Exposed to the market: utility stocks not so doing well

Traditionally regarded as defensive stocks, utilities have been harder hit by the recession than many expected, says Nigel Hawkins.

Whenever the economic outlook appears bleak, equity investors focus on defensive stocks. These are expected to outperform a falling market. Within this category, where demand is likely to drop less steeply than elsewhere, there are four staple sectors: food retailing, pharmaceuticals, tobacco and utilities.

The first three have performed comparatively well since equity markets began to plunge two years ago. Top grocers, such as Tesco and Morrison, have prospered, while in the pharmaceutical sector, GlaxoSmithKline - despite its lack of new blockbusters - has held its own. Not surprisingly, tobacco companies like BAT and Imperial, both of which have heavy overseas exposure, have been notable outperformers.

Unexpectedly exposed

Historically, utility stocks - on a wide definition - have been regarded as the crème de la crème of defensive stocks. However, they have not done particularly well recently - but why?

The most valuable utility stocks are electricity-related - and are mainly generators rather than price-regulated networks. As such, they are more linked to the market generally than many might appreciate. After all, historically there has been a correlation between economic growth and load growth. Negative load growth is a key factor for the lacklustre performance of several large European Union electricity companies.

EDF's output from its heavily depreciated nuclear plants has fallen noticeably, while its net debt is now €37 billion. Neither trend benefits its share price, which has fallen from more than €80 in early 2008 to below €42 today. Despite its predominately fossil-fuel portfolio, Italy's Enel has suffered similar setbacks - reducing its high net debt is now paramount.

With German electricity demand down by more than 5 per cent, it is no surprise that Eon's share price has fallen sharply. It has declined from €65 in November 2007 to €29 currently. The positive German election result has failed to provide a lasting boost.

In the UK, Drax Power, which effectively comprises the eponymous, and iconic, 4GW plant, has also seen its share price slide. In its case, falling sales prices has been a real problem, with its pronounced negative impact on the bottom line. In the first six months of 2009, Drax reported net electricity sales of 11.4TWh at an average achieved price of £50.7/MWh: the figures for the corresponding period of 2008 were 13.0 TWh and £53.6/MWh.

Green generators

The recession has also dented prospects for renewable generators, whose valuations had soared during the glory days. The world's largest renewables generator, Iberdrola Renovables, which was floated in late 2007, has seen its shares fall from €5.50 in February 2008 to €3.20 today.

Traditional recession-proof characteristics are most obvious within regulated wires businesses. Back in the early 1990s, there were 12 price-regulated and separately quoted regional electricity companies. Most have now been incorporated into larger energy businesses, but if they were still quoted their financial features, including near guaranteed returns and solid dividend growth, would undoubtedly have attracted investors.

National Grid's share price has held up reasonably well despite persistent concerns about its net debt, which exceeds £22 billion. This figure was readily accepted during the boom years but it carries real risk during a recession.

Gas sector

The evidence from the gas sector is less explicit, all the more so since many gas operations are subsumed within multinational energy companies, such as Shell and BP.
The UK's leading pure gas player, BG, is now primarily an exploration and production company. The shares of BG (originally part of British Gas, which was privatised in 1986) have been one of the FTSE-100's stars of the past three years, mainly due to the company's shareholding in the vast Santos Basin off Brazil, and specifically to the very valuable Tupi section of this gas field. The technical challenges in recovering
this gas are formidable but the sheer volumes involved have driven BG's share price
upwards even if gas prices, especially in the US, are weakening.

Centrica, with nearly 50 per cent of the UK retail gas market, has been a relatively solid investment, although the chances of it being acquired by Russia's Gazprom have receded noticeably. In fact, Centrica is a blend of a utility business and an exploration and production operation. The company is taking advantage of weak gas prices to build up its supply portfolio - its Venture Production acquisition was part of this strategy. Its involvement in exploration and production is likely to expand, especially with the Morecambe Bay gas field running down.

Price review prevails

With its regulated returns and absence of any serious competition, the water sector would normally be regarded as the epitome of recession-proof investments - providing stringent economic times did not coincide with a periodic review. On this occasion, these two factors have overlapped. Hence, water stocks have responded far more to regulatory concerns than to the prevailing economic environment.

With the final determination now in the public domain and Ofwat's refusal to budge on its 4.5 per cent weighted average cost of capital, the market is now focusing on water sector dividend cuts: Severn Trent and United Utilities are obvious candidates. It is also assessing who may undertake rights issues and who may decide to slug it out with Ofwat at the Competition Commission. Thames is the favourite to go down this route, but others will also seriously consider it.

In fact, the exposure of water companies to the recession is mixed. Deflation, especially as reflected in the November price-setting formula, is negative: reduced revenues from lower industrial activity are also unwelcome. A bout of inflation, though, is good news for the sector because it increases regulated prices and widens margins. The reality is that, with the possible exception of Pennon's Viridor business, recent water share price movements have been driven by the periodic review.

Elsewhere in the EU, other negatives have arisen, most notably in France. In Veolia's case, its shares have fallen steeply, mainly due to serious problems in its waste operations. Its Silo business has been particularly disappointing. Neither has Suez Environnement performed that well given that much of its revenue is backed by lengthy contracts in the water and waste sectors. It has suffered, too, from downgraded waste growth expectations.

Not recession proof

Looking at the sector's performance overall, some investors are disappointed that utilities have not proven to be more recession proof. Electricity valuations are dominated by generation returns, and there are now few wires-only quoted, regulated electricity companies. In gas, most major companies are valued on exploration and production criteria - a very different scenario from price-regulated utility businesses. In water, either Ofwat's periodic review in the UK or waste setbacks elsewhere in the EU have conspired to reduce the security of water company earnings.

This recession has shown that utility stocks, while far stronger than many other industries, are not untouchable. They are exposed to many more market risks than was commonly believed.

Nigel Hawkins is a director of Nigel Hawkins Associates, which undertakes investment and policy research. Email: nigelhawkins1010@aol.com

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