Why Severn Trent plc could be a better buy than United Utilities Group plc

Roland Head considers the outlook for water groups United Utilities Group plc (LON:UU) and Severn Trent plc (LON:SVT).

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The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

Water utility stocks are often seen as safe and boring. At face value, today’s results from United Utilities Group (LSE: UU) confirm this view. The group’s underlying operating profit rose by 1.3% to £312.5m, while the interim dividend was increased from 12.81p to 12.95p per share.

Shareholders seeing today’s figures may be wondering why the group’s share price has fallen by 6% over the last three months. Two factors that could explain it are rising inflation and rising bond yields. Utility stock prices are closely linked to both, due to the way in which utilities are financed, and because their shares are owned for income.

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Falling share prices at United Utilities and its peer Severn Trent (LSE: SVT) have pushed up the dividend yields available from each stock. Is now the right time to consider topping up, or could these shares have further to fall?

Is Severn Trent more profitable?

It’s worth noting is that Severn Trent generates a higher return on capital employed (ROCE) than United Utilities. ROCE is a useful way of measuring how much profit a company generates, for each pound that’s invested in its business.

United Utilities’ ROCE has fallen from 6.7% in 2011 to just 5.1% last year. Today’s interim results suggest that the figure for this year will be 5.2%, assuming profits remain stable during the second half.

In contrast, Severn Trent’s ROCE has remained fairly stable over the last five years. In 2011, ROCE was 7.0%. Last year, it was 6.8%. This gives Severn Trent a small but worthwhile advantage over United Utilities, in my opinion.

The highest yield?

United Utilities’ dividend yield of 4.3% is significantly higher than the 3.7% on offer at Severn Trent. But Severn Trent’s is expected to be covered 1.3 times by earnings this year. The equivalent figure for United is just 1.15 times.

United Utilities is only able to offer a higher yield because it pays out a larger proportion of its earnings. My calculations show that if both companies had the same level of dividend cover, they would offer almost exactly the same dividend yield.

The similarities between these two companies’ are not surprising. Both operate in a heavily-regulated market, with limited opportunities for growth.

One possible exception is the opportunity each company has to make acquisitions. This is relatively unusual among UK utility businesses, but Severn Trent has bucked the trend this month by entering into a bidding war with investment firm Ancala Fornia, for Welsh water company Dee Valley Group. Ancala currently is the current leader, having upped its bid in response to Severn Trent’s offer. It’s not yet clear what the final outcome will be.

Which water utility looks better?

As I’ve explained, I think that the differences between United Utilities and Severn Trent are fairly small. I certainly wouldn’t sell one in order to invest in the other. I’m also concerned that if bond prices continue to fall next year, we could see further falls in utility stocks.

We can’t predict the future, but as things stand, I reckon that Severn Trent looks slightly more attractive than United Utilities.

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