You may well wonder whether utilities — most of which have lagged the market since the turn of the year — have what it takes to deliver double-digit returns in 2015. And you may also suggest that at a time when the FTSE 100 trades above 7,000 points, their poor performances won’t last forever — so, which one should you choose right now?
Water Under The Spotlight
I am not a big fan of the broader utility sector, but it looks like Severn Trent (LSE: SVT) is a much more enticing investment proposition than Pennon (LSE: PNN), which may struggle to outpace its rivals this year.
Forget about Centrica (LSE: CNA) (-7.6% year to date) and SSE (-3.2% year to date), but don’t rule out a fast recovery for National Grid (-2.1% year to date) — I wouldn’t be surprised if its valuation proved to be more resilient than that of its rivals in the next 12 months or so.
The best bet of all, however, could turn out to be United Utilities (LSE:UU), whose shares might be worth keeping on the radar.
Pennon (£3.3bn Market cap, £5.7bn Enterprise Value)
The shares of Pennon have risen at an average clip of 12% annually in the last five years, but they are down 9% year to date. Is it an opportunistic buy?
The stock trades at a slight discount to the 850p average price target from brokers, and that’s unusual: since February 2014, the shares have often traded above consensus estimates from analysts.
What’s wrong with that?
The company operates two units: waste management and water and sewerage, both of which have grown nicely since 2013. That said, its fundamentals are not incredibly attractive, and leverage could become problematic if core profitability falls. Management changes, however, have been welcomed by the market, and have opened talk of a possible takeover of Pennon.
The company announced last week that Ken Harvey would leave at the end of July after almost 20 years as chairman. He will be succeeded by John Parker, who is currently the chairman of Anglo American, and was the chairman of National Grid for about a decade until 2011.
Its high dividend yield signals risk, rather than opportunity, in my view.
Severn Trent (£4.9bn Market Cap, £9.5bn EV) & United Utilities (£6.4bn Market Cap, £12.3bn EV)
Severn Trent (+3% year to date, +6% in the last five trading sessions) is 20% cheaper than Pennon, based on cash flow multiples, but the two utilities trade in the same ballpark based on net earnings multiples.
Severn Trent’s risk profile has materially improved in the last six months, in my view, and its operating profitability is much higher than that of Pennon, whose Ebit margin is 10 percentage points lower than that of Severn Trent.
United Utilities (+3% year to date, +6% in the last five trading sessions) is 10% cheaper than both Severn Trent and Pennon based on its relative value to earnings, but its operating profitability is 10 percentage points higher than that of Severn Trent.
Does this mean that United Utilities is best bet right now? Very possibly.
The problem I have with its valuation is that it has been inflated by takeover rumours for more than a year now — and the same applies to Severn Trent’s equity value.
Of course, I like United Utilities and Severn Trent more than Centrica, which was recently downgraded by Moody’s — that didn’t come as a surprise to me, although Centrica tried to preserve its credit rating by cutting its payout ratio.
Still, most stocks in the sector carry insanely high debt loads. Yes, the cash flows of utilities tend to be stable, but if I were to take any risk at all, I’d bet on the one — United Utilities — whose core profitability is structurally higher.
Frankly, for the risk involved, I'd rather bet on FTSE 100 than on utilities, looking to capitalise on possible upside for miners and oil producers. Alternatively, I'd build up my own portfolio, including most of these terrific stocks, which promise a very nice balance of yield and growth into 2016.
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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.