It has not been a fantastic year for utilities in the UK so far, but is the tide turning for their shareholders?
At a time when risk-off trades are coming back with a vengeance, portfolio rotation may soon dominate the headlines — which means that some stocks boasting lowly trading multiples could become even more attractive, particularly those of companies operating in highly regulated sectors…
In fact, investors may soon pursue more stable returns by investing in defensive businesses offering relatively higher dividend yields. Let’s look at the prospects of three potential value candidates: National Grid (LSE:NG), Severn Trent (LSE: SVT) and Centrica (LSE: CNA).
Severn Trent’s Premium
Severn Trent has been the best performer of the three on the stock market, recording a +8% performance in 2015, and a +12.4% performance over the last 12 months.
Based on its price-to-earnings ratio (P/E ratio), which stands at about 25x for 2016 and 2017, its stock trades at a 60% premium over the shares of National Grid, but that premium drops to 20% when the two stocks are compared based on their adjusted operating cash flow multiples.
The valuation gap is represented by a takeover premium that has been implicit in SVT’s valuation for some time, and this is one reason why I am not too interested in its stock (although its management team has done good progress in recent months).
Furthermore, Severn Trent’s net leverage is higher than that of National Grid. Finally, if you trust analysts, there’s downside of between 3% and 13% from its current level, according to estimates from Thomson Reuters, while upside appears to be limited.
National Grid & Centrica: Cheap Enough?
A yield play rather than a growth story, the performance of National Grid has been particularly disappointing in recent months.
Its shares are down 4.5% this year, and are flat over the last 12 months. At their current price of 866p, they offer a nice forward yield but little capital appreciation — at least until investors decide to shy away from defensive stocks.
The stock hit a record high of 965p in November 2014, which would be a fair valuation going forward based on its fundamentals, in my view. In short, NG remains my top pick in the sector, and to my mind is a safer bet than another cheaper alternative — Centrica.
True, Centrica is a restructuring play that offers more potential than Severn Trent and National Grid, but I need more evidence to invest in its stock — higher returns and better cash management, or a combination of the two, possibly combined with targeted asset disposals, would convince me to snap up its stock in future.
Its shares are the cheapest of the lot, and trade at about 10x forward P/E. They are down 3% year to date, and 13% over the last 12 months, but it’s hard to say whether the British Gas owner has turned the corner and its stock has actually bottomed out. My view is that its dividend yield is still way too high, in spite of a cut earlier this year, and signals more risk ahead.
