How Will Severn Trent Plc Fare In 2014?

For most shares in the FTSE 100, 2013 was a good year and investors have likely enjoyed capital gains and rising dividend income.

That makes me nervous about investing for 2014 and beyond, and I’m going to work hard to adhere to the first tenet of money management: preserve capital.

To help me avoid losses whilst pursuing gains, I’m examining companies from three important angles:

  • Prospects;
  • Risks;
  • Valuation.

Today, I’m looking at water utility operator Severn Trent (LSE: SVT).

Track record

With the shares at 1674p, Severn Trent’s market cap. is around £4,000 million.

This table summarises the firm’s recent financial record:

Year to March 2009 2010 2011 2012 2013
Revenue (£m) 1,642 1,704 1,711 1,771 1,832
Net cash from operations (£m) 645 654 721 654 659
Adjusted earnings per share 92.7p 122.8p 105.6p 88.9p 98.9p
Dividend per share 67.34p 72.32p 65.09p 70.1p 75.85p

1) Prospects

Severn Trent’s soon-to-retire Chief Executive reckons regulatory compliance in the water industry requires delivering more of what customers want and the environment needs, whilst keeping prices down.  

The firm has been good at achieving real price reductions for its customers over the last five years by sharing the benefits of efficiency gains and outperformance. In terms of the dividend, Severn Trent investors have done well over the period too.

It takes ongoing capital investment to achieve an efficient operation with minimal environmental impact. In a glimpse of what lays ahead the firm recently released its business plan to regulator OFWAT for the period April 2015 – March 2020. As well as committing to keeping price rises below inflation the firm plans raise capital expenditure by 23% compared to the previous planning period, to £3.2 billion.  

However, there’s a shift in focus taking place in the regulatory environment. Rather than creating incentives for debt-funded capital expenditure in isolation, the regulator now seems interested in

total expenditure, which includes revenue-funded operational expenditure. Severn Trent plans total expenditure of around £6 billion over the planning period.

With expenditure going up and charge-out prices going down, it’s clear that efficiency needs to be squeezed in the middle if investors are to continue to see decent returns on an investment in the company. With the firm targeting a retail margin of 0.7% and a margin of 3% from businesses, capital investment must work hard if it is to keep the accounts in the black.

2) Risks

Severn Trent reckons the regulatory landscape is complex and fluid and, according to the company’s own risk statement, one of the main risks to the business is the potential for the firm to mess up on compliance. Ofwat sets challenging operational targets, which if missed, could jeopardise future funding or result in regulatory penalties.

The capital-intensive nature of the business relies on the availability of debt funding. If anything happens to make funding more difficult to get hold of, or more expensive, it’s hard to see such a scenario working out well for  Severn Trent’s investors and customers.

3) Valuation

As with all utility companies the main attraction for investors is likely to be the dividend yield. Severn Trent’s forward yield for 2015 is running at about 5%. City analysts expect adjusted earnings to cover that dividend just over once.

You can buy into that income stream for a forward P/E multiple of about 19 at today’s share price. Given forward earnings growth expectations of 5%, I think that valuation looks full.

What now?

There’s no doubt that Severn Trent’s business, with its captive customer base, is a reliable cash generator capable of producing a steady stream of dividends. However, such ‘defensives’ have been in high demand recently and I think the valuation has become stretched.

Dividend investing is not always as simple as it might appear. That’s why the Fool has just released a special report featuring 5 Golden Rules for Building a Dividend Portfolio. The rules can help avoid some of the pitfalls waiting to trap dividend-hunting investors.

If you’re thinking of taking the plunge with high-yielding shares, I recommend reading this report first. To get your copy, click here.

> Kevin does not own shares in Severn Trent.