I. Sector landscape and outlook

Utility sector consists of the essential services catering to the consumers’ need for water, wastewater management or sewage treatment, gas and power to mention a few. This essential service forms part of public facilities which are generally heavily regulated by the Government. The utility sector is a necessity for the upliftment of the society and economy as a whole. The 24/7 criticality of the industry makes it kind of safe investment for investors, holding stocks for long-term to infuse stable income into their portfolio.

In the stock market, utilities are a defensive sector. Investors put money into utility stocks to escape market volatility. For income-seeking investors, utility companies also offer a steady stream of dividend pay-outs. Utility stocks were safe havens during the financial crisis of 2008. Investors poured funds into electric and water companies because they were safe bets against haemorrhaging markets.

But the sector has also witnessed deep correction during the pandemic. After years of slow and steady growth, one that mirrored the more rambunctious bull run of the broader market, the S&P 500 Utility Sector also crashed and burned as markets screeched to a halt after a decade-long bull run. Investors scrambled to find a safe haven from the market’s gyrations. However, after hitting the year’s low on March 23rd, 2020, the index has bounced back and up approximately 38% to August 17th, 2020.

Fig 1: S&P 500 Utility Index

 
Source: Investing.com

UK Water Sector

The UK has privatised its water utility businesses, and the business stability of the companies operating in this sector is derived from the fact that their activities are highly regulated. Any changes to the regulatory environment would lead to a dramatic effect on the investment case. The water regulator of the UK 'Ofwat' sets price limits every five years, and any changes can have a significant impact on the industry's profitability.  The political climate can also cause dramatic effects on these companies.

The UK water sector, like almost every sector in the UK, has not escaped from the pressures posed by the COVID-19 crisis. Government and regulators have been acting together to support businesses through this period. In the water sector, Ofwat's actions have been guided by the central principle of protecting customers' short and long term interests – in particular by relieving businesses of the immediate pressure of having to pay water bills if impacted by Covid-19 while ensuring all customers have access to reliable water and associated retail services now and into the future.

Many businesses have reduced their commercial activities or have temporarily closed in the face of measures to combat the Coronavirus. Overall demand for water in the non-household sector over the next quarter is likely to fall as a result. Such reductions will not be immediately apparent to wholesalers and retailers, because for example settlement volumes will be on the basis of 'business as usual' forecasts of water usage. This would mean retailers would be liable for paying wholesalers for higher volume consumption than the actual usage.

Ofwat and MOSL worked together to progress urgent code changes aimed at more accurately reflecting the amount of water being consumed by business customers. The impact of Covid-19 on retailers, in particular, where they may be impacted by delayed payments, creating a liquidity issue in the market.

On March 30th, 2020, Ofwat and MOSL put in place urgent retail code modifications to resolve the immediate liquidity problem facing retailers in the retail business market and align wholesale bills more accurately to the reduced consumption caused by temporary business closures.

Liquidity Support by the regulators

1. A limited extension of liquidity support until the end of October 2020, but not to allow Retailers to opt into the scheme if they had not already done so by July 2020.

2. The total amount any one Retailer will be allowed to defer will be subject to a cap equal to 40% of primary charges due from March-July 2020, effectively limiting the total amount of liquidity available to the amount that was made available in its April Decision. In addition, in any one month it will not be able to increase the amount it is deferring by more than 40% of that month’s primary charges.

3. Deferred wholesale charges need to be repaid in full by end March 2021 and subject to this, the regulator confirm that Retailers and Wholesalers will be given the opportunity to agree their own repayment profiles. In the absence of reaching an agreement they have specified a backstop profile. The backstop profile sets out that Retailers should have repaid 33% of outstanding deferred income at 31 October by end of November, 66% by end of January and 100% by 31 March 2021.
 

