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Is it Time to Sell United Utilities Group Plc?

City analysts expect a 10% uplift in United Utilities (LSE: UU)’s earnings per share from their full-year results, but looking forward, projections on earnings are less rosy, which could end up pressurising the firm’s famously steady dividend.  The dividend yield is running at about 4.2% but cover from earnings is thin, and the shares trade on a heady P/E rating approaching 20.

If you’re sitting on a big gain with United Utilities, now might be a good time to consider locking some of that in as the firm has some ongoing headwinds.

High debt

Operating, developing and maintaining a network of water and sewage assets is a capital-intensive pursuit. United Utilities serves about seven million people in North West England, with its water and waste network, which includes some 42,000 kilometres of water pipes from Cumbria to Cheshire, around 76,000 kilometres of sewers, 569 wastewater treatment works, 94 water treatment works, and about 56,000 hectares of water catchment land.

Such assets constantly suck in capital as the firm strives to improve the system by, for example, renewing worn-out pipes to reduce leakage. Improvements like that help the firm both to deliver a better customer experience and to comply with regulatory requirements. However, cash flow can’t always support the capital requirements of the business and, over time, United Utilities has built up a lot of debt. At the last count, the firm’s net debt figure stood at around 10 times the level of its operating-profit figure. We can see by the table that debt has been out-pacing profits:

Year to March

2009

2010

2011

2012

2013

Operating profit (£m)

730

768

580

592

605

Net debt (£m)

5381

5175

5058

5534

5972

Debt divided by profit

7.4

6.7

8.7

9.3

9.9

Admittedly, United Utilities uses its  consistent cash flow to manage interest payments, but a trend of rising debt can’t go on indefinitely.

Escalating industry regulation

United Utilities enjoys a privileged position in the utility space, as the firm’s customers can’t opt to buy their water and sewage services from competing firms, as they can with gas and electricity services. Potentially, that’s a great geographically monopolistic business model for United, with constant and predicable flows of cash assured.

However, stiff regulation protects the interests of consumers and the environment, which includes compulsory capital investment into the firm’s assets. Regulation crimps the firm’s ability to turn a profit so it’s unlikely that explosive earnings’ growth will ever become a factor for investors to consider here. City analysts have earnings’ growth of just 3% pencilled in for 2015 and an earnings’ decline of 6% for 2016. In today’s world, it’s hard to imagine recent escalating regulatory requirements easing up. If anything, regulation seems set to get stiffer.

Since emerging as a focussed water utility in 2011, the firm has managed to keep its dividend rising:

Year to March 2009 2010 2011 2012 2013
Adjusted earnings per share 26.5p 50.8p 35.1p 35.3p 39.1p
Dividend per share 32.67p 34.3p 30p 32.01p 34.32p

Adjusted earnings covered last year’s dividend just over once and, going forward, the twin spectres of rising debt and escalating regulation could eventually choke the firm’s ability to reward investors with a dividend increase every year. If that happens, the shares will likely lose their premium P/E rating, which could happen by means of a falling share price.

What now?

If you own United Utilities shares then the chances are strong that you’ve been holding them for the generous dividend payout, and recent share-price gains could have come in as something of a bonus.

However, if you've acquired a taste for capital gains, I recommend a share idea  from one of the Motley Fool's top small-cap investors. His diligent research has uncovered what looks like one of the best growth shares for 2014.

Sometimes growth comes from within when a company reinvents itself and pursues a different line of operations. When that happens, valuations can remain modest, as investors are slow to catch on to the new growth potential. That's what seems to have happened with this gem. A strong recovery in profits followed restructuring and the directors predict double-digit margins driving a profits surge in the years to come.

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Kevin does not own shares in United Utilities Group.