I. Sector Landscape and Outlook 

Amid COVID-19 outbreak, the UK is planning to enforce further six-month lockdown to curtail the second phase spread of coronavirus. In this hard time, when all the businesses are closing down, the utility businesses are crucial to cater to the essential needs of the consumers. Utility business such as water, wastewater management or sewage treatment, gas and power to mention few, is a necessity for the advancement of the society as well as the economy. These businesses are generally immune to the economic cycles owing to the nature of their operations.

Let’s understand the water and power utility landscape prevailing in the economy. 

Water Utility: Water is among the most vital natural resources on the planet and, considering the growing fears about its availability as the world's population grows, and climate change makes it scarcer. Historically, the supply of water has been owned and operated by the central and state government to ensure that citizens have access to it at a reasonable price. However, many countries have turned to the private sector gradually post realising that public ownership was not providing enough funding for the innovation needed to meet the evolving challenges of the industry. Privatisation leads to transfer a vital resource into the hands of profiteering business, but it has also provided more excellent investment and a faster pace of development.

The UK has privatised its water utility businesses, and the stability of the stock prices 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. Fears were hovering over the UK water utility companies after the opposition Labour party pledged to renationalise Water utility companies during their December 2019 general election campaign, but a stonking win of PM Johnson avoided that risk for the next five years at least.

Ofwat gives green signal to a massive investment programme to transform the UK water sector 

On February 24, 2020, the water service regulatory authority or Ofwat has finalised its price review for 2020-25 and confirmed a substantial investment programme to improve services for customers and the environment. The regulator has announced a spending package of £ 51 bn for the next five years and one fourth of that worth (~ £ 13 bn) will be directed towards resilient services and a better environment amid increasing population and climate changes. Customers will also see a benefit of reduction in average nominal bills of ~ £50.

Further, it has decided new levels of services which will benefit water companies significantly over the next five years. These are Cutting leakage by 16%, identify and support another 2 million customers who need extra support, £1bn additional investment to protect communities from risk of flooding and preparation for drier weather by granting £450m to explore new water resource such as reservoirs or moving water.

Fig 1: Rainfall, River Flows and Groundwater level 

Source: Hydrological Outlook UK

Power Utility: Similar to the water, energy is also an essential part of the life.Let’s take a look at the production and consumption of electricity in the UK. In 2019 the UK generated 323.7 TWh of electricity, maximum of which are from gas followed by renewables, nuclear and coal. The total consumption of electricity was 294.3 TWh. Out of the total consumption, domestic sector used ~35% followed by commercial (34%) and industrial (31%) sector. Whereas gas production in 2019 was 439.9 TWh and 518.1 TWh import. During the period under consideration, Total energy production was 0.5 per cent lower than in 2018

The demand is anticipated to fall owing to the lockdown while the demand is expected to shift from commercial to domestic consumers as most of the people will be working from home in the near term.

 

The recent mayhem on account of COVID-19 outbreak has put the spotlight put back on the utility stocks owing to their defensive business. Further, lower interest rate environment makes the companies operating in the sector further attractive owing to the dividend yield they are offering. 

In the wake of COVID-19 pandemic, which has so far killed about 37,000 lives globally and around 1,400 people in the UK alone has led Central Banks across the world including the UK to rush for an interest rate cut and to exercise huge open-market operations in order to pump liquidity in the economy. When there is so much liquidity from the Central banks entering the market, one can't find the yield on securities. This has brought utility stocks into the limelight again as utility stocks pay a consistent dividend. Also, these companies are stable businesses that are relatively less volatile regardless of the economic cycle and their predictable business nature suits long-term investors, as they are considered as defensive play and reduces unprecedented downside risk in the portfolio. The average dividend yield of the UK's utility sector (excluding outliers) stood at 4.5%, which is very lucrative amid falling interest rated regime.

Relative outperformance amid free fall in the market

Coronavirus spread has led bloodbath in the global financial markets and in the UK as well. However, water and electric utility company have relatively outperformed the broader trend on LSE. On average, they have outperformance the benchmark FTSE 100 index significantly by 20% and 13% on a YTD and M/M basis, respectively.

Fig.6. YTD Relative Performance of the stocks under discussion against FTSE 100

 

II. Investment Theme and Stocks under Discussion (PNN, SVT, UU, SSE) 

After gauging through the industry dynamics, let’s take a detailed view of the companies in the utility sector in terms of their performance and outlook. To assess the same, companies’ stocks are evaluated based on Discounted Cash Flow (DCF).

1. LSE: PNN (PENNON GROUP PLC)

(Recommendation: Buy, Potential Upside: 12%)

Pennon Group Plc is an environmental infrastructure company. The Company's segments include Water and Waste management.


 
 

 
  
Valuation 

Our valuation model suggests that stock has a potential upside of ~12% on 30 March 2020 closing price.


 
2. LSE: SVT (SEVERN TRENT PLC)

(Recommendation: Buy, Potential Upside: 11%)

Severn Trent Plc treats and provides water and removes wastewater in the United Kingdom and internationally. It provides solutions through two businesses: Regulated Water and Wastewater, and Severn Trent Business Services.


 
  

 
Valuation 

Our valuation model suggests that stock has a potential upside of ~11% on 30 March 2020 closing price.


 
3. LSE: UU (UNITED UTILITIES GROUP PLC)

(Recommendation: Buy, Potential Upside: 11%)

United Utilities Group PLC is a water and wastewater company. The Company, through its subsidiary, United Utilities Water Limited (United Utilities Water), manages the regulated water and wastewater network in the North West of England.


 
  

   
Valuation 

Our valuation model suggests that stock has a potential upside of ~11% on 30 March 2020 closing price.


 
4. LSE: SSE (SSE PLC)
(Recommendation: Buy, Potential Upside: 11%)
SSE PLC is an energy company. The Company is engaged in the generation, transmission, distribution and supply of electricity, in the production, storage, distribution and supply of gas and in other energy services.

 
 
 
 
 
 

 
 
 
 
 
 
 
 
Valuation 
Our valuation model suggests that stock has a potential upside of ~11% on 30 March 2020 closing price.

 
Note: All the recommendations and the calculations are based on the closing price of 30 March 2020. The financial information has been retrieved from the respective company’s website and Thomson Reuters

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