Why Severn Trent Plc Should Be A Loser This Year

The energy companies have been hit of late by political talk, becoming convenient bad guys for the electioneers to take a pop at. But water companies like Severn Trent (LSE: SVT) aren’t being accused of overcharging for the wet stuff, so what are their prospects like?

Here’s a look at Severn Trent’s last five years of headline fundamentals, together with the latest analysts’ consensus for three further years:

Mar EPS Change P/E Dividend Change Yield Cover
2009 92.7p -5% 10.7 67.34p 6.8% 1.4x
2010 122.8p +32% 9.7 72.32p +7.4% 6.1% 1.7x
2011 105.6p -14% 13.8 65.09p +9.0% 4.5% 1.6x
2012 88.9p -16% 17.4 70.10p +7.7% 4.5% 1.3x
2013 89.9p +11% 17.3 75.85p +8.2% 4.4% 1.2x
2014* 84.5p -14% 19.7 80.38p +6.0% 4.9% 1.1x
2015* 87.1p +3% 19.1 84.93p +5.7% 5.2% 1.0x
2016* 80.2p -8% 20.8 80.94p -4.7% 4.9% 0.9x

* forecast

Volatile times

Severn Trent’s shares have had an erratic ride over the past year, pushed skywards by a takeover approach last summer and then back down again after the firm firmly rebuffed all offers. As I write the shares are up only 5% over the past 12 months to the current 1,680p.

But over five years we’re looking at a rise of nearly 70%, while the FTSE 100 has managed only a little over 40%. And at the end of it, the shares are on a prospective price to earnings (P/E) ratio of nearly 20 heading based in March 2014 year-end expectations — and it’s set to rise by 2016.

That’s a significantly higher valuation than, for example, United Utilites, which I took a look at recently — United Utilities is on a forward P/E for the same year-end of 16, and I think that disparity is hard to justify.

Cover is falling

In fact, for me to buy Severn Trent at today’s price levels, I’d want to see higher dividend yields, better earnings and dividend growth forecasts, or better dividend cover — or, ideally, some combination of those. But in fact, Severn Trent is looking weaker than United on those measures. Its dividend yield is a bit lower, though there’s slightly higher dividend growth expected.

But forecast earnings growth is lower, and dividend cover is falling badly. Sure, utilities companies are able to pay almost all of their earnings out as dividends, but I think we still need to see cover staying at around 1.2 times if we’re going to justify strong prices for the shares.

As it happens, Severn Trent’s cover looks set to have fallen for six straight years if those forecasts prove accurate, and its dividend would not even be covered by earnings in 2016 — earnings will be pressured then by OFWAT’s new AMP6 regulations due to come into force in 2015.

It’s the takeover

What’s the reason for Severn Trent’s higher valuation than United’s, despite its poorer forecasts?

Well, debt could be a part of it. The utilities traditionally rely on debt-funding, although United is carrying more of it as a proportion of its market capitalization than Severn Trent.

But I can’t help feeling there’s a bit of takeover fever still built into today’s share price, with optimists hoping for a further bid approach as 2014 develops. Will it come? I’ve no idea. But I do know that past takeover attempts are no guide to future attempts, and I don’t really see Severn Trent as being any more attractive to those with an acquisition bent than United.

It’s not my strategy

If it should happen, then I’ll be wrong and Severn Trent shareholders should have a nice 2014. But I don’t think investing in the hope of a takeover is a sensible strategy, and on fundamentals alone I think Severn Trent shares are a bit too pricey.

Verdict: Heading for a damp 2014!

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> Alan doesn't own any shares in Severn Trent or United Utilities.