The City Editor

By DAILY MAIL REPORTER
Updated:

 

The number of 'hits' which Thames Water gets every day makes the Internet group Freeserve look like a midget. Every time a tap is turned on or a loo is flushed, Thames connects with one of its 12m customers. The prospects for sending advertising jingles down the tap are doubtful, but the loyalty of the customer, who has no other choice, must be the envy of every dot.com in the country.

A solid customer base with predictable earnings is not everything, of course, but nor should it be ignored. Sadly for the utility sector, this is exactly what investors are doing. Nick Pink at broker Warburg Dillon Read says it is 'absurd' that utility prices have plummeted so far. The water sector has underperformed the market by 40% over a year; electricity by 25%. Severn Trent, PowerGen and Anglian Water are yielding a remarkable 10% on forecast dividends. Kelda yields 12%. Yet their dividends are seen as secure. Yes, there are good reasons for their unpopularity. The price reviews of the watchdogs were tough and earnings will fall sharply next year, with slow growth thereafter. Bonds, a rival investment, offer rising yields. Most of all, who wants to own a boring utility when Internet stocks are soaring?

The absurdity, as Pink sees it, is that these rock-bottom prices imply that investors are looking for a total return of 10% to 20% annually over five years. This is the kind of return which Internet stocks might give --yet utilities are far lower risk. Pink predicts utility prices will rise to reflect more normal rates of return of 7% to 8%. He says at some stage - perhaps if tech stocks dive or sanity returns - the shares could double.

If investors continue to shun utilities, bidders may move in. With five-year price caps in place, they can now hope for a degree of certainty. The regulator's stance on water mergers has also softened. The trouble is that many big investors are focused on growth and are ready to pay high prices for it. To them, slow-growing companies are of little interest. Even fans say the underperformance could drag on for a long time.

With that caution in mind, there are a handful of utilities that deserve a hard look from long-term investors. A recent small bounce in the sector suggests some are already dipping in. Thames Water is now the third-biggest player in the international water scene. Profits from outside the UK utility are £30m and rising rapidly. They are targeted to make up 30% of the group total by 2005. Cost control is tight and analysts expect Thames to grow earnings and dividends by 4% a year for five years. At 698 1/2p, it yields 5.7%.

For a little telecom excitement wrapped up with a solid dividend, try United Utilities. Gordon Culfeather at Sutherlands expects its Norweb Telecom to fetch £400m in a flotation next year, worth 80p a share. The rumoured sale of its electricity supply arm Energi could raise up to £400m, worth another 80p. A share buyback or enhanced dividend should follow.

The remaining business is benefiting from cost cuts. Jason Steed at HSBC puts a 783p sum-of-parts valuation on the shares, now 622 1/2p. The aggressive ScottishPower (496 1/2p) made its name with the £3.9bn purchase of US utility Pacifi-Corp. Shaking this up should bring benefits.

ScotPower owns over 50% of recently-floated telecom arm Thus, which has doubled in value, and has an Internet portal with Royal Bank of Scotland, selling utility and banking services.

This is one company squeezing the most out of its customer base. Warburg Dillon Read has a 670p target price. Do not wade into the sector. Sentiment may take some time to turn. But at these levels, the best stocks must surely be near the bottom.

Most watched Money videos