No growth and high leverage are the perfect ingredients for value destruction at Severn Trent (LSE: SVT).
2013 Results
The water utility company reported today preliminary full-year results that were broadly in line with market consensus estimates.
Severn Trent said that it was “continuing to deliver” on its dividend policy, “with 6.0% growth year on year to 80.40 pence”, which will be followed “by growth of 5.6% in 2014/15 to 84.90 pence.”
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Investors were not impressed. At 8.36am, the stock was down almost 1%, while the FTSE 100 index was up 0.23%.
The company added that its “non-regulated business delivered a mixed performance, with growth in ‘operating services’ contrasting with a disappointing performance in ‘products’, which recorded a loss for the year.”
Investors should ask themselves why their money should finance a business whose valuation will unlikely yield meaningful returns unless a takeover takes place.
And even then, upside may be limited.
Valuation
The ratio between the enterprise value (market cap plus net debt) and the trailing revenue of Severn Trent is about 5 times.
Stocks trading at such a high sales multiple usually discount a high growth rate for revenue and earnings as investors buy into a stock that promises a steep growth rate in future. That’s not the case of Severn Trent, of course.
In fact, the ratio is inflated by a net debt position whose book value (£4.3bn) is almost equal to the company’s equity value (£4.5bn).
Utilities tend to offer little growth but a rich dividend yield. Severn Trent is no different than others. A high level of indebtedness, however, could jeopardise the payout ratio. The business has been burning about £350m of cash during the last five years.
Severn Trent’s operations are sound, but its capital structure is not properly balanced. In its current form, there is little long-term value in it.
Stock Performance/Interest Payments
Its stock is up 12% this year. It looks like the market is pricing in the likelihood of takeover, rather than significant operational improvements.
Severn Trent was approached by LongRiver Partners, a consortium of international investors, in the summer of 2013, when it rejected a final offer of £22 a share, which valued its equity capital at roughly £5bn.
For a buyer, refinancing existing debt with cheaper funding remains one of the key attractions. Severn Trent’s profit and loss statement shows that the company has spent almost a quarter of a billion pounds annually in interest payments, which implies a cost of debt of 4.7%.
Will Cash Flow Rise?
Severn Trent’s operating profit – earnings generated by revenue minus costs, before taxes and interest payments — has averaged about half a billion pounds yearly in the last seven years.
The utility’s net leverage, as gauged by net debt divided by adjusted operating cash flow, is well above 5 times. That’s high both against rivals and in absolute terms.
Adjusted operating cash flow has historically been 30% higher than operating profit but may expand at a faster rate, if analysts’ estimates prove accurate.
Still, if anything goes wrong, and assets underperform, Severn Trent might have to raise more equity to strengthen its balance sheet. The value of the stock will have to reflect a large discount offered to investors to commit to the deal.
As a matter of fact, Severn Trent stock is still trading about 15% below LongRiver Partners’ offer. It is clear who lost out last year.
