Shares digital

The upcoming review of the water industry promises to throw a spotlight on this area of the market. Carlo Svaluto reveals what to look out for and how to tap the money well

Awave of red tape will soon be descending on the UK’s water industry thanks to sector regulator, Ofwat’s review of the industry. This lengthy negotiation process with companies takes place every five years and results in either increases or cuts in water bills. These in turn give a fairly accurate picture of how companies’ revenues and profits will grow, and therefore a clue about their dividends and share prices trends in the following five years.

Investors have reacted differently to each regulatory review. At first, the privatised and regulated regime was a novelty and they were cautious. However, ahead of the last review, the PR04 review which took place in 2004 and set water bills’ levels for the 2005-2010 period, water companies’ shares rallied, as the regulator seemed to leave room for companies to make tasty profits and reward shareholders.

The PR09 review, which sets prices for the 2010-2015 regulatory period, is due and this time the picture is clearly different. Analysts are trying to establish once again how share prices will react but there is far less clarity than last time.

The relationship between Ofwat and water companies is key to investors. Every five years, Ofwat discusses companies’ business plans with them and gives guidance towards their capital structure – the mix of equity and debt that funds their business. Because of a series of requirements they have to meet in terms of capital structure and balance sheet strength, they tend to run operations that are pretty strong financially, and this means their dividend policies are usually stable. Ofwat basically establishes how large their returns can be by deciding how much companies can increase bills charged to customers ever year.

The discussions takes place over a lengthy multi-phase period, which begins as early as three years before the price increases and the regulations are actually enforced. As in the past, the discussion for the 2010-2015 price limits promises to give a headache to both the companies and the regulator, as the latter haggles down the size of customers’ bill increases and firms try to pitch their financial and operational needs.

It would be too easy to say that the companies that will be allowed the highest increases in customers’ bills will be the best to invest in. There are myriad factors and variables Ofwat and the companies take into account when setting the final price increase limits.

Fit and able

The main things they look at are companies’ capital structure, the strength of their balance sheet and the value of their equity, which are all aspects of what the regulator calls ‘finance ability’, or the ability of a company to raise finance in the capital markets.

It’s not difficult to work out that good finance ability, or easy access to the capital markets, applies to companies that are expected to deliver good returns to shareholders, either in the way of dividends or capital gains. This is one of the reasons why share prices soared ahead of the last review: as negotiations with Ofwat went on, investors were given increasingly reassuring sings that the companies would be able to run profitable and financially strong operations, thus securing fat payouts and pushing valuations up.

This time things could be different. To set the scene, some key background factors that will influence the discussion in the next couple of years have changed. Energy costs are at their highest and push companies’ operational expenditure is higher. Interest rates will have a major impact too, as they ultimately drive the costs of financing firms’ operations. They fell throughout 2005 after the last price review and then rose steadily until recent months. The latest cuts, rising inflation and high energy costs, could be halted for some time as the hands of policy makers are tied.

While dozens of ratios will be considered by the regulator, the main bone of contention will be at what level Ofwat will set cost of capital for companies. This is a measure used in the classic financial model called capital asset pricing model (CAPM), it represents the weighted sum of the cost of equity and the cost of debt, both of which are calculated according to the expected return on equity and debt assets.

All eyes, both of companies’ managers and their investors, are on this number, which the regulatory body defines as ‘The minimum return that providers of capital require to prompt them to invest in or lend to the appointed water companies given their risk’.

Ofwat put it simply at the last price review: ‘A company which is efficiently managed and financed should be able to earn a return at least equal to the cost of capital [...] If the cost of capital is set too low then companies may experience difficulties in financing their mandatory investment programmes. If it is set too high, shareholders may earn windfall returns.’

At the 2004 price review, Ofwat set cost of capital at 5.1% post tax in real terms, compared to the 4.75% used at the previous review. These numbers factored in large capital programmes, which were needed at the time to improve infrastructure and respond to the complex needs of customers. The need for continuous improvements in infrastructure and services hasn’t disappeared, however, this time all things indicate that the regulator will lower the figure, with analysts forecasting it to drop to as low as 4.5%.

Water rates

Ofwat makes assumptions on a number of financial ratios to calculate financeability and set the allowed return levels. These are cost of debt, which is likely to be lowered amid lower interest rates and as companies moved to cheaper forms of financing arrangements like index-linked debt. The other main ones are capital expenditure and debt-equity ratio (or leverage).

Analysts at investment bank Morgan Stanley reckon that combining these with the the required operation expenditure and efficiency levels and the companies’ asset base, Ofwat will be able to lower the allowed return to 4.5%. This in turn will lead to cuts in customers’ bills in the first year of the 2010-2015 period, after which tariffs will be flat throughout the end of the period.

The bank flags up the risk that as a consequence of lower cost of capital, or the minimum return required by investors, revenues, profits and finally dividends could come under pressure. This is because the lower cost of capital will justify smaller increases in tariffs which will hit both the top and the bottom line. All these relative measures should put in the context of inflated equity valuations. Morgan Stanley notes, interestingly, that PE ratios of utilities are 32% higher than their 20-year average. This will be a topical factor investors will look at.

