Expectations that the Bank of England could raise rates by the end of this year have increased following governor Mark Carney’s speech last week. The yields of many utility shares are well in excess of those of UK government bonds, but the gap between them have recently been decreasing significantly. And, any further increase in the yields of gilts will likely push the dividend yields of utility shares higher by causing a sell-off in the sector.
The problems facing many utility companies are not limited to higher interest rates, as water companies are seeing their returns cut by recent regulatory reviews, electricity generators are feeling the squeeze of lower wholesale electricity prices on their margins and energy suppliers are witnessing a rise in competition from smaller competitors. With these underlying trends, investors need to be more selective in the sector to choose companies that have assets that are coping better than others.
Centrica‘s (LSE: CNA) adjusted operating profit fell 35% to £1.75 billion, as lower oil prices crushed its upstream profits. Compounding these problems, supply margins and customer numbers have decreased, as consumers have become more price-conscious and are more willing to switch energy suppliers.
Last week, it promised to cut household gas prices by 5%, which makes it the cheapest of the big six utility companies; but will that reverse the decline in profitability, or could it threaten to start a price war that has been seen in the supermarket sector?
In hindsight, Centrica’s upstream diversification now seems to be a mistake. The downstream assets, which generate more stable cash flows, would most likely trade at a much higher valuation than Centrica as a whole.
As a break-up is unlikely, Centrica’s shares are unattractive. They trades at a forward P/E of 15.6, and has a forward yield of 4.3%.
National Grid (LSE: NG) is relatively more attractive than Centrica, because an overwhelming majority of its earnings is derived from regulated assets. The income from these assets are typically very stable and not dependent on fluctuations in demand nor changes with wholesale prices.
Its shares currently have a forward P/E of 14.7. Its dividend should grow by at least RPI inflation, and has an indicative dividend yield of 5.1%. With a higher than average dividend yield in the sector, and greater foreseeability over earnings in the medium term, National Grid is probably the most attractive in the sector.
Drax (LSE: DRX) will be hit hard by the recent changes in the Climate Change Levy, which will now include biomass electricity generation in the levy from 1 August 2015. The power generator, which has been switching from burning coal to wood pellets, expects the change would cost it £30 million this year and £60 million in 2016.
Unless the government delays the changes or makes a policy U-turn, shares in Drax are unappealing.
Pennon Group (LSE: PNN) had completed its regulatory review of its water utility business in 2014, which gives it greater certainty over cash flows in the next few years and allows it to commit to dividend growth of 4% above RPI inflation until 2019/20. By contrast, United Utilities (LSE: UU) and Severn Trent (LSE: SVT) have only promised dividends will grow at least in line with RPI inflation.
As is typical of other water companies, Pennon’s dividend yield of 3.9% is relatively low. Although the utility company has a more attractive dividend growth plan than the other listed water companies, a high P/E valuation and relatively low dividend yield should mean Pennon’s shares could be hard hit by increases in interest rates.
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Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended Centrica. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.