Utility shares are great favourites of income investors. That’s because these regulated businesses can plan their long-term investment and cash flows with much greater predictability than the average company. Water utilities, in particular, have strong monopolies, making them very stable businesses.
Severn Trent (LSE: SVT) did recently take a decision to rebase its dividend by 5% after accepting regulator Ofwat’s parameters for the next five years, but serious dividend shocks from utilities are virtually unknown.
Severn Trent today released the kind of trading update that shareholders enjoy: dull and predictable. “There has been no material change to business performance or outlook since the Preliminary Results on 22 May 2015”, the company said. Just the ticket!
The Board also reaffirmed its commitment to pay an 80.66p a share dividend for the company’s financial year ending March 2016. Severn Trent offers a 3.7% yield, and, with management’s policy being to increase the dividend annually by no less than RPI inflation until 2020, the company appears — on the face of it — to be a more attractive income stock than Lloyds (LSE: LLOY) (NYSE: LYG.US).
Lloyds has only recently paid a first dividend since the financial crisis — and that a token 0.75p payout, giving a yield of less than 1%. Even though analysts forecast a healthy rise to 2.75p for the current year, the resulting yield of 3.2% is still lower than Severn Trent’s 3.7%.
However, looking beyond the immediate yields, there are good reasons to believe that Lloyds’ future dividend payments could surpass National Grid’s. And that, in the longer term, investors today could receive a higher income from buying shares in the bank than from taking a stake in the water company.
When it announced its first token dividend earlier this year, Lloyds said its aim is to have a progressive dividend policy, “increasing over the medium term to a dividend payout ratio of at least 50% of sustainable earnings”.
The forecast 2.75p dividend (3.2% yield) I mentioned earlier, represents a payout ratio of just 33% — showing how much scope Lloyds has to lift its dividend higher, compared with Severn Trent, which has a 93% payout ratio.
Analysts expect only a modest uplift in Severn Trent’s dividend next year to give a yield of 3.8%, but they expect Lloyds to lift its payout ratio close to 50% — sending its yield galloping past Severn Trent’s at 4.9%.
In time, Lloyds could lift its payout ratio higher still; perhaps as high as 65%. That’s because Lloyds is well on the way to positioning itself as a UK-focused, low-risk traditional lender. Banking is really a very simple and effective business when run on prudent principles, and the Black Horse’s most recent quarterly results show how profitable such a business can be, without the extraordinary risks and excesses that banks indulged in before the financial crisis.
Many analysts now believe that Lloyds will have billions in surplus cash as early as next year, which could be distributed to shareholders as a special dividend or used for value-enhancing share buybacks.
So, while utilities such as Severn Trent will remain popular picks for income investors — and certainly have a place in a diversified portfolio — Lloyds could prove to be a top-notch dividend choice, based its prospects for cash distribution, both in the near term and for many years to come.
