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Water utilities must be some of the most unpopular FTSE 250 stocks around. But they might be more attractive than they look – especially for passive income investors.
As an example, shares in Pennon Group (LSE:PNN) come with a 7% dividend yield. There are definitely risks, but I think passive income investors shouldn’t be too quick to dismiss this one.
Water utilities
In general, no stock trades with a 7% dividend yield without investors finding something fairly obvious to dislike about it. And it doesn’t take much looking to see what that is in Pennon’s case.
Nobody likes water companies. Customers resent their bills going up, hosepipe bans and reports of sewage leaks. And governments object to the amount of money they make. This makes them constant targets for regulators.
They’re also very capital intensive, requiring significant infrastructure investment. And that means they often have debt levels that are well above average for UK businesses.
By itself, these issues might be enough to put investors off buying shares in the likes of Pennon – and that’s fair enough. But for those willing to look closer, I think there’s a lot to like.
Debt
Between now and 2030, Pennon is set to invest £3.2bn in reservoirs, storm overflow protection, water treatment plants, and so on. And all of that has to be financed with either debt or equity.
But I think that investors should view all of this positively. Water utilities are allowed to earn a specified real return on these investments, which is currently in the region of 5.1%.
In essence, Pennon’s profit is the difference between its cost of capital and its return. And the more cash it earns this on, the more money it makes for its shareholders.
As long as the FTSE 250 firm can raise the cash at a lower rate, it stands to make money on its investments. And its recent communications indicate that it thinks it can do this.
Durable dividends
The difference between the two figures might not be huge, but it probably doesn’t need to be. Like all water utilities, Pennon benefits from some significant – and obvious – advantages.
Most obviously, it provides a service that people simply can’t do without. Demand for things like cleaning products tends to hold up well in a recession, but water is on another level.
It also benefits from having no competition. In the UK, people don’t have a choice about what water company they use and the associated costs mean I don’t see that changing any time soon.
That puts the firm in an extremely strong position when it comes to dividends. And with a 7% yield, income investors might think they don’t need much in the way of growth to do very well.
Don’t be too hasty
Unusually large debt levels and high capital expenditures are enough to put a lot of investors off water utilities like Pennon Group. But I think they might be too quick to dismiss it.
As long as its cost of capital stays below the allowed rate of return, the firm’s spending on water infrastructure is an investment, not an expense. And that’s a good thing for shareholders.
Maybe there are better ways to earn a 7% dividend yield at the moment. But I think passive income investors should consider companies like Pennon properly before making a decision.
