It used to be easy to invest in the utility sector. Most investors assumed that names such as water company United Utilities Group (LSE: UU) operated steady, cash-generating businesses supported by their monopoly positions in the market. So, it seemed like a no-brainer to buy the shares to collect the often-large dividend payments with the reasonable assumption that the underlying business would be stable for years to come.
It always seemed as if the share prices of the utility firms would be unlikely to cause too much trouble during a long-term holding period — therefore, we thought, we’d invested in a low-risk compounding machine, and all we had to do was periodically reinvest the dividends and wait for a happy and prosperous retirement.
But I don’t think it is as simple as that now. A number of big questions hang over the utility sector that challenge our previous cosy assumptions. Firstly, there’s the large pile of debt that many utility companies carry. Capital-intensive operations in the sector require huge amounts of money to develop and maintain, and utility companies have turned seeking, managing and servicing borrowings into an art form. United Utilities, for example, revealed in today’s half-year results report that its gross borrowings stand around £8.68bn, which compares to last year’s underlying operating profit of £645m – the figure for debt is large, and the sheer quantity of words dedicated to talking about borrowings in today’s report underlines how big an issue it is for the firm.
Of course, there’s nothing new about utility companies running up large piles of debt, but the regulators have been cranking up the pressure on firms such as United Utilities. It wouldn’t take much to tip the balance so that the big figures of revenue and costs fail to produce enough of the little figures for free cash flow and profit. If that happens, the directors could face hard choices between servicing the interest on borrowings or servicing shareholders with a dividend. Perhaps they could end up with a situation where they can’t service both. If that happens, expect dividends to be cut and share prices to fall.
Yet debt and regulatory risks aren’t the only things to worry about. I reckon there’s also a lot of political risk hanging over the utility firms at the moment. Labour and the Conservatives seem close in the polls and the next general election could see a Labour government – one that has pledged to nationalise utility companies. If that happens, I certainly wouldn’t want to be holding shares in any firm that falls in the crosshairs of politicians in power who want to ‘get even’ with ‘greedy’ capitalist directors and shareholders!
Despite my reservations, today’s figures are good. Revenue for the first half of the firm’s trading year rose 4.6% year-on-year and underlying earnings per share shot up almost 23%. The directors pushed up the interim dividend by 3.9%. At the recent share price of 775p, the forward dividend yield for the trading year to March 2020 runs around 5.5% with the payment covered almost one-and-a-half times by anticipated earnings. If you are comfortable with the over-arching risks and uncertainties, the yield looks attractive. But, to me, it’s a big ‘if’.
Kevin Godbold has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.