Why I’d ditch Severn Trent plc for this 6% yielder

Roland Head believes profits could get washed away at Severn Trent plc (LON:SVT).

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Until recently, water utilities were seen as super-safe dividend stocks to buy and hold forever. But Severn Trent (LSE: SVT) shares have lost 28% of their value since May. Why?

One concern is that water regulator Ofwat isn’t expected to be as generous in its 2019 price review as it may have been in the past. Spending plans for the next regulatory period (2020-2025) could contain tougher performance targets and leave less room for profit.

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However, we don’t yet know how much of this threat is real and how much is just political posturing.

In today’s third-quarter trading statement, Severn Trent advised investors that it’s on-track to receive outperformance payments of “at least £50 million” this year. Full-year profits should be in line with forecasts.

Looking ahead, the company expects to enjoy “strong outperformance opportunities” during the 2020-2025 regulatory period. So things could still turn out well.

Why I’m avoiding this stock

One of the main secrets behind water utilities’ ever-increasing dividends is cheap debt. Borrowing costs have fallen steadily in recent years, allowing companies to borrow more and refinance at lower costs. However, this could soon change. This week’s market wobble is thought to have been caused by the prospect of rising US interest rates.

With net debt of £5.2bn, Severn Trent’s finance costs could rise quickly if rates rise. This could put pressure on dividend payments, which are expected to add up to 72% of this year’s forecast net profit of £282m.

Severn Trent’s forecast yield of 4.8% may seem tempting. But in my view the political, regulatory and financial risks facing the firm make it less attractive. I’d rather invest elsewhere.

One stock I’d double up on

Like Severn Trent, pub chain Greene King (LSE: GNK) has fallen steadily since May. The FTSE 250 firm’s shares are now 35% cheaper than they were eight months ago.

The main risk facing investors is that that weak consumer spending growth and rising costs could put pressure on profits and might lead to dividend cuts.

However, unlike water utilities, pub groups have already been through a long period of adjustment. Thousands of pubs have been closed across the UK and all of the big companies have made changes to their business models.

Time to start buying?

Greene King enjoyed strong trading over Christmas, but the group’s trading during the remainder of the year has been weaker. Sales fell by 1.2% to £1031.4m during the six months to 15 October, while adjusted pre-tax profit fell by 8% to £127.9m.

This highlights a key risk for investors. Pubs have high fixed costs, such as staff and premises. A small fall in sales can lead to a big reduction in profits, an effect known as operational gearing.

Sales are expected to be broadly flat during the current year and next year. Profit growth seems likely to depend on the firm’s ability to hit a cost-cutting target of £40m-£45m. Further pub disposals will also help generate cash and manage debt levels.

These shares aren’t without risk, but this year’s forecast yield of 6.6% is expected to be covered 1.9 times by earnings. And with the shares trading on a forecast P/E of 7.8, there’s scope for gains if profit growth returns.

I believe the shares could be a long-term buy at this level.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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