Utility stocks are often seen as safer investments than cyclical industrial stocks like Rolls-Royce Holding (LSE: RR), but is this really true?
Since peaking in September 2013, shares in Centrica (LSE: CNA) have fallen by 43%. Centrica’s dividend has been cut by 30%. Over the same period, Rolls-Royce shares fell by 34% and the firm’s dividend was cut by 30%. There’s not really much difference, is there?
Centrica clearly hasn’t delivered the more stable and reliable returns expected from a utility stock. Is water supplier United Utilities Group (LSE: UU) any better?
Time to take profits?
As it happens, investors in United Utilities have enjoyed strong returns over the last two-and-a-half years. United’s shares have risen by 34% and the firm’s dividend has risen by 11%. But United’s post-tax profits were lower last year than in 2013, suggesting the gains have been driven by a higher valuation, not by fundamentals.
Water utilities have just entered into a new five-year period of regulatory pricing, which runs until 2020. Water prices have been cut, and United warned on Tuesday that underlying operating profit is expected to fall this year.
United Utilities shares currently trade on a forecast P/E of 20. This high valuation has pushed the firm’s yield down to just 4.2%. That’s only slightly higher than the FTSE 100 average of 4%.
United shares look expensive to me. I believe there’s better value elsewhere.
Two potential buys
It’s a different story at Centrica and Rolls-Royce. Both companies have already seen their valuations plummet, cut their dividends and appointed new chief executives. Turnaround plans are underway at both companies, but is either a buy?
Centrica has cut capital expenditure and introduced a £750m cost-cutting programme. Savings of £200m are expected in 2016, which will include 3,000 UK redundancies.
Consensus forecasts suggest that Centrica’s adjusted earnings will bottom out at 15.3p per share this year, before rising modestly in 2017. A 2016 dividend of 12.2p per share is forecast, giving a potential yield of 5.4%.
Although these forecasts have been cut a number of times over recent months, I do expect Centrica’s profits to stabilise over the next year. The firm has now got a grip on its North Sea oil and gas business. Meanwhile, profits from British Gas and Centrica’s US utility business have been fairly stable. Now could be a good time to invest in Centrica, in my view.
A financial black box?
One of the problems with Rolls-Royce was that profits from its jet engine business had become hard for the City to understand. Earnings guidance was repeatedly changed and profit warnings became regular.
This led to long-time Rolls-Royce investor Neil Woodford dumping his holding in the autumn. In his blog, Mr Woodford cited “an increased level of uncertainty” about the firm’s profitability over the next three-to-five years.
However, Rolls’ new chief executive, ex-ARM Holdings boss Warren East, has announced plans for cost reductions of £150-£200m per year. He says 50% of these have already been identified. Mr East has also given a commitment to improve disclosure and transparency.
There may be more volatility ahead, but Rolls-Royce remains a quality business whose products have few alternatives. I suspect the firm’s shares could be a good long-term recovery buy at current prices.
