Sewage smells sweet in the stock market

It’s a crowded field, against a backdrop of greedflation and sexual-misconduct scandals, but water utilities have a strong claim to be considered public enemy number one in the British corporate world. Spilling sewage into rivers and coastal bathing waters hundreds of thousands of times a year is no way to win friends and influence people, whatever the mitigating factors or arguments over the relative quality of UK beaches. The industry apologised last week and pledged to triple investment in sewer modernisation this decade to £10 billion ($12.4 billion) — only to provoke further outrage when the companies said they will recoup this later through higher customer bills.

Much of the case for the iniquity of water companies’ behavior has focused on their generous dividends and high levels of debt. There’s a questionable logic at the heart of this narrative. Governments put essential public services into private hands, as Margaret Thatcher did with the water companies in 1989, in the hope they will be operated more efficiently, benefiting consumers and saving the state money. In turn, providers of private capital expect a return. Otherwise, why should they take part?

There’s nothing wrong, in principle, with private, profit-driven companies paying dividends if they have the earnings to support them. Likewise, the capital structure of a company should be something for management to decide. A business that takes on too much debt puts itself at risk of failure, so there’s no incentive for owners to be reckless. This can and does happen, of course, but utilities are more suited than most to taking on leverage because of their stable cash flows. Most people have no choice but to buy water, gas and electricity. It’s not like selling Louis Vuitton handbags; the risk of a business slump that renders a company’s debt unserviceable is small.

The subtext of the high-dividend-high-debt argument is that shareholders are unfairly extracting cash from the business rather than investing in the infrastructure that would prevent sewage from gushing into our waterways hundreds of times a day. This is a regulated industry, though. The utilities have to perform to a standard determined by the Water Services Regulation Authority, or Ofwat. The companies regularly exceed Ofwat’s benchmarks (the word “outperformance” appears 44 times each in the most recent annual reports for Severn Trent Plc and United Utilities Group Plc). If the regulator thinks the water companies aren’t investing enough, then it should design a framework that incentivises them to do so.

One way to evaluate whether the regulator has set the bar too low (other than looking at Britain’s rivers and beaches) is to study their stocks. If the water companies are really making out like bandits, then they should be providing outsize returns to investors. Utilities are supposed to be about the dullest creatures in the equity universe: plodding and predictable earners that resemble bonds more than the more exotic birds of the high-growth firmament. If they’re behaving like investment stars, then something is amiss. Does this apply to UK water utilities? In a word, yes.

The UK has three publicly traded water companies, and they have all been fabulous long-term investments. Anyone who put £100 into Pennon Group Plc when it listed at the start of the 1990s and kept reinvesting dividends would have about £3,900 today, according to data compiled by Bloomberg. That compares with about a ninefold return for the FTSE All-Share Index. Severn Trent has provided a 37-fold total return and United Utilities a 31-fold return. That’s not dull.

Look at leverage, meanwhile, and it’s easy to see why some critics charge that the companies are borrowing to fund dividends at the cost of necessary investments and consumer interests. Net debt to Ebitda has generally been higher at the UK water suppliers than at Essential Utilities Inc. and American States Water Co., two of the closest comparable listed US providers — sometimes by a wide margin. Severn Trent’s £7.3 billion net debt was more than seven times the equity on its balance sheet as of March 31. Severn Trent has one of the lowest regulatory gearing ratios in the sector, a spokeswoman for the company said.

Unlike their American counterparts, the UK water companies aren’t averse to paying more than 100 percent of earnings as dividends — something that wouldn’t be possible, at least on any sustained basis, without an alternative source of finance. Severn Trent will pay out more than double its profit for the year ended March 31, based on annual results posted Wednesday, extending a trend of distributions that exceed income. The dividend payout ratio at Essential Utilities and American States Water hasn’t exceeded 100 percent in the past decade.

Has piling on the debt made the UK utilities more efficient? Not really. Performance has become more volatile, as financial theory would dictate (leverage magnifies things on the way up and the way down). In the year ended in March 2022, return on assets worsened at all three of the British companies, widening the gap with their better-performing US peers.

Admittedly, the shares of US utilities have also provided market-beating returns, so there may be other things going on here. Most obviously, there is the long-term decline in interest rates, which increases the value of fixed regulatory returns that tend to be pegged to the prevailing cost of borrowing.

Either way, profit-driven companies can’t be blamed for acting the way they’re supposed to and trying to maximise gains within the rules of the game. If the arrangement doesn’t work for consumers and society — as it appears not to in Britain — then it’s up to the government and regulator to change it. Leaks need to be plugged at the source.

Matthew Brooker is a Bloomberg Opinion columnist covering business and infrastructure out of London. Views are personal and do not represent the stand of this publication.

Credit: Bloomberg