Utility shares still out in the cold

Last year was a bad one for the FTSE generally and utilities especially. Tough-talking regulators and Brexit uncertainty mean it is unlikely 2019 will prove much kinder.

The UK stock market had a very poor final quarter in 2018, as a swathe of profit warnings, falling oil prices, a major downturn on the high street and ongoing uncertainty about Brexit effectively signalled the end of the long-standing post 2008/09 bull market.

Over the full year, the FTSE-100 fell by 12.5 per cent as market confidence waned, not helped by leading US tech stocks falling very sharply from their earlier peaks.

For the utilities sector, real protection on the downside is provided by their comparatively high yields, with most offering a prospective 5 per cent+ yield – way above any returns from bank deposits.

In fact, the 2018 performance of the largest quoted utilities – National Grid, SSE, Centrica, Severn Trent and United Utilities – saw average falls that broadly tracked the FTSE-100 itself.

Centrica provided the most resilient performance of the quintet, barely unchanged over the year. By contrast, SSE was the outlier on the downside – off by almost 20 per cent during 2018 as it sought to manage the fall-out from its abandoned Innogy supply deal.

Like many other stocks, the UK’s leading utilities were unable to resist the market’s downward direction. Upward pressure on interest rates, driven by the controversial US Federal Reserve’s policy, seriously disconcerted markets.

Seemingly recurring profit warnings were not helpful either. Both Centrica and SSE went down that undesirable route in 2018 – to the detriment of their share price ratings.

The Brexit impasse also weighed heavily on the wider market. To be fair, this issue had a greater bearish impact on quoted housebuilders and on EU-based airlines; but it certainly discouraged some overseas investment in the UK stock market, given the profound uncertainty about the Brexit outcome.

For the UK utilities sector, two other salient issues dominate.

First, price regulation has always been a key driver – on both the upside and downside – of utility share prices.

Investors and commentators with long memories will recall the shambolic regulatory U-turn on the electricity distribution review in March 1995, which saw utility shares plummet within seconds of the market opening on the day of the announcement.

A less sensational example of this reaction was provided on 18 December when shares in National Grid plunged by over 9 per cent on the back of Ofgem’s revised cost of equity proposals – a pivotal element of the assumed weighted average cost of capital (Wacc) calculation for the next price review.

Remarkably, a seemingly innocuous tweak of the proposed allowance for the Wacc equity component wiped around £2.5 billion off National Grid’s market capitalisation at a stroke. The review itself will not be implemented until April 2021 and its impact is limited to National Grid’s UK operations. But the market’s response showed how sensitive it is to such regulatory issues.

Furthermore, the controversial introduction of the £1,137 energy price cap has de-stabilised the Centrica supply model – it recently announced it is seeking a judicial review on certain aspects of the price cap implementation.

The water sector

For the water companies – quoted and unquoted – Ofwat’s ongoing review will be pivotal; it will be implemented in April 2020. Indeed, despite all the political shenanigans affecting the water sector, PR19 remains the “only game in town”.

Second, politics is always a live factor for quoted utility stocks. This time round, the risks are far higher since the current government is being propped up by a seriously unhappy group of Democratic Unionist party (DUP) MPs: an early general election remains a real possibility.

Importantly, the Labour party leadership has put forward a radical agenda, part of which is based on the widespread renationalisation of the utilities sector. Details are sketchy but the one certainty is that equity shareholders would not be beneficiaries if such a policy were implemented.

While politics will assuredly remain key in 2019 – with the priority being to nail Brexit – what is the scope for leading quoted utilities to reverse their share price falls of 2018?

National Grid’s share price rating is often driven by short-term movements in bond rates, especially among US investors. Many see the stock as a surrogate for bonds. However, on the regulatory front the forthcoming price review will be crucial, since it will determine returns from its monopoly UK electricity and gas transmission businesses, currently accounting for over 40 per cent of operating profit.

During 2019, Ofgem will be moving the price review forward, especially in terms of the assumed Wacc, future investment requirements and the quest for greater operational efficiencies. Any material changes could bring real pressure on current dividend growth expectations and therefore on the share price.

SSE’s investors will certainly be looking for good news, particularly given the low dividend cover. SSE is exposed to various regulatory reviews but it would welcome a recovery in generation prices. Furthermore, following the Innogy setback, SSE will be seeking alternative solutions so that it can focus on its two core businesses: networks and renewable generation.

Centrica had a challenging year in 2018 and there is no indication that the pressure will ease up. The impact of the recently introduced price cap is difficult to gauge, along with future gas prices that are so pivotal to Centrica’s finances. For shareholders, they would welcome any news that shored up the dividend and provided greater confidence that the controversial North American strategy will eventually bear fruit.

On the water front, PR19 dominates as companies seek to secure the best possible deal. Ofwat’s final determinations are due to be announced in December. Importantly, most water companies seem reconciled to a Wacc assumption of c2.4 per cent, which would constitute a cut of a third on PR14.

Severn Trent will be hoping that it becomes one of Ofwat’s “exceptional” or – failing that “fast tracker” – companies; both designations confer some financial rewards, a lighter regulatory touch and kudos among industry peers. It has performed well across several spheres but whether this is sufficient to merit either the much-coveted “exceptional” or “fast tracker” status remains to be seen.

In any event, both Severn Trent and United Utilities have low dividend cover so that dividend cuts from 2020/21 are quite likely. In the latter’s case, its leakage record remains poor and it is an unlikely candidate even for “fast-tracking”.

Pennon’s prospects are slightly different. Its core water and sewerage business remains solid and has improved noticeably over the years. However, its waste operations, via Viridor, offer some upside but the waste market – and especially prices – remain volatile.

While the fortunes of Wessex are represented – to a limited extent – through the share price rating of its Malaysian owners, YTL Infrastructure, some of its shareholders are reputedly unhappy about Ofwat’s much lower Wacc assumption for PR19.

Undoubtedly, the outlook for dividend growth will remain a prime driver of utility share prices, but 2019 could see some corporate activity, especially as utility share prices are low: sterling, too, is weak.

Of course, much depends on the Brexit scenario. But the electricity sector has seen some recent corporate action, including Shell’s acquisition of First Utility. It could become a far more potent force in the UK energy supply if it chose – as could BP.

SSE’s energy supply business is “up for grabs”, as arguably is that of RWE. And Centrica itself has really been struggling and may well become the object of bid speculation.

Water company consolidation is certainly possible, especially after PR19 is “done and dusted”. After all, Severn Trent recently made a “tuck-in” acquisition of Dee Valley; similar deals may follow.

In any event, 2019 seems likely to be a very lively year for the UK utilities sector. The heady brew of political turmoil, pivotal regulatory rulings, rising interest rates and an unstable global economy will certainly keep utility investors, sector analysts and journalists on their toes.