I have no doubt that the shares of water company United Utilities have found their way into the portfolios of many income-seeking investors, so today's trading update provides an opportunity to gauge whether it's a good idea to continue holding, or perhaps to buy in for the first time.
Steady trading, but...
Utility firms tend to be prized for their defensive, cash-generating operations, but I reckon it pays to remain vigilant with all shareholdings, even those we intend to own for a long time. Things can change, and previously attractive circumstances can disappear. Look no further than that other once-coveted 'defensive' sector the supermarkets for evidence of the rug being pulled from under a long-term investment story.
United Utilities says that its trading is in line with the directors' expectations for the year ending on 31 March 2017. We'll have to wait until 25 May to see the full-year results, but City analysts following the firm expect earnings to slip around 5% compared to the year before.
As I write, the share price sits at 1,004p, which throws up a dividend yield of 3.9%, which is covered just 1.16 times by expected earnings. Meanwhile, the price-to-earnings (P/E) ratio exceeds 22 for the current year, which seems hot to me. Forward growth in earnings isn't on fire like the rating, though -- 3% for the year to March 2018 and 9% for the year after is the City analysts' consensus.
How valuable can this dividend be?
To me, investors are putting a lot of faith in United Utilities' ability to carry on generating cash and paying the dividend. During uncertain economic times, such as we're experiencing, defensive firms such as United Utilities can seem all the more attractive, but I think the trade may have been overplayed here.
Given such lacklustre growth prospects, I'd expect a P/E rating lower than this and a higher dividend yield, especially when cover from earnings for the payout is so low. United Utilities might operate in a defensive sector but there is still risk in holding the firm's shares and that is not, in my view, being fully accounted in the valuation. So, over-valuation seems like the first threat to investors' interests to me.
This firm is spending above its means
Big utility firms face regulatory pressure to invest vast sums of capital into operations, and such capital intensity often leads to big borrowings. At the last count, United Utilities' gross debt stood at 13 times the level of last year's operating profit. Such big debts generate big interest charges, which along with ongoing capital expenditure compete with dividend payments for the firm's cash inflow.
Last year, there wasn't enough incoming cash to pay the dividend, so the firm borrowed more to pay the dividend. That way of proceeding seems nuts. The dividend should not have been paid, I reckon. Take a look at the cash flow statement issued with the last interim results and you'll see what I mean. Capital intensity and high debts seem like the second threat to investors' interests to me.
Today's update from the company declares that United Utilities has accelerated investment in assets across the current five-year regulatory period. That's an acceleration that I'd argue the firm can't afford given that cash inflow has not been meeting cash outflow. The investment proposition with United Utilities looks precarious to me, so I'm avoiding the firm's shares.
Kevin Godbold 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.