Regardless of the size of the tariff cut in the first year and the amount of revenues the companies will be allowed to collect in the following years, dividend cover levels are particularly worrying. If Ofwat asked for a big tariff cut in the first year, some companies would even see the level of dividend cover falling below the recommended barrier.

The bank suggests that the sectors’ defensive characteristics and residual M&A activity could support share prices going forward into the new regulatory period, however, higher valuations and faltering levels of dividend cover could in turn scare off investors.

Therefore, the outlook for share prices is quite unclear. Morgan Stanley says that regulation has been a ‘learning process’ for investors, who initially felt it was a tough thing to cope with. In the first years companies traded at a discount to their asset base due to this, but investors slowly realised that the regulatory environment was actually attractive and accepted paying hefty premiums for water companies. This view was exacerbated by the rich valuations seen in M&A transactions.

More importantly, this time Ofwat is making some significant changes to the methodology of the review. It is going to ask companies to drive costs down and to improve competition, and it is going to introduce ‘menu regulation’ for capital expenditure, which means that companies will have to choose between a series of options about their capital expenditure programme. These new methodologies make it tougher this time for the negotiations to go through and raise uncertainty.

Some companies, like Northumbrian Water (NWG), have raised concerns about the introduction of these measures. The company says: ‘The range of new proposals creates considerable uncertainty particularly since, in several cases, the details have yet to be developed. It is not clear to us that such significant change is justified.’ Northumbrian is worried that these changes make the review process less transparent and that the regulator is not giving enough incentives, favouring ‘sticks’ to ‘carrots’.

However, Stephen Thomas, analyst at Landsbanki, believes the re-rating of shares ahead of the review is still a possibility: ‘Ofwat will reduce the cost of capital, as things have changed from the last review, and if you look at other energy regulators they have already done so. However, a rally like the one ahead of the last price review is quite likely. In the water industry, the review at the period end starts with sub positive K factors [the annual increase in charges that an appointed water company can make] but going into the second year of consultations they move to positive territory.’

He adds: ‘It is a game of fencing. Some companies may not get everything they want when it comes to draft determinations, but they may get a significant increase on the draft when the final determinations come.’ This would turn pessimistic perceptions into optimistic ones and share prices would move accordingly.

It should be noted that in the run up to this price review, the market has already developed a positive bias towards water companies. Investors turned the spotlight to utility companies last year, as they fled to find solid companies amid the market turmoil. Water companies’ defensive qualities have much lower risk profiles than any other consumer-exposed firm.

All dried up?

Water stocks, which have outperformed the market by 13% since August according to number-crunchers at Morgan Stanley, feature in most ‘2008 top picks’ portfolios flagged by City firms. This even after last summer’s floods left some suffering, as did a series of fines by watchdogs over client bills and financial reporting issues.

Is the City right in saying that water firms are still a good bet, or should investors take profits after so many years of outperformance? The utility sector enjoyed a spectacular rally since the market bottomed in 2003. Gas, water and multi-utilities constituents on the FTSE All Share soared by more than 137% between March 2003 and its peak in May 2007. The best performer over the period was Northumbrian Water, which surged 263%, followed by Pennon (PNN), up 202% and Severn Trent (SVT), up 147%. However, last year the sector performance has been volatile, as it fell by 13% between April and August, pushing 17% higher subsequently and falling again into negative territory in January then along with the markets’ nasty start of the year.

M&A activity, which boosted share prices in the past, has not dried up, according to John Cuthbert, managing director of Northumbrian Water. He believes that there are still funds available out there, as well as private equity and infrastructure funds interested in taking control of water companies.

These have been hungry for utility assets in the past years, attracted by the combination of cash flow predictability and chunky dividends, and aided by the large amounts of cheap debt offered by banks for buy-outs. Thames Water was snapped up by Australian bank Macquarie in a ground breaking £8 billion deal. The era of cheap debt may be over now but the trend doesn’t seem to have been bent by the credit crunch.

Last Autumn, in spite of frozen credit markets, owner of Yorkshire Water-owner Kelda (KEL) was bought for £3 billion by a consortium made up of Citigroup, Prudential’s (PRU) infrastructure fund, HSBC (HSBA) and GIC Special Investments. United Utilities (UU.) sold its electricity distribution business for £1.8 million to a consortium of Commonwealth Bank of Australia and JP Morgan.

These deals show the hunger for water companies’ assets and could become an important factor in moving share prices. But it is difficult to establish who are the most likely takeover targets, as different risks and different valuations are associated with different companies.

Investors with different attitudes to risk, from private and institutional players to the buy-out funds, all draw obvious advantages in pouring money in the water sector in the current times. However, the mix of positive factors that lifted share prices in the past years, with low interest rates, high allowed returns, and cheap debt available for private equity firms and infrastructure funds to buy assets in the sector, is bound to change.

What happens next?

2008

January: Consultation on approach to PR09 ends

March: Publication of decisions on approach

April: Publish information requirements

April to May: Companies publish draft water resource plans for consultation

August: Companies submit and publish summaries of draft business plans

2009

January: Issue final business plan reporting requirements

April: Companies submit and publish summaries of final

business plans

July: Publish draft determinations for comments

July to August: Companies publish final water

resource plans

November: Final determinations

2010

January: Companies decide whether to accept price limits

or to seek a referral to the Competition Commission

April: New price limits take effect

Source: Company data, Morgan Stanley Research