The performance of a number of utility stocks has been rather disappointing during the course of 2015. A key reason for this is an expectation that interest rates will begin to head northwards, which makes their yields less appealing and also may mean that the cost of servicing their often large amount of debt becomes more expensive.
For example, Centrica (LSE: CNA), Pennon (LSE: PNN) and Drax (LSE: DRX) have posted share price falls of 16%, 20% and 40% respectively since the turn of the year.
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However, the reality is that, while interest rate rises are almost a certainty in the coming years, the pace at which they will rise is unlikely to be rapid. That’s because the global economy remains a rather uncertain place and, while the UK economy is performing well, it could easily catch a cold if China sneezes. As such, policymakers are unlikely to risk the current purple patch of economic growth just to push interest rates higher. And, with inflation being near-zero, the risk of deflation remains, thereby making brisk rate rises very unlikely.
Due to their share price falls, the likes of Centrica, Pennon and Drax now offer even more appealing yields. For example, Centrica currently yields 5.2% even after cutting its dividends by 30% earlier in the year, while Pennon and Drax yield 4.6% and 2.3% respectively. Clearly, Drax’s yield is less enticing than those of Pennon and Centrica and, with the biomass/coal power station set to post declines in earnings during the next two years, it is expected to slash dividends by 44% next year, which puts it on a forward yield of just 1.3%.
Also making Drax unfavourable versus Centrica and Pennon is its lack of diversity. It is a single site operator and, while its transition to biomass is a sound strategy given the emphasis on cleaner electricity production, the profitability of doing so remains questionable. For example, Drax’s forecast of earnings per share of 5p next year is less than 8% of its level in 2010, which indicates that investor sentiment could continue to slide.
Meanwhile, Centrica’s business model is also somewhat unfavourable. It has been hurt by a lower oil price and, while under previous management it had ambitions to become a major oil and gas producer/exploration play, new management do not share these ambitions. As such, Centrica will focus on domestic energy supply and sell a number of high value assets over the coming years. This has the potential to improve investor sentiment, although the company’s share price performance may remain somewhat volatile in the meantime.
Because of this, Pennon seems to be the best buy. As a water services company, it is a very stable business and offers reliability and resilience for its investors. Furthermore, with the water services sector being the subject of persistent M&A rumours, a bid for Pennon would not be a major surprise which, alongside a top notch yield, makes it the pick of the three utility companies.
