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In theory, water utilities should be some of the FTSE 100’s most reliable businesses. In reality though, a lot of people see the entire industry as outright uninvestable.
High debt levels and maintenance costs make these stocks unpopular with investors. But I don’t think they should be so quick to dismiss these potential opportunities.
Water utilities
Water companies are generally extremely unpopular with customers. But while most people see constant burst pipes and bills that keep going up, there’s a lot more to it than this.
Demand is incredibly resilient even in a downturn. And regulation means customers don’t have any way of switching to another provider, so competition is non-existent.
The downside is that companies don’t get to set their own prices. These are determined by sector regulator Ofwat, which means that profits are limited despite the lack of competition. Not being able to control their own pricing is a risk. But when the regulators are on their side, water utilities – especially good ones – can be very reliable cash generators.
Debt and equity
Investors are often wary of these businesses for a couple of reasons. One is the amount of debt they have and the effects of inflation on their maintenance costs.
Severn Trent‘s (LSE:SVT) a good example of both. In terms of its balance sheet, a debt-to-equity ratio of 6 is one of the highest in the FTSE 100.
On top of this, the firm has around £14bn in fixed assets that it’s legally required to maintain. That’s roughly the same as AstraZeneca – which generates almost 25 times the revenues.
Both of those are reasons investors often don’t give the company a second thought. But I think that anyone who moves on without at least taking a closer look might be making a mistake.
Protection
The regulated nature of Severn Trent’s business means its profits are limited. But it also removes a lot of the risks associated with high debt levels and maintenance costs.
As long as the allowed return stays above the company’s borrowing costs, more debt should actually mean higher profits. Investments add to the asset base the firm can earn a return on.
Importantly, Ofwat named Severn Trent’s business plan for 2025-2030 as ‘Outstanding’. As a result, it’s allowed return is 4.33%, rather than 4.03% water utilities are able to earn by default.
Investors should also note that this is a real return. So if inflation increases, the firm should get a higher return on a bigger equity base as the value of its assets goes up.
Durability
Severn Trent has a good case for claiming to be the FTSE 100’s most underrated company. Investors who only see high debt and heavy maintenance costs might be missing out.
In a regulated industry, there’s always a risk allowed returns might contract in future. But Ofwat also has a strong incentive to allow operators to make a decent return.
That’s especially true of the best in the business, which includes Severn Trent right now. So I think that investors – especially those looking for passive income – should take a closer look.
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