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Should I buy or sell Severn Trent shares right now?

by | Last updated 27 Nov, 2022 | Utilities

Severn Trent Plc (LSE:SVT) shares have proven to be a sturdy shelter against stock market volatility this year. With investors becoming more defensive in the face of rising interest rates, the water utility business has become immensely popular amongst UK stocks. But does that make it a good long-term investment?

Let’s take a closer look at what this business does and whether I should consider it for my portfolio today.

What does Severn Trent Water do?

The company is one of the UK’s largest water service providers. It primarily acts as a water supplier, delivering two billion litres of clean water to over eight million people across the country daily. However, the group also has activities in property development for wastewater treatment plants and invests in renewable energy projects, including wind, solar, hydropower, and anaerobic digestion.

Needless to say, it’s quite a diverse operation. And to keep everything running smoothly, the company employs over 7,100 people.

Being focused on the future, the management team have outlined the steps it’s taking to accomplish its end goal of providing clean water to consumers:

  • Partnering up with regulators and other stakeholders to develop sustainable solutions at several locations.
  • Educating and encouraging consumers to use less water.
  • Working with over 5,000 farmers to help reduce the agricultural run-off that pollutes the water supply.
  • The company initiated a management program under the title ‘Farming 4 Water’ to improve the quality of water released back into nature.

That’s quite admirable, and Severn Trent shares have been gaining a lot of points with ESG funds. Even more so given the highlighted importance of trying to protect biodiversity while safeguarding against droughts and flooding. Perhaps this is a leading reason why financial institutions own more than 50% of the ordinary shares outstanding, with BlackRock retaining the largest stake at 8.7%.

But while the group seems to be winning the hearts and minds of professional and retail investors, is it actually a good investment?

What is Severn Trent’s financial position?

While water utilities is hardly the most exciting enterprise, the firm has been enjoying a few post-pandemic tailwinds. With businesses and manufacturing lines returning to pre-pandemic levels of operation, industrial water consumption has improved.

Looking at its latest full-year results for its 2022 fiscal year ending in March, this has translated into a turnover growth of 6.4%, landing at £1,943.3m. Meanwhile, with margins remaining solid, profits before interest and taxes (PBIT) came in at £508.3m – 7.5% higher than a year ago.

Sadly, net earnings did land in the red. However, this appears to result from a one-time deferred tax charge. Ignoring this expense, the earnings-per-share (EPS) arrived slightly ahead of analyst expectations at 96.9p.

Despite this, the full-year dividend-per-share (DPS) stands at 102.1p, with dividend payments issued twice a year in May and December. That means Severn Trent stock provides an attractive dividend yield of 3.8% at today’s share price of 2,677p – more than double the 2.14% industry average. But it also raises some concerns about its long-term reliability and sustainability.

With more cash flow being distributed to shareholders than the group is currently generating, even on an underlying basis, management is having to tap into cash on the balance sheet to cover this expense.

Providing that future earnings start to climb, this may not be a problem. But EPS has been dropping since the pandemic began, with a further decline expected in 2023, according to broker forecasts. In my experience, this could be an early indicator of an eventual dividend cut.

With the following earnings report expected in mid-November 2022, a clearer insight into the earnings situation may soon be available.

Risks of investing in Severn Trent shares

Beyond my concerns surrounding dividend sustainability, there are other challenges and threats this business has to deal with.

The Water Utilities industry is growing at a much faster pace than Severn Trent itself. And while seeing a larger addressable market size emerge is enticing, it does beg the question of whether management’s strategy is working fast enough to prevent competitors like United Utilities from stealing market share.

Only time will tell. But given CEO Liv Garfield takes home a £1.51m compensation package, I’d be concerned to see any large-scale competitors outpace this business.

Another significant risk that often gets overlooked is the firm’s talent pool. Building and maintaining water infrastructure requires expert engineering knowledge and skill that is not easy or cheap to come by. If the business cannot attract and retain skilled engineers, the long-term potential of this enterprise could become compromised.

How has the stock performed?

Severn Trent shares are currently trading around 2,677p per share, placing its market capitalisation close to £6.7bn. And despite the seemingly lacklustre EPS performance, the stock has been on a steady upward trend since 2018.

While the Severn Trent share price is only up around 35% over the five-year period, the additional income generated from dividends has made it a lucrative stock to buy and hold. 2022 has been a bit more wobbly, with the share price tumbling over the last couple of months only to start climbing back up again.

Since the start of the year, the company’s market cap is down by around 8%. But what lies in store for 2023, 2024, and beyond?

It seems analysts share a diverse range of views on this business. The average consensus reveals expectations of continued turnover and dividend growth over the next two years. In fact, the dividends are expected to reach 115.9p per share by 2024.

However, views on valuation seem to vary drastically, with some predicting Severn Trent shares will rise to as high as 3,280p and others suggesting a much lower price target of 2,000p within the next 12 months.

Should I buy or sell?

All things considered, the clean water company seems to have a promising future ahead, with more than £6bn being invested in new and existing projects between 2020 and 2025. These include water pipes, treatment facilities, and reservoirs, all in the pursuit of achieving one of the lowest average combined bills in the United Kingdom of just £1 a day.

That certainly makes the business seem solid. But is the valuation fair? On a forward basis, the price-to-earnings (P/E) ratio stands at around 26 times. That’s pretty close to the industry average, suggesting Severn Trent shares may be trading close to their fair value.

The dividend coverage situation does give me pause. But given its impressive track record, I’m cautiously optimistic about the future. And therefore, I believe adding Severn Trent Plc to my personal portfolio could be a wise long-term investment decision.

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Saima Naveed does not own shares in any of the companies mentioned in this article. The Money Cog has no position in any of the companies mentioned. Views expressed on the companies and assets mentioned in this article are those of the writer and therefore may differ from the opinions of analysts in The Money Cog Premium services.

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