VALUE INVESTING
United Utilities: An Attractive Yield Play

By Stephen Bland (TMFPyad)
August 8, 2003

United Utilities (LSE: UU.)(NYSE: UU) is a high yielding, multiple utility share which I expect is held by many income investors. In addition, I have included it in both of my high yield portfolios. The historical yield at the present price of 545p is about 8.7%.

United Utilities has interests in water and electricity, both of which are government regulated businesses. It also has some increasingly profitable unregulated activities concerned with operating management services for other utilities, supplying outsourcing services and a telecoms operation. There is some chance that in the event of a stock market recovery, the company may float of some of these businesses, which perhaps makes the company a somewhat more attractive yield play than some other utilities.

In recent years, it has paid out virtually all its available profit as dividends, meaning that the dividend cover is only around 1. By general market standards, this is very low. Most shares will pay out only a proportion of net profit as dividends, such that cover is 1.5 or more. Until 2000, United's dividend cover was much higher, at about 2 times, but falling profits since then combined with small increases in the dividend have resulted in the present low cover figure. Although the price of the company's products is regulated, it has a much more stable income base and cash flow than most normal trading companies, which is the usual reason given for the relatively high dividend payout compared with profits.

This is not a pyad share, as it has very substantial debt and trades over book value. Readers may be interested to know that, in the early days of utility floats, some water companies were indeed pyad shares. But then there was a rash of mergers and massive debts were incurred to finance these deals.

On July 28, the company announced a rights issue, offering 5 new shares for each existing 9 shares at 330p. The exercise is intended to raise around £1b. Unfortunately, it is a little more complex than that. The payment is in two stages, denoted as Initial A shares of 165p each in September 2003 and Further A shares of 165p each in June 2005. Investors who do not acquire any of the initial A rights shares will not be entitled to participate in the further stage in 2005. After the second stage has been completed, all the A shares will be consolidated into ordinary shares on the basis of two A for one ordinary. Prior to this occurring, the A shares will be treated as one half of an ordinary share for the purposes of dividends and other matters.

Dealings start in the initial A rights on 27 August 2003, nil paid, with the final date for payment of the first 165p being 17 September 2003 at 10.30am. Following that, these shares will trade as fully paid initial A shares, with the right to subscribe for a further A share at 165p in June 2005.

Existing shareholders who do not take up their rights will have their nil paid entitlements sold for them in the market. The amount realised, less expenses, will be paid out to them. This assumes the nil paid rights trade at a premium, which is pretty likely. Another way to realise the premium for those not interested in taking up the rights is to actually sell the nil paid rights themselves in the nil paid time window between 27 August and 17 September rather than wait for the compulsory sale resulting from simply doing nothing.

Because United Utilities will be held principally as a yield play, it is important for holders to note that the dividend on the existing shares will be adjusted for the rights issue. The effect of this is that those taking up their full rights will receive a similar yield on their new total holding to that prevailing pre rights. However, this means that those who do not take up their full rights allotment but keep their existing ordinary shares will suffer a reduced dividend on those shares in future. Against that they will receive a capital payment from the sale of their nil paid rights, assuming these trade at a premium. The actual figures issued by the company indicate that compared with the dividends of 47.6p paid for the year ended 31 March 2003 on the existing shares, the dividend would have been 43.18p had the initial A shares already been in existence and 40.34p had both the initial and further A shares been in existence.

Equally importantly for income holders, the company states that they will maintain their existing commitment to raise dividends in real terms throughout the current five-year regulatory period, which ends in 2004. From 2005-10 they will "maximise payments". This does not tell us too much but to be fair they cannot be expected to give any firm figures on dividends until they know the outcome of the next five-year regulatory review.

So what should shareholders do? This depends on whether investors wish to stay in the shares. If not, they may as well sell in the market now, which will probably create a loss for most people. If they do, then several options occur:

1. Do nothing or sell the nil paid rights in the market. This will result in a payment being received equal to the nil paid rights premium less expenses (assuming there is a premium) in a few weeks' time. Following that, reduced dividends will be receivable compared with the previous year but this still leaves the existing ordinary shares on quite a high yield, depending upon the investor's original purchase price. This is what a strict no-dabble high-yield portfolio investor living on income rather than reinvesting would do, treating the cash returned as additional income.
   
2. Take up all the rights. This requires sufficient cash of course, specifically for every 9 ordinaries held, the investor will have to find 5 x 165p = £8.25 now, and the same again in June 2005 if it is still desired then to take up the full entitlement. In effect, the investor is simply increasing their investment in the company, a decision which must be taken in the light of its general desirability, the overall portfolio strategy being followed, potential other investments for the cash and so on, just like any other new investment. Note that the yield on the rights shares is massive. At say 40p dividend on a final cost of 330p, this gives about 12%, even though the average yield on the total new holding will be the same as before. A similar yield obtains on the half value initial A shares until consolidation in 2005.
   
3. Sell just enough of the nil paid rights, raising sufficient cash to purchase the remainder of the rights entitlement. This will involve some overall dividend reduction but has the merit of no cash outlay now. In 2005, the options available can be re-examined in the light of contemporary circumstances.

What is the best path? Not a question I have much opinion on really because it depends on the extent to which existing investors wish to increase their investment in the company and that is a personal thing. Clearly if they are firm on not wishing to do so, the rights should not be taken up. Equally if they have the cash and desire a further stake in a utility like this, then they should go for it because the rights are way below the market price at present. It might even make sense for these investors to buy more rights in the market at the prevailing premium, because they carry the entitlement to the 2005 issue.

I would comment though that in my view the rights makes the company more attractive as a yield play. But this comment is relative to its earlier position and income investors must look at the rights cost against the merits of alternative high yield shares out there.

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