Unsurprisingly, like their electricity-producing counterparts, water utilities have faced increased regulatory pressure to drive down costs for consumers. In December, providers finally got a clearer vision of the regulatory framework they must operate under for the next five years, after Ofwat delivered its final determinations for the 2015-20 period
Providers submitted their initial business plans at the end of 2013. The regulator then issued its draft determinations in August, in time for companies to make adjustments before final submission. Ofwat determines the prices the utilities may charge consumers as well as their service requirements.
Pennon Group (PNN), owner of South West Water, had the easiest ride of the process, after it was granted enhanced status by the regulator. This meant it received its draft determination in April and its business plan was unchanged. But United Utilities (UU) surprised markets due to the gulf between its estimates for spending and Ofwat's. Total expenditure for the group's wholesale waste water and water businesses had been in advance of the regulator's draft estimates by £769m and £215m, respectively. However this was eventually reduced to £179m and £9m in the final determination, prompting a 4 per cent rise in shares.
Ofwat did reduce the allowed return on capital to 3.74 per cent from 3.85 per cent, due to the falling cost of debt. But this was broadly in line with existing estimates from analysts at Deutsche Bank. Analysts expect Severn Trent (SVT) and United Utilities to announce their updated dividend policies before the end of next month.
Now there is some clarity on the Ofwat determinations, talk will undoubtedly turn to M&A activity among the water providers. Severn Trent already came close to a takeover by LongRiver Partners, which withdrew its offer in June 2013. Analysts at Whitman Howard said they "would by no means rule out a bid from it or another party for Severn Trent or one of the other water utilities in the medium term".
| Company | Price | Market value | PE ratio | Yield | 1-year performance (%) | Last IC view |
| Pennon Group | 909 | 3624.15 | 22.2 | 3.4 | 32.8 | Buy, 901p, 2 Dec 2014 |
| Severn Trent | 2135 | 5116.16 | 22.6 | 3.85 | 28.07 | Hold, 2,054p, 26 Nov 2014 |
| United Utilities Group | 971 | 6621.14 | 24.4 | 3.77 | 39.51 | Hold, 909p, 26 Nov 2014 |
Favourites
Pennon's waste management business, Viridor, faced a tough time in 2014. However management is establishing new recycling facilities, which will come on stream this year. This year's cash profits are also expected to be ahead of last year. What's more, the shares trade at a lower premium to the value of its regulatory asset base than its peers.
Outsiders
Management at Severn Trent is currently reviewing its dividend policy, with an announcement expected shortly. Ofwat's determination was pretty much in line with expectations. The shares also trade on 22 times this year's earnings, a premium to its peers. We reiterate our hold advice until there is greater clarity regarding its dividend policy.
