The fixed revenue allowances bestowed on the UK's water utilities by Ofwat can make them seem attractive to investors as a lower-risk income play. The sector performed particularly well last year, viewed by some as a proxy for low-yielding government bonds. Shares in Severn Trent (SVT) and South West Water-owner Pennon (PNN) have increased by 20 per cent and 26 per cent respectively over the past 12 months, while United Utilities (UU) has seen a 38 per cent rise. However, investment in these companies is not risk free as they're subject to strict pricing controls by the regulator and occasional political interference.
Investors got the clarity they needed last week, when Severn Trent and United Utilities accepted Ofwat's final determinations on pricing for the next five-year regulatory period. This enabled them to finalise and outline their dividend policies. Management at United Utilities said it would target a minimum dividend growth rate equivalent to the Retail Price Index (RPI) each year through to 2019-2020, from the 2014-15 base rate of 37.7p per share. The group also said it would maintain gearing - measured as net debt to regulatory capital value - within its existing range of 55 to 65 per cent.
However, for Severn Trent a lower allowed return on capital plus the need to improve its operations - including a £3.3bn capital investment plan - forced it to shave 5 per cent off its dividend payout for 2015-16 to 80.66p, but the utility has promised it will then grow at no less than RPI until March 2020. In addition, the terms of Ofwat's final determinations will allow the group to expand its gearing ratio from 58 per cent to 62.5 per cent, incorporating a £100m share buyback programme. While the buyback means an initial cash layout it will ultimately increase the group's dividend cover.
Far from being perceived by investors as bad news, Severn Trent's 5 per cent dividend cut seemed to reassure the markets. Consensus estimates had pointed to a 10 cent dividend cut, which explains why the shares rose marginally on the day of the announcement. Angelos Anastasiou, utilities analyst at Whitman Howard, said the share buyback was unsurprising given the group's gearing levels and dividend cover.
Ofwat's final determinations also enhanced the water utilities' attractiveness as potential takeover targets. Severn Trent is the most likely candidate for takeover, having already rebuffed an offer from LongRiver Partners in 2013. However, it looks at though much of this bid speculation has been priced into the shares. Severn Trent is already trading in line with its previous offer at around £21 a share, although analysts at Credit Suisse have estimated that a price of £25 a share would be needed for a potential offer to materialise.
It's worth noting that falling RPI inflation could throw a spanner in the works for UK water stocks. RPI inflation settled at 1.6 per cent in December, its lowest level in five years. This is important since UK companies have their revenues linked to RPI. Higher than expected inflation bolstered cash flows and performance across the previous regulatory period. Yet analysts at Credit Suisse predict the lower out-turn of RPI coupled with lower oil prices could reverse this trend. However, Mr Anastasiou pointed out that if prices continue to fall, "then other costs should be falling and a number of these costs should feed through to the companies as well".
Water utility companies often purchase index-linked debt in order to hedge against dips in inflation. Around 47 per cent of United Utilities' debt is long-term index-linked and it has additional protection against RPI through an inflation swap with its pension fund. However, Severn Trent is most exposed to any fall in RPI since it does not hedge against dips in inflation.
What's more, there is a chance that Ofwat could eventually switch from RPI-indexation to a system that employs the Consumer Price Index (CPI). The CPI measure is based on a geometric, as opposed to an arithmetic mean - and generally produces a lower rate. The idea of Ofwat switching to CPI-indexation for wholesale water prices was floated in 2009 by then chief executive Regina Finn. Unsurprisingly, with just one year before the start of the next regulatory period, the proposition did not go down well with the utilities and did not come to pass.
The water companies can take succour from the fact that the present price limits are set until 2020. But there have been concerns around the robustness of using RPI as an inflation measure. In 2013 the ONS concluded RPI did not meet international standards and recommended that a new index was published. A spokesperson for Ofwat said: "We are currently in the early stages of considering how we will regulate and set price limits in the future. It's too early to set out our direction on this, but we are open to ideas, including asking the question as to whether we need to consider the use of RPI indexation."
IC VIEW: Confirmation of Severn Trent and United Utilities' dividend policies was long awaited by the market and, despite a dividend cut, reactions were positive on the whole. The fact that potential M&A activity has already has been priced into the shares is risky, given that there are no firm plans on the table. The shares are also trading on higher premiums to the value of their regulatory capital bases than they have previously.
Favourites
United Utilities managed to close the gap in its wholesale wastewater business plan between its proposed expenditure and the draft determination, which had been £769m, with a further £215m gap in water. This gap looks to have shrunk to £188m in the final determination. Admittedly, EPS is forecast to remain fairly stagnant over the next three years. However, the group's shares are also the cheapest in the sector, trading at the lowest premium to the value of their regulatory asset base when compared with their peers. So, with dividend growth of at least RPI inflation promised for the next five years, we upgrade our rating to buy for investors willing to take a longer-term view.
Pennon is the only water company not to have revealed its dividend policy for the next five years. This is due when the group publishes its full-year results. However, since it was granted 'enhanced status' by Ofwat, a dividend cut is unlikely. Analysts at Whitman Howard predict that the group may have difficulty maintaining its 4 per cent dividend growth because of a tightened allowed return on capital, but growth of 2 to 3 per cent is feasible. Viridor, its waste management business, has faced a tough time recently, but it remains on track to launch five energy recovery facilities by the year-end. Management also expects cash profit for the full year to be ahead of last year. We reiterate our buy advice.
Outsiders
Severn Trent's 5 per cent dividend cut came as a relief to the market, which had been expecting a greater reduction. While the group is the most likely candidate for possible M&A activity, this has been well priced into the shares. Management has planned a new organisational structure for the 'AMP6' investment period, which will likely involve 500 job losses with savings of £400m a year. The shares are also trading at a slightly higher premium to the value of its regulatory asset base than United Utilities. We advise investors to hold.
