Here on The Value Perspective, we try to steer clear of politics so readers will just have to guess at our views on Ed Miliband’s recent announcement that, should Labour win the next general election, the party will freeze gas and electricity bills and impose a more stringent regulatory regime on energy companies.
There is, however, a wider investment point to be made in this context, which relates to the traditional – and, as we will argue, misleading – image of utility companies as wonderfully stable businesses that are protected from competition by regulation, generate inflation-protected cashflows and pay nice, reliable dividends.
If you had not started to question that idea already, then Miliband’s recent intervention should certainly focus the mind. after all, one of the reasons utility companies enjoy the benefits of regulatory protection is because they are so important to the national interest. But it is because they are so important that politicians inevitably like to get involved and, when politicians get involved, things can go horribly wrong.
So, in reality, how resilient might these supposedly stable businesses prove to the sort of shock that now appears on the cards should Labour win power in 2015? To take one example, electricity group SSE has borrowings of around 3x EBITDA (earnings before interest, tax, debt and amortisation), which is more than we would typically think was sensible for even a very stable business. However, the energy firms are not as leveraged as some other utilities.
The UK’s water companies are significantly more vulnerable to shocks – of the Miliband variety or anything else. Severn Trent and United Utilities, for example, have borrowings of over 5x and over 6x ebitda respectively, which is way outside of our comfort zone. There is also anecdotal evidence to suggest some of the privately owned water companies are more leveraged still. The chart below from the water company regulator OFWAT shows how the mixture of debt and equity among the regulated water companies as a whole has risen over the last 20 years.
Source: OFWAT analysis based on data from the 2010-11 financial performance and expenditure report and company regulatory accounts data.
Date: 5th March 2013
At these high levels of leverage, a business will have little ability to withstand any kind of shock and yet Severn Trent’s 2016 bonds are yielding just 1.0%, its 2018 bonds 2.3% and if you feel like lending to Severn Trent for the next 30 years then you can get a whole 4.5% for the privilege.
For shareholders there is also the issue that very few companies manage to sustain such high levels of debt while also paying out large dividends for long periods – particularly not in investment-heavy regulated markets such as water. Income investors in the sector seem more than a little complacent about this in our view.
As we often point out, circumstances – political or otherwise – change all the time, a fact repeatedly overlooked by many investors who tend to be overconfident that the status quo will continue forever. As and when change for the worse occurs, high levels of debt effectively amplify the extent to which shareholders feel pain – the higher the leverage the greater agony.
Whatever you may think about the politics of his proposals, Ed Miliband’s interest in the sector should remind investors that the large debts of many utility companies has the potential to leave them in hot water.
Source for chart - http://www.ofwat.gov.uk/mediacentre/speeches/prs_spe20130305jcrae.pdf