Is this income safe haven under threat?

As 2014 draws to a close, focus inevitably turns to the new calendar year. The FTSE has picked up again after October's flash crash, but risks still remain for equities. Earlier this week Prime Minister David Cameron warned of a second looming global crash; oil prices remain a quarter lower than June's levels; the Eurozone remains on the brink of another recession and geopolitical tensions continue to reverberate around the world.

This forward focus has put pressure on the high-yielding utilities. The sector has underperformed the market this quarter, despite meeting or beating expectations in the first nine months of the year, notes Morgan Stanley. Visibility for 2015 is cloudy as most companies keep targets back for the first quarter of the year. Under the broker's coverage, only US utility PG&E missed guidance in its third-quarter update, while Scottish & Southern Energy lowered guidance to the bottom of its range.

"Even though the sector's earnings momentum remains better than that of the broader market, we believe the increased focus on 2015 explains the underperformance of utilities since the beginning of October," says Morgan.

Concerns remain over the price of commodities, foreign exchange, Brazil hydro conditions and weather, they add. Fear of blackouts is likely to influence policy in the run up to the UK General Election next year, too, and companies aren't out of the water regulation woods either. A "competition paradigm" has taken hold, says Investec Securities.

Water everywhere…but in your portfolio?

For the UK water and waste sector, Investec reckons its unpopularity lies with a dependence on shareholders' equity for investment programmes.

"Since privatisation in 1989, an investment programme of around £100 billion has been built on the back of equity support," it says. "The balance of risk and reward was 'just right'. But the Price Review 2014 (Baby Bear) and impending competition reform (Mummy Bear) portend an adverse shift in this balance. Indeed, we believe the implicit 'stakeholder contract' underpinning equity's role in the sector is itself at risk of unravelling (Daddy Bear). As such, we sympathise with equity investors who may want to 'do a Goldilocks' and head for the door."

The utilities sector is clearly a defensive element in an investor's portfolio. The public will always need electric, gas and water. No wonder, the typically high-yielding sector has been a beacon to investors in the wake of the global financial crisis in 2008. Of course, stocks were not immune during the downturn, but calm returned as early as the beginning of 2009, and Investec calculates that the sector trades 20% above pre-crisis levels.

Regulatory risk

But there are three regulatory risks that put the industry's "Goldilocks era" under threat; the current price review 2014, liberalisation of the water sector and the relationship between the state, customers and investors. The 2014 price review has deteriorated the risk and reward proposition for equity investors thanks to a cut to weighted average cost of capital (WACC), putting investor returns under threat. A further cut to WACC in December also looks to be on the cards. The switch in power towards the customer could also dampen investment in the sector as users may be drawn to the "do minimum" option, says the broker.

The impact of the liberalisation of the water market is expected to be felt in 2017, and while it will boost competition and benefit the customer, the sector will require further injection of equity and higher returns on these investments to reflect the initial risk. And with these regulatory changes, the role of equity will become confused, changing its role, they say.

HSBC reckons that regulator OFWAT has capped the sector's outperformance reach by introducing its recent incentive mechanisms. Investec analysts are wary, too: "Given the changes in legislative and regulatory ingredients, the Goldilocks era for UK Water is now at greater risk of unravelling than at any time over the last 15 years, at least from the point of view of equity investors, which is our focus. This has implications for the current focus of investors on valuations, dividends, and prospective ownership of the sector. "

So the year ahead could be a bumpy one as regulation and policy takes hold. But concerns have already depressed the sector, which could present an attractive entry point in the right company. We take a look at three candidates.

Pennon Group

Water utility and waste management company Pennon owns South West Water and Viridor, which specialises in landfill disposal, recycling, and generation of electricity from landfill gas and waste combustion.

Although Pennon has an "aggressive" dividend policy (it aims to increase the payout at the same rate as the retail price index plus 4%), Investec analyst Roshan Patel doubts it can be sustained as its landfill business winds down and WACC allowance is tightened. Full-year revenue is expected to rise to £1.3 billion, but cash profit will fall to £396 million from over £407 million last year. Despite pre-tax profit falling to £19.5 million, dividend per share is set to rise to 32.3p.

The major risk to Pennon is M&A activity thanks to the development of its energy recovery facilities unit at Viridor, despite its unregulated business, says Patel, who has a 'hold' recommendation on the stock with an 835p target price.

Pennon has a relatively low cost of debt and its diversification should stand it in good stead. It trades on a hefty 23.3 times forward calendar year earnings with a current dividend yield of 4%.

United Utilities

United Utilities, the UK's largest listed water company, is expected to generate revenue of £1.7 billion in 2015, with cash profit and pre-tax profit following suit, rising to £999 million and £398 million respectively.

But it is still at risk from regulation. HSBC said: "We consider that Ofwat's move to upper quartile efficiency benchmarking represents a greater challenge for United Utilities, despite its significantly improved operational outperformance under the current senior management team."

The stock was the top performer, returning 35% (see chart) and trades on just under 20 times earnings, the cheapest of the three, according to Bloomberg data. Its dividend yield of 4.4% is higher than Pennon and Drax, too. But HSBC has concerns.

We remain unconvinced that United Utilities will be able to hold its dividend, especially as the CFO has said publicly that he does not favour hybrid issuance to underpin the balance sheet. In our 22 September report, we assume a 5% dividend rebasing in 2015-2016e. We also note that UU's revenue profiling as a percentage of appointed revenues (designed to reduce bill volatility) means it will have to set a dividend policy that will be appropriate for the revenue reductions from 2017 onwards unless it can be very confident of creating operational and financial headroom against lower revenues.

Investec rates the company 'sell' with a 730p target price, warning that it is exposed to potential downward revisions to WACC.

Drax

Power generator Drax meets up to 8% of the UK's electricity needs and, despite challenging market conditions, a strong operational performance and contracted position meant it could keep its guidance unchanged when it issued a trading update earlier this month.

The firm aims to turn itself into a mainly biomass-fuelled generator, and a decision to give state aid for the development of its third biomass plant offers significant upside to the company, says Deutsche Bank, rating it 'hold'. The broker reckons approval will be given at £100/Megawatt hour (MWh).

"A worst case scenario of no EU approval for the CfD combined with flat medium term power price would merit a 620p valuation," commented Bank of America Merrill Lynch. "We believe the current share price discounts an even more bearish outlook, while our central case supports 800p."

The analysts also expect news on a fourth conversion unit and US pelleting plants investment in February. This will help outline its dividend policy. Forward guidance was also reiterated at £210 million - £220 million of cash profit, giving EPS of 21-23p.

Deutsche Bank recommends investors 'hold' the stock with a 650p target price.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.