The prospects of rising interest rates does not bode well for the utility shares. Shares in utility companies generally become unattractive as investors anticipate an increase in rates. Although buy-and-hold investors will continue to find the dividend yields offered by many utility companies attractive, the performances of these shares are likely to be disappointing in the short term.
However, this does not mean that investors should avoid the sector completely. Not all utility companies are the same, and the recent sell off has created opportunities to invest in those companies that have strong balance sheets and a steady dividend growth outlook.
SSE (LSE: SSE) has one of the highest dividend yields, at 5.9%, but also offers one of the most attractive fundamentals. Weak generation and supply margins is partially offset by a significant increase in the value of its regulated assets. With half of its underlying earnings comes from its regulated business, SSE is increasingly resembling National Grid (LSE: NG).
As a majority of its income is derived from regulated assets, it should be able to continue to generate stable cash flows to service its debt and pay dividends to shareholders, even as dividend cover diminished. Dividend cover is expected to fall to 1.2x in 2015/6, but this should not affect the company’s ability to grow dividends by at least RPI infaltion.
Centrica (LSE: CNA) suffered a credit rating downgrade from Standard & Poor’s earlier this month, as the ratings agency expects Centrica will continue to struggle with low commodity prices and a competitive retail environment. The decision to scale back Centrica’s upstream operations is a step in the right direction, but there are relatively few near term catalysts to support its share price in the near term. The company’s recently announced 5% cut to household gas prices will crimp margins further and do little to stem the flow of retail customers to its smaller rivals.
With the recently announced changes to the Climate Change Levy, electricity generation from biomass will no longer be exempt from the levy. Consequently, Drax Group (LSE: DRX) is expected to see its EBITDA decline by around £30 million this year and £60 million in the following year. Shares in Drax have bounced back 17% since the announcement of better than expected interim results, but the outlook for earnings continues to bearish. What’s more, shares in Drax trade at 27.9 times its expected 2015 underlying EPS of 9.4 pence.
Although electric utility companies face greater headwinds in the form of lower wholesale electricity prices, cuts to renewable electricity generation subsidies and increasing competition, the valuations of most water companies are rather expensive. In addition, dividend growth for many water companies are slowing, as debt levels are relatively high and future revenue growth is limited following recent regulatory reviews.
The share prices of many water companies have fared better in recent months. Shares in United Utilities (LSE: UU) have fallen 11% over the past three months, but valuations are still expensive. It has a forward P/E of 20.3 and a dividend yield of 4.2%.
United Utilities’s new dividend policy promises dividend growth of at least the rate of RPI inflation until 2020, which is less ambitious than its previous target for dividends to grow at RPI + 2%. For much of the sector’s history, rapid dividend growth has been sustained by increasing leverage, but with debt levels already quite high, there is little scope for raising debt further without risking its investment grade credit rating. In addition, more indebted companies suffer more greatly from the increase in interest cost from higher interest rates.
With slower growth and a relatively more expensive valuation, shares in United Utilities are probably most vulnerable to a sell-off when the Bank of England finally raises interest rates.
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Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended Centrica. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.