Water company dividends over the last ten years

At first glance, water companies seem one of the safest homes for your money on the stock exchange. After all, everybody needs and uses water regardless of what's going on with the economy. This means that the profits and cash flows of water companies should be relatively easy to predict. They should be relatively stable and are unlikely to bounce up and down a lot.

And in general they are. However, because water companies are local monopolies and face no competition the amount of money water companies can ultimately make is restricted by a regulator called OFWAT.

Every five years, OFWAT takes a good hard look at how good a job the water companies have been doing (known as a periodic review), how much money they have been spending and how profitable they have been. It then puts together a plan for the next five years.

It tells the water companies how much money they should be spending on maintaining all the pipes, sewers and reservoirs that they own and how much they can spend on expanding their networks. If OFWAT gets its sums right then customers should get a reliable source of clean water without their bills going up too much. In return, the water companies will be able to earn a reasonable profit on their assets. After spending money keeping those assets in good working order, they should have enough money left over to pay the interest on any borrowings, tax and those all important dividends to shareholders.

During the early years after privatisation, water companies were able to pay big dividends that kept increasing every year as they cut more costs than OFWAT expected them too. OFWAT eventually wised up to this and started setting very tough efficiency targets on spending and even cut customer bills. On top of this, as interest rates and the cost of borrowing money has come down in recent years, OFWAT has ruled that water companies don't need to be as profitable as they were in the past - they can get by with a lower return on their assets.

As a result, it has become harder and harder for water companies to keep on increasing their dividends.

If you look at the chart below you can see that the dividends paid by the three remaining water companies have been through a bit of a rocky patch during the last ten years. Both Severn Trent and United Utilities have had to cut their dividends whereas Pennon (which owns South West Water) has been able to keep on increasing its payouts. During the last OFWAT price setting period from 2010-15 all three companies were able to pay a rising annual dividend to their shareholders.

But on a close inspection of their profits and cash flows you could be forgiven for thinking how on earth have they been able to do this?

Below is a data table built in SharePad. Without doing any further research, the numbers in it could easily lead you to worry about the safety of water company dividends.

Why do I say this?

Well for starters, the forecast dividends are barely covered by profits (in this case, earnings per share) as the forecast dividend cover ratios are barely more than 1.0. However, dividends are not paid from profits but from cash flow. The past history of water companies' cash flow makes for very grim reading.

During the last ten years, water companies have spent a lot more money on assets than the depreciation charge in their accounts. This has meant that there hasn't been much in the way of free cash flow produced - certainly nowhere near enough to fund the total dividends paid to shareholders.

So what's been going on? Have the water companies been pulling the wool over investors' eyes and been borrowing money to pay dividends? Or is there a clearer explanation?

Current cost accounts

Stay with me on this one. You are about to learn why the numbers in current cost accounts are extremely useful.

Standard company accounts are based on something known as historic costs - what was actually paid or received at the time of a transaction. Some water company assets can last for more than thirty years which means that the depreciation charge in the accounts might be based on the cost of something thirty years ago. That asset will probably cost a lot more to replace today.

This is what current cost accounts do. They adjust costs for inflation so that the depreciation charge is a more realistic estimate of what a water company needs to spend to maintain its assets. In these accounts you will find two key numbers:

• Current cost depreciation
• Infrastructure renewals charge

Add these two numbers together and you have a true and accurate figure for stay in business capex. You can then work out a water company's real profits and cash flows. When it comes to working out the safety or otherwise of a company's dividend it is best to focus on cash flows.

Why this matters

The water companies have had detailed spending plans for the period 2015-20 given to them by OFWAT. This means that they have a very good idea how much money will be coming into the business and how much will be going out. This in turn means they also have a good idea of how much free cash flow there will be and the size of dividends they can pay. This has allowed them to make the following statements about future dividends a few months ago:

Pennon:

"The Board was pleased to announce in March the continuation of the current dividend policy, targeting 4% year-on-year growth above RPI inflation to 2020."

Severn Trent:

"2015/16 dividend 80.66 pence, followed by annual growth of no less than RPI until 2020."

United Utilities:

"dividend growth rate target of at least RPI inflation each year through to 2020"

Enterprise value (EV) to regulatory capital value (RCV) multiples

Another useful number in the regulatory accounts is something known as the regulatory capital value (RCV). This is the total value of the water company's assets and is used by the regulator to set a company's allowed profits. RCV is sometimes referred to as regulatory asset value (RAV) or regulatory asset base (RAB).

RCV is also seen by City analysts as an estimate of the market value of the water company. To see if a water company's shares are cheap or expensive the company's enterprise value (the market value of shares plus net debt) is often compared with its RCV.

Here are some rough rules of thumb for using this method:

• EV should be more than RCV if a company can make more money than the regulator has assumed - known as a premium.
• EV should be less than RCV if the company will make less money than the regulator has assumed- known as a discount.

A premium should be biggest at the start of a price review period to reflect the size of any extra profits expected to be made. As the next price review approaches (in 2020) the premium should be very small and could even move to a discount as the regulator shares any gains made with customers by lowering prices in the future.

Some water companies have been taken over for as much as 40% more than their RCV in the past. These takeover prices have been explained by the buyer being able to stuff the company with lots of cheap debt and therefore make more money than the regulator had assumed. Most experts don't expect this kind of generous takeover to happen again anytime soon although Severn Trent has been the subject of takeover rumours recently.

*Estimate of value for Pennon's Viridor waste business

Based on this quick analysis, water company shares are priced at a healthy premium to their RCV's. Smart investors would ideally look to buy water company shares at a much lower premium or ideally a discount.

The analysis of water companies is quite involved but hopefully you can see that a bit of extra effort helps you to learn a lot more.