United Utilities - Contrarian investment

The flight to safety looks to have boosted water group United Utilities as its shares have jumpedas equity markets have lurched downwards. The stock recently hit a three-and-a-half year highdespite paying out a large amount of earnings as dividends. This is as the reliable dividend on offercompares favourably to UK government debt yields.
The North West of England is not an area known for an absence of rain and so typically doesn’t havethe hosepipe bans that afflict the South East of England. This ensures that keen gardeners in theregion have less to worry about as their supplier, United Utilities, keeps the water flowing.
Stock market investors have also found reason to cheer the water utility recently with the shareshaving increased by over 10% over the last two months. During a period when stock markets havesold off on European sovereign debt concerns and slowing growth in China and the US.
The key is that with UK Government debt, which is supposedly risk free, have sold off to record lowyields at around 1.6%. For investors who pursue low risk (almost risk-free) assets water stockshave therefore become attractive with such groups including insurers and some pension funds. Thelower UK Government yields reflect a flight to safety and the prospects for slower growth. On thegrowth front this increases the prospects for further UK quantitative easing which would keep bondyields down and increase inflation. It also means that interest rates would stay low for longer as theeconomy flat lines.
As such the attractiveness of a near riskless alternative like United Utilities is clear. United Utilitieshas the further advantage that although the prices it sets are regulated it does have RPI inflation passthrough. This means that if inflation increases the group is able to increase water bills by the sameamount to offset its rising cost. The company is therefore able to commit to dividend increases thatwill offset inflation without knowing what future inflation will be.
As such United Utilities has the added advantage that it is similar to an index (inflation) linked bond asso offers further protection over a fixed 10-year UK Government bond. Pension funds with long-termliabilities are therefore keen investors in the water sector while clearly the stock offers a better yieldthan UK bank accounts.
The new 5-year regulatory regime for the water industry was seen as tough but does at least providestability for the next few years. As a reminder, the new regulatory framework took effect from 1st April2010 and included an annual real average price decrease of 0.4% to 2015. From the new dividendbase in 2011 the commitment of United Utilities was to increase the dividend at RPI +2% until “at least2015”. This was achieved in 2012 with the dividend up by 6.7% - RPI inflation of 4.7% in the periodwith an additional 2%. Of course the dividend can in reality only be increased in line with earnings inthe long-term and so the underlying business is critical
However, it is important to realize that United Utilities is to some extent priced off other equities and tosome degree priced relative to Government bonds and corporate bonds. Against bonds the stock isinexpensive having a prospective yield of over 5%.
Water stocks also remain potential acquisition targets for large pension funds. Recently the BTpension scheme bought a stake in privately held Thames Water while Northumbrian Water wasbought by a Hong Kong investment consortium in August 2011.
This report was produced by Senior Research Analyst, Aman Mashiana