in point. Water utilities have outperformed the overall UK market by 11 per cent this year to date, thanks to their perceived ‘defensive’ attributes. However, we believe that the earnings visibility and dividend stories are increasingly less valid, and current outperformance is largely passive – it has been driven by the collapse of markets and little else.

Restricted growth, stretched valuations

Our causes for concern on water utilities are twofold. First, earnings growth is slowing, meaning that there is limited visibility on future dividends. The latter, of course, are a key driver of returns in the sector. Perhaps most crucially, the next price review (April 2010 to March 2015) is likely to be stricter than the current one, with allowed returns on assets expected to be cut by around 600 basis points and earnings growth at a very mediocre two to three per cent. Meanwhile, bad debts and power costs are increasing.

Our second major concern on water utilities relates to valuations. These are stretched, and it is unlikely that there will be any merger and acquisition (M&A) activity in the medium term to lend any support. Admittedly, valuations have come down since the intense M&A period of 2006/07. However, price-to-earnings ratios and multiples based on companies’ regulated asset bases remain relatively high and only Severn Trent (SVT) offers a yield above five per cent. We think further M&A is unlikely, at least until the new price review is determined, and equity and credit markets have stabilised to some degree.

Consequent downgrades

On the back of these concerns, we have recently downgraded United Utilities (UU) to ‘sell’, with a fair value target of 560p. Operationally, UU is something of a laggard. Its vast size (c.15 per cent of total industry assets) has actually made it more difficult for the company to outperform, because it is such a large component of the regulatory benchmark. Consequently, smaller players have tended to do rather better, even though as a larger name UU should benefit from economies of scale.

Financially, UU also appears at risk. Its bad debts account for 30 per cent of the industry total and represent nearly four per cent of the company’s revenues (versus an average of two to three per cent). Unfortunately, on the valuation front, the news doesn’t get much better either. On a p/e basis, it trades at a premium to the sector. Our fair value is based on a sum-of-the-parts valuation, and represents around a
13 per cent discount to the current share price.

Comparative strength

For investors who would like to have some exposure to water utilities, we view SVT as being the most attractive water stock on valuation grounds (rated ‘neutral’). SVT has enjoyed a significant operational turnaround and is working hard to improve its relationship with the regulator. Moreover, following UU’s 30 per cent cut in dividends per share for 2008/09, SVT is now the highest-yielding water name, offering 5.2 per cent.

Our fair value based on a sum-of-the-parts valuation of £15.00 assumes a ten per cent premium to 2009’s regulated asset base. It’s seven times 2009’s earnings before interest, tax, depreciation and ammortisation (EBITDA) for unregulated activities, and is 20 per cent above the current share price.

Although on paper SVT looks attractive, we see the same upside in National Grid, which, in our view, benefits from both better visibility on future earnings and stronger growth. Consequently, it remains our favoured regulated utility name overall. In the current environment, National Grid is very attractive because it offers a valuable combination of low financing risk, low operational risk and solid growth prospects.

The stock has outperformed the MSCI UK index by 22 per cent over the past three months and the MSCI UK utility sector by nine per cent, which means multiples are now more in line with peers – 12.9 times forward p/e versus 13.1 times for the sector, and yielding five per cent. Unlike some water utilities, National Grid appears to be a genuinely defensive investment for turbulent times and, more importantly, comes with the benefit of a decent price tag.

Henk Potts is equity strategist at Barclays Wealth