As water companies, Severn Trent (LSE: SVT) (NASDAQOTH: SVTRF.US) United Utilities Group (LSE: UU) (NASDAQOTH: UUGRY.US) are some of the defensive investments you can make.
However, due to new proposals from industry regulator, Ofwat the future of these companies has been called into question and with it, the traditionally dependable dividend payouts of both United Utilities and Severn Trent are under threat.
Pressure from regulators
Ofwat is proposing that water companies will have to accept lower rates of return on equity and capital in the next five-year regulatory period that runs to 2020.
Ofwat’s preferred measure for calculating water companies’ return is a blended measure of the weighted average cost of capital, which is effectively the return companies make on the debt and equity they use to fund investment. Ofwat believes that this return should be pegged at 3.85%. Unfortunately, this means that the current WACC of 4.2% is too high.
Unsurprisingly, City analysts have described Ofwat’s proposal as “a negative for water companies” and some analysts have speculated that a lower WACC could force United Utilities and Severn Trent to reduce dividend payments as their profitability declines.
Rising debt
While Ofwat is planning on crimping water companies profitability, it would appear that these companies are already struggling to pay the bills.
For example, during 2013 Severn Trent spent just under £770m on both dividends and capital projects, although the company’s only generated £660m in cash from operations. Meanwhile, United Utilities has spent almost all of its cash flow from operations on capital projects every year for the past five, leaving no cash for dividend payouts.
As a result, both companies net debt for has risen rapidly. In particular, at the end of 2013 Severn Trent and United Utilities had a net debt to equity, or gearing ratio of 500% and 320% respectively. These levels of debt are actually quite concerning because when interest rates start to rise, the cost of maintaining these debt piles is also going to rise. Yet another headwind these utility companies will have to grapple with in the near future.
What about a takeover?
Still, there has been a lot of speculation during the past year or so that water companies could become acquisition targets. But with these new plans from Ofwat on the table, many City analysts believe that any potential bidder will want more clarity on the industry’s outlook before making an offer. And I don’t blame them, acquiring a business, which may be forced to reduce its profitability in the near future is not an attractive investment.
For this reason, it is widely believed that neither Severn Trent nor United Utilities will receive a buy-out offer in the near future.
Foolish takeaway
So, with pressure building on both Severn Trent and United Utilities to reduce profits in favour of lower prices for customers, investors could see dividend payouts come under pressure in the near future.
All in all, with these risks ahead, it would appear that water companies are no longer as defensive as they once were.
