Smart Investor: are Severn Trent shares watertight?

With all the rain the country is currently experiencing, writing an article on a water company feels quite topical. FTSE 100-listed Severn Trent (SVT.L) is one of the largest of the 10 regulated water and sewerage companies in England and Wales, providing services to more than 4.2 million households and businesses in the Midlands and mid-Wales.

Having been formed in 1974 as a regional, state-owned water authority based in Birmingham, Severn Trent is responsible for water management and supply as well as waste water treatment and disposal in the catchment areas of two of Britain's largest rivers; the Severn and the Trent. It employs over 8,000 people, and, with a market capitalisation of £4 billion, is the 71st largest listed company in the UK.

A mighty debt pile

The first thing to note about Severn Trent is its grand pile of debt. Financial gearing (using the debt-to-equity ratio) stands at 451%, and interest cover is alarmingly low at just 2.06. Of course, supporters of Severn Trent will rightly argue that it is a utility with a stable revenue stream, so can live with higher debt levels than your average company.

However, 448% is high even for a utility and, with capital expenditure unlikely to be substantially reduced in future years, it leaves the company more reliant upon operating cash flow or a rights issue to provide the required capital. In contrast, SSE (SSE.L)’s gearing levels are much lower and afford it a greater amount of flexibility for future capital expenditure programmes.

Performance under the microscope

In terms of performance, Severn Trent has had a rather mixed past five years. It has been profitable in four of the five, with the company making a £57 million loss in 2009. Otherwise, net profit has been quite healthy, although it fell from £272 million in 2011 to £171 million in 2012.

These figures translate into a disappointing return on equity figure of 17.6% last year, and an average of 16.1% over the period. Considering the amount of money the company has borrowed, this is low.

Of course, utilities are usually top income stocks, and many people own them for little else but their yield. However, Severn Trent’s yield is just 4.1%, which, although slightly better than the FTSE 100 average, lags well behind utility and other 'defensive' rivals. 

A payout ratio of 97% last year suggests there is little headroom, although the payout ratio was 56% in 2011 and has been up and down throughout the last five years as profits have been volatile.

Will it deliver on dividends?

In addition, promises of dividend growth from senior management are perhaps a little less reliable than they first appear. Substantial capital expenditure, large total dividend payments and the cost of servicing a large amount of debt mean that cash flows (and possibly one day, shareholders) are being squeezed.

As for value, a price-to-earnings ratio of 23.5 – using last year’s diluted earnings-per-share (EPS) figure – and a price-to-book ratio of 4.1 are wholly unattractive. Even using 2011’s much better diluted EPS figure of £1.14 gives a price-to-earnings ratio of 14.8.

Money down the drain

There seems to be little to attract investors to Severn Trent at the moment. Sure, its economic moat is large and full, with water services likely to be in demand long into the future. In addition, because its charges are set by the regulator, Ofwat, it will be allowed to make a return of sorts for shareholders.

However, volatile profits, huge debts, disappointing return on equity (especially when the degree of financial leverage is considered), an average yield and under-pressure cash flow mean that Severn Trent is an investment to avoid.