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United Utilities mulls Ofwat's latest move

BROKERS' VIEWS: Trading at the water supplier has been stable, but all may change when Ofwat publishes its review for the regulatory period 2015-2020.
February 7, 2014

What’s new

• Trading conditions remain stable

• Outperforming 2010-2015 regulatory targets

• Reviewing latest Ofwat guidance for 2015-2020

IC TIP: Buy at 723p

United Utilities' (UU.) recent trading update confirms that trading since the start of October has been in line with previous guidance. The company, which provides water and waste-water services in North West England, says customer service as measured by the regulator Ofwat is improving, "narrowing the gap" to the sectors' leaders. It also says it is ahead of schedule in meeting 2010-15 regulatory outperformance targets.

This is all solid stuff, but what investors really want to know is what the next few years will hold. Ofwat is currently drawing up plans for the 2015-20 regulatory period that will determine allowed returns for the UK water companies and the signs are that it will take a tough line.

Just days before United Utilities’ trading update, Ofwat announced new risk and reward guidance for the 2015-20 period that implied a lower allowed cost of capital than the water companies had hoped for. United Utilities, though, gave little indication of what it thought of Ofwat’s move, saying merely that it is “currently reviewing” the guidance, so investors will have to await further developments.

Credit Suisse says…

Neutral. We see no material change in guidance, though the statement suggests that capex in 2014-15 may be slightly higher than we expected. Key is that United Utilities did not provide much comment on Ofwat’s publication of guidance on risk and reward, aside from to say the company is reviewing it. United Utilities is the least expensive UK Water stock, with the shares trading on a 10 per cent premium to the expected regulatory asset base in 2015, compared with Severn Trent (SVT) and Pennon (PNN) on premia of around 17 per cent. But we are cautious on the prospect of a dividend cut following the final determination for 2015-20 in December.

Morgan Stanley says…

Overweight. The 2014 regulatory review will clearly be tough, but this is surely well known. We expect clarity on allowed returns shortly, which should remove uncertainty, and we think fears of dividend cuts are overdone. United Utilities is our preferred stock in the water space, primarily due to a combination of valuation and attractive growth in regulatory capital value (RCV). United Utilities offers the highest dividend yield of the water utilities and trades at the lowest premium to RCV. Expect adjusted EPS of 39.2p in 2014, rising to 40.9p in 2015.