LONDON -- Despite the prospect of excellent dividends from water supplier Severn Trent (LSE:SVT), I believe investors should steer clear from the shares ahead of next year's regulatory review, which will determine future water charges.
Severn Trent operates in the ultra-defensive utilities sector, which should, generally speaking, bolster the likelihood of a chunky payout regardless of the economy's performance. But I believe potential regulatory issues could hamper Severn Trent over the medium term.
Gear up for more legislative concerns
Severn Trent announced last month that it had accepted a revised "Section 13" notice from Ofwat, the water regulator, which softened outlined changes to the regulatory requirements for water companies. The move also reduced the possibility that the matter would be referred to the Competition Commission ahead of 2014's price review.
Although this development has removed the immediate risk for Severn Trent, further reforms of the water industry can be expected, and political concerns over the impact of rising utility bills on customers' wallets could cause Severn Trent to weaken as negotiations heat up once again.
Steady but unexciting growth expected
City analysts anticipate earnings per share to crawl 4% higher to 93 pence for the financial year ending March 2013. A 4% increase to 96 pence per share is expected in 2014 before growth slows to 2% to 98 pence.
A soaring P/E ratio further undermines the growth investment case -- a projected readout of 17.3 for this year is estimated to remain high at 16.7 and 16.4, respectively, for the next two years.
Steady income flow
Severn Trent remains a popular pick among investors due to its enviable properties as a great income share. A dividend yield of 4.8% for the year ending in March is up from 4.5% during the previous 12 months. And this is expected to continue heading northward over the medium term -- respective yields of 5.1% and 5.4% for 2014 and 2015 have been penciled in by City brokers. This compares with the current 3.5% payout average for the FTSE 100.
However, Severn Trent does not offer chunky dividend cover -- indeed, a figure of 1.2 is forecast for the year ending in March and is expected to be matched in 2014 and 2015 as well. Broadly speaking, a dividend-cover reading below two is considered risky, although the firm's role as a prime player in the defensive water sector helps to mitigate this issue.
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Royston does not own shares in Severn Trent. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.