Power Utility

In the first quarter of 2020 (March 31st), the UK energy production was 1.8% higher than in the first quarter of 2019. Coal production reached a record low in the quarter, down 26% on the same period last year. Total primary energy consumption fell by 0.9%. Final energy consumption (excluding non-energy use) was 0.7% higher than in the first quarter of 2019. Domestic consumption rose by 4.5%, potentially a result of increased home working from March 2020. On a temperature corrected basis, final energy consumption was up 1.0% over the same period.

Fig 2: Total energy production


Source: Department for Business, Energy & Industrial Strategy

The UK power industry lost £ 1.1 billion (US$1.4 billion) in the five months to August as reduced electricity demand and wholesale prices cut revenues for suppliers, generators, and grid companies.  Just under half of the income loss can be attributed to lower wholesale power prices with the rest down to lower earnings from transportation costs, renewable subsidies, network charges and balancing costs. 

The UK economy suffered more than any major European nation during the coronavirus lockdown because of its reliance on services and “social consumption,” such as eating out and shopping. The nation’s biggest power utility firms from Centrica Plc to Drax Plc have reported reductions in income caused by the impact of the virus.

With August showing the power market almost back to pre-pandemic levels, attention now turns to the heating season during winter. Demand and power prices have started to recover now, but it has underlined the volatility of the wholesale market, which not only affects some power plants’ ability to operate profitably but risks curtailing any future investment dependent on wholesale revenue.

Why One should invest in Utility Stocks

UK utility operators are presenting a high dividend income opportunity for investors:Amid falling interest rates across the world, the UK utility stocks are offering a decent dividend yield for the investors. Further, despite heightened financial pressure, none of the company has slashed its dividend payment. Also, increasing government intervention is expected to bring financial stability in the sector. The four utility stocks under consideration; SSE PLC, Drax Group PLC, United Utilities Group PLC, and Pennon Group PLC are together offering an average dividend yield of 5.2%, which is approximately 1.37 times of the FTSE 100 dividend Yield of ~3.8% and approximately 25.66 times of the UK 10-year Government Bond Yield of 0.202%, respectively.

Fig 3: Yield Comparison

 
Source: Kalkine, Refinitiv (Thomson Reuters)

Relative Price Strength: Further, the stocks under consideration have shown relative strength against the benchmark equity index of the London Stock Exchange. In the relative price chart, we can clearly see that all of the stocks under coverage have relatively outperformed the benchmark index of the UK over YTD basis, with shares of Pennon Group Plc is the outlier and outperformed the benchmark FTSE 100 index by 26.15%, United Utilities Group Pls shares have outperformed the index by 15.39%, Drax Group PLC shares outperformed the index by 13.84% and SSE PLC outperformed by 11.5%.

Fig 4: Relative performance of the stocks under discussion (YTD)


Source: Refinitiv, Thomson Reuters

Risk:
 

1. A second wave of COVID-19 outbreak could further have a weigh on the UK energy and water demand, further, disruptive business models, changes in the geopolitical landscape, uncertainties Brexit, tightening labour markets are key risks for  the UK Utility Sector.

2. The industry is extremely capital-intensive. The infrastructures are expensive and require continuous upgrades maintenance. Most of the time, the company have to buyout infrastructure by floating debts in the market and giving higher yields to investors, thus increasing the costs of the infrastructure further.

3. When the economy is booming, market interest rates generally go high, thus increasing the overall costs of the company.
 

Outlook

The utility sector is immune to the economic cycles as it provides basic services such as electricity, natural gas, water services, creating a constant demand for its services. Utility stocks are considered defensive as they offer long term investment options for investors and provide stable and consistent dividends. As the services fall under essential services, the demand never dies, making the companies’ revenues less volatile. This creates a stable business operation which is reflected in the market trajectory of utility stocks. Given, the economy is expected to remain uncertain in the near term; utility stocks are likely to be in the limelight. Further, the outperformance of stocks under coverage shows a relative price strength against the benchmark.

II. Investment theme and stocks under discussion (UU., PNN, DRX and SSE)

After understanding the sector, let us now look at four companies listed on the LSE. The price potential of the companies under discussion has been analysed based on ‘Discounted Cash Flow’ method.