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Severn Trent: Profits flow on low interest rates

Persistent concerns about the health of the global economy, coupled with worries about the impact of negative interest rates weighed on equities this week.


Bank stocks fell sharply as declining revenue in an increasingly negative bond yield environment, alongside exposure to vulnerable oil-related debt, weighed on sentiment. Despite the commodity price weakness it has been the most recession sensitive asset classes and sectors that have underperformed this year, with telecoms, banking and leisure products faring the worst.


After rallying on the back of a weaker US dollar last week, which came as participants scaled down expectations for further US interest rate hikes, oil prices came under renewed pressure. Brent crude fell back towards $30 a barrel before finding support from a report from the US Energy Information Agency that revealed crude stockpiles had dropped for the first time in five weeks.


Meanwhile, the Vix volatility index, Wall Street's fear gauge, spiked to 29.60, the highest since August 2015 and some way above the 20 level that is associated with heightened anxiety in the equity market. I fear a prolonged period of excessive volatility in risk assets may start eroding capital spending plans and personal consumption, creating a self-fulfilling slowdown in economic growth.


That said, the macro-economic backdrop still suggests this is a correction rather than a bear market. Most emerging economies began slowing in 2011, so the recent weakness is not a new development and the underlying fundamentals of the US economy remain healthy. Last Friday's key US employment report for January showed moderate job creation alongside improving wage growth, while Fed chair Janet Yellen's testimony on Wednesday was hardly bearish.


Ms Yellen said financial conditions in the US have become less supportive of growth, with declines in broad measures of equities, higher borrowing rates and a further appreciation of the dollar. Yet the Fed still expects, that with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace in the coming years.


The financial futures market has driven down the level of anticipated interest rates for years to come, placing them squarely at odds with policymakers' projections. Investors are pricing in very little chance of a rate hike until the summer of 2017, which coupled with the drop in equities and jump in the Vix, indicates too much fear may be priced into markets.


Technical analysis of the FTSE 100 illustrates this concern, as the oscillators fell into acutely oversold territory. It is worth noting, however, that they are showing signs of bottoming-out, implying the recent selling pressure may have been exhausted, which combined with some bullish divergence and historical support at 5600, should provide a base. Near term targets are seen at 5890 and 5950, while further support is seen at 5450.


In conclusion, I remain encouraged by recent global macro-economic data that this is merely noise or volatility in equity prices. The technicals point to an improved outlook, which alongside supportive central banks and oil building a base around $30 a barrel, should enable stocks to recover throughout 2016. The caveat, however, is that if markets do not stabilise by March, it may prompt me to lower my projections for where the FTSE may end 2016.


A sector that will benefit from the likelihood of lower interest rates, especially in the US is the highly indebted utility sector. Water giant Severn Trent (Epic: SVT) has already taken advantage of record low borrowing rates by refinancing some of its debt pile, while it is on target to enjoy further benefits after shifting its borrowing from higher-cost fixed rates to lower cost floating rate debt.


The Birmingham-based company, with a market capitalisation of £4.9 billion, managed to reduce the effective interest rate from 5.5% to 4.6%, on its £4.6 billion net debt pile at the end of September, reducing finance costs during the first half and boosting profit margins.


Interim results on 26th November, for the six months until the end of September 2015, revealed adjusted pre-tax profits jumped 13% to £174.7 million on flat turnover of £896 million, pushing underlying earnings per share up 11.4% to 58.6p.


Despite cutting water prices, Severn Trent made more money than last year, while reducing the number of complaints by over a third. In addition, the company said it would receive £15 million in incentives from the regulator after meeting new targets for leaks and keeping its sewer network flowing. New performance targets are part of the five-year regulatory period, which will run until 1st April 2020.


Chief executive, Liv Garfield said: "There remains much to do, but this year is shaping up to be a great start to the current regulatory period." Management pledged to grow the dividend at no less than RPI over the next five years, with a projected yield for the current year of 4%.


Despite a tough regulatory environment, the ability to generate cash and profits from an infrastructure network has not gone unnoticed by overseas investors. Canadian private equity group Borealis launched a joint bid for Severn Trent at 2200p per share circa two years ago, alongside plenty of other predatory interest over recent years.


Several water utilities have been taken out for premiums of as much as 35% to their regulated asset value, suggesting a possible 2400p buyout price for Severn Trent, implying 17% upside from current levels.

 

 

 




 

 

 

 

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