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Water looks good, for now

Apart from Invesco Perpetual's well-respected and often vocal fund manager Neil Woodford most analysts and shareholders in the water sector are happy with the outlook. That's at least until a new regulatory pricing regime is announced, and details on this might not be forthcoming until 2014, so there's plenty of time for investors to benefit.

Having been the biggest equity buyer in the sector for many years, Mr Woodford sold down £400m worth of shares at the back-end of the year, predominantly in United Utilities, but also in Severn Trent. The income fund manager blamed Ofwat for his disposals, claiming that the regulator focused too heavily on the needs of the customer, rather than the shareholder.

But most in the sector disagree with his thesis in the short term. Since the implementation of the latest pricing regime in April 2010, water share prices have made excellent ground, all increasing 20 per cent or more, with Severn up an impressive 45 per cent. That's not a bad return for a sector generally deemed to be dull and safe. This strong performance is largely due to a benign regulatory outcome and bid speculation.

Although two of the four listed water companies saw their prices decrease in the final review, most outperformed during the first six months of the year operationally and in terms of financing. Severn restructured back-office support systems, cutting 275 staff and saving £10m annually, while front office roles are also now under scrutiny. Meanwhile, United Utilities cut staff and completed its streamlining process by selling all non-regulated assets.

The benefit for the utilities of maintaining cost levels is that regulatory price increases are reflective of Ofwat assumptions on inflation, which have been some way below actual figures. So revenues increase, but cost levels are maintained. These benefits are also true of the rates received when financing. Overall, the companies in the sector have fixed large proportions of debt at levels below Ofwat’s forecast real rate of 4.5 per cent. Currently, United Utilities has secured £300m of outperformance, while the average rate achieved on Pennon's fixed-rate debt is about 3.8 per cent - way below Ofwat's assumption.

Not quite as tough as initially feared, the new price controls have also given water companies the confidence to pledge attractive dividend policies that offer yields above the FTSE All share average. November's interim results season saw Severn Trent announce a policy of 3 per cent annual growth above inflation until 2015, while Pennon, Northumbrian and United Utilities all previously indicated real growth of 4, 3 and 2 per cent respectively.

This rosy picture isn't expected to last forever, though. Post 2015, many analysts are questioning the prospects for the sector due to regulatory change, particularly with a number of consultations ready to be published in 2011. Elaine Coverley, analyst at Brewin Dolphin, is confident on the sector for the current price review and the metrics set, but is more concerned about the long-term changes to the industry, noting: "The uncertainty is that we don't know what the industry will be like after the next price controls."

The long-term challenges facing the industry are population growth, security of supply, climate change and environmental standards. Reflecting these issues, the Department of Food, Environment and Rural Affairs is reviewing the role of Ofwat as a regulator and examining changes to the industry as a whole. A white paper will be published in the summer of 2011, with retail competition and