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Utilities have been paying dividends with amazing regularity and in the main have raised their dividend payments every year for decades.

Water, electricity and gas are hardly exciting things to talk about.

However, they are somewhat hard to live without. From an investment perspective:

  • basic utilities provide electric, gas, and water services, so their products are in demand no matter what the economy is doing
  • the relative revenue stability enables these companies to consistently pay their shareholders above-average dividend yields
  • utilities' businesses benefit hugely from low interest rates. As they have massive infrastructure, they tend to borrow a lot of money to keep things running smoothly. As interest rates move lower, they borrow at lower rates. Reducing operating costs leads to generating bigger profits and sustainable dividends
  • the key to utilities' growth is buying or building the infrastructure that will ramp up transmission capacity. The more 'hardware' -pipelines and electricity cables- they own the more cash flow they can generate, allowing for inflation-beating dividend increases.

Own the hardware, not the fuel!

In comparison to the oil and gas industry, pure utilities aren't extracting the oil and gas, instead they are moving it around in the transmission networks they own. When they do so, they charge fees for energy transmission independent of the price of energy transported i.e. they perform a typical toll bridge function. As a result, there is very little commodity price sensitivity.

That is the type of utilities we are after. Utilities that are independent from fluctuating commodity prices. Utilities that 'just' process and ship gas and electricity, whilst others transport water.

These type of utilities clearly have a wide economic "moat." They own the pipeline. It's near impossible to compete with them, because

  • both truck and rail can't compete with them in terms of cost
  • it's virtually impossible to get all of the permitting and locations required in order to build a competing transport network right next to an existing pipeline

No matter what the economic conditions are, the cash flows of these types of utilities depend primarily on product volumes, not commodity prices. The government-regulated rates they can charge may vary depending on where their transmission networks are located, but one thing is for sure - their rates are normally not pegged to commodity prices.

The evolution of the UK gas utility industry

In February 1997, shareholders of British Gas approved the demerger of Centrica - British Gas was renamed BG plc.

Centrica Plc (OTCPK:CPYYY) is the company that supplies gas to millions of homes in the UK under the British Gas brand name, although these days it also has an increasing oil and gas exploration and production operation, in particular in the North Sea.

BG held on to British Gas' transportation and storage business (Transco) and the exploration and production arms, as well as a few other bits and pieces.

In December 1999, BG plc completed a financial restructuring that resulted in the creation of a new parent company, BG Group plc. This was followed, in October 2000, with the demerger of the gas pipeline business Lattice Group Plc creating two separate companies.

In October 2002, Lattice Group merged with National Grid to form National Grid Transco, while BG Group Plc (OTCQX:BRGYY) increasingly focused solely on gas exploration and production activities with substantial activities in Brazil, the Middle East and Australia.

In July 2005 National Grid Transco was renamed National Grid Plc (NYSE:NGG) in order to provide what the company described as 'a unifying identity across its operations.'

Nowadays, in the United Kingdom, National Grid Plc is the nearest we have to a pure play gas and electricity utility. The group solely focuses on the transmission and distribution of gas and electricity in both the United Kingdom and the U.S.

The other main player is SSE Plc (OTC:SSEZF), formerly Scottish and Southern Energy Plc. SSE is the second-largest electricity generator across Britain, and Ireland, and owns half of the Scotland and Southern gas distribution networks. It provides electricity and gas to more than nine million people.

Both National Grid and SSE enjoy relatively predictable revenue and earnings, which enables them to service rather high levels of debt. They also offer some of the most sustainable dividend distributions around.

Since flotation both National Grid's and SSE's dividends have consistently grown above the inflation rate, which is stupendously good for a defensive utility. Both are part of a small group of FTSE 100 companies to have delivered above-inflation dividend growth in each and every year since 1999.

SSE prospects

Until the recent cold spell in the UK, SSE saw gas and electricity demand from its customers plummet as they turned down their heating in the mild winter.

SSE is expecting profits for the year to March 2012 to grow at the same rate as the last three years following a price rise in September. This means it will be in the 1.5 percent to 3 percent range, which is a little disappointing and well lower than forecasts.

The company has been heavily investing in new generation, both in onshore and offshore wind farms and the company's hydro-electric schemes, and investors are awaiting the uplift in profits this will bring in due course.

On the dividend front - "SSE's key financial objective is to deliver above-inflation increases in the dividend every year" - SSE has announced that it will deliver an increase of at least 2 percent more than RPI (retail price index) inflation in the full-year dividend. This means the payout this year should be 80 pence a share. The dividend is expected to be comfortably covered by the new generation projects that are coming on stream over the next couple of years.

See this recent article for more on NGG.

Source: Gas Utilities Enjoy Safe Predictable Revenue, Earnings And Dividends