The Pros And Cons Of Investing In Severn Trent plc

Stock market selections are never black-and-white decisions, and investors often have to plough through a mountain of conflicting arguments before coming to a sound conclusion.

Today I am looking at Severn Trent (LSE: SVT) and assessing whether the positives surrounding the firm’s investment case outweigh the negatives.

Price hike controversy threatens future revenues

In the face of mounting ire over rising utility bills, Severn Trent has acceded to calls by regulator OFWAT for water suppliers to rein in planned price increases. Like its peers in the electricity sector, the profitability of these firms looking ahead has been called into question as a backdrop of squeezed living standards puts the issue of rising bills increasingly under the microscope.

The firm announced this month plans to raise bills by 1.2% below retail price index (RPI) inflation for the current AMP6 regulatory period which runs to 2020, with hikes planned after a prize freeze in the first year commencing April 2015.

An attractive dividend policy

Severn Trent’s prime position in a defensive marketplace makes it a winner for dividend investors. The utilities play has ramped annual payouts significantly after being forced to slash 2011’s dividend, and last year’s 75.85p per share payment was up 8.2% from the year ending March 2012.

Severn Trent laid out its stall for more bumper rewards last month when it raised the interim dividend 6% to 32.16p per share. Indeed, brokers expect the company to provide full-year payouts of 80.38p and 84.92p in 2014 and 2015 respectively, forecasts which create yields of 4.8% and 5.1% respectively. This easily outstrips a forward average yield of 3.3% for the entire FTSE 100.

Near-term earnings woes expected

But Severn Trent faces the prospect of fresh earnings pressure in the medium term due to revenue constraints and rising costs. The firm’s November interims revealed that underlying pre-tax profit dipped 5.8% during March-September, to £141.3m, as total operating costs rose to the tune of around £15m to £666.1m.

City analysts expect the company to post a 14% decline in earnings per share in the year ending March 2014, to 85.1p, before a modest 5% snapback the following year to 89.3p. These projections make the company looks an expensive pick, providing P/E multiples of 19.7 and 18.8 for these years versus a forward average of 17.9 for the complete gas, water and multiutilities sector.

Cash continues to flow

Even though Severn Trent’s earnings outlook remains subdued for the medium term, the water provider’s robust cash flows help to assuage fears of implications on its dividend policy during the period.

The business reported last month that, although free cash flow dipped 7% during the March-September period, this still registered at a respectable £152.3m. Indeed, Severn Trent confirmed that  “the group’s cash flow requirements are funded until 2015.”

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Despite an uncertain earnings outlook, I believe that Severn Trent’s defensive nature and strong balance sheet should maintain its popularity as a solid dividend selection, at least during the medium term.

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> Royston does not own shares in Severn Trent.