Stick or twist?
Today’s update from United Utilities (LSE: UU) highlighted earnings growth of 5% in the first half, along with management’s plans for investment and balance sheet structuring going forward.
United Utilities shares gained just over 1% at the open, and still remain close to an all-time high of 1,025p. This is despite what remains a relatively meagre outlook for earnings growth, a generally full valuation and a leveraged balance sheet.
I suspect that the current share price has more to do with investor hopes of a bid from one of the Canadian pension funds, who were previously circling Severn Trent, than it does the medium-term investment prospects of the shares.
However, in defence of the management team, they have gone to great lengths to prepare the group balance sheet for an end to the ‘ultra low interest rate era’. As such, in today’s release they also reported that at least 50% of the group’s debt costs were fixed out till 2020.
This may help to cushion investors from some of the fallout that could arise if the Fed takes the plunge next month and raises rates. However, it still leaves £3 billion of index-linked debts that the group has to service.
If, by some off chance, commodity prices and CPI inflation were to stabilise once into the new year, then it wouldn’t take an awfully long time for rising retail price inflation to translate into higher financing costs for the group.
With every 1% increase in the cost of RPI-linked debt likely to increase the group’s interest bill by anything up to £30 million, it does not take a financial wizard to see how, on a two- to three-year time horizon, finance costs could present a significant headwind to earnings growth at United Utilities.
On balance, United have probably been one of the safer or more steady bets on the utilities sector in recent years, but whether or not a 4% yield and a topped-out share price will be enough to justify the risks of holding on through the coming hiking cycle will depend entirely upon the individual investor in question.
Time to walk away?
After a strong run throughout the ‘near-zero’ era, SSE (LSE: SSE) shares gained 65% at their peak when compared with their 2010 lows, but have twice failed to break above their previous highs of 1,6750p in the last 12 months. Now they trade close to the 1,450p level after an interim update that was uninspiring at best.
With earnings under pressure from wholesale commodity prices, a new regulatory regime likely to constrain the group’s ability to subsidise itself by increasing the prices charged to consumers and with dividend cover already uncomfortably low at 1.25x — the outlook for SSE is growing increasingly dark in my view.
While it is possible that SSE shares may attract some technical or sentimental support in the run-up to Christmas, it is difficult to envisage there being any impetus for a renewed push higher during the months ahead.
On the contrary, if the Federal Open Market Committee decides to take the plunge and raise rates in mid December, then I believe that the shares could face yet another bout of sustained selling pressure.
Summing Up
Many of the drivers shaping the utility sector at the moment appear to all lead toward the same outcome for shareholders in my view: disappointment.
In recent years, investors have bought heavily into the sector after becoming tempted by the stability of its constituents and attractive levels of dividend growth.
Now with sector constituents facing mounting headwinds to revenue growth, dividend cover falling to uncomfortably low levels and the end of an era in terms of near zero interest rates fast approaching, I believe that the utilities shares could be about to reach an inflection point.
In my view, if there are any benefits to be gained over the medium term from new or continued investment in this area, then I am doubtful as to whether those benefits would justify the risks that now come attached to the shares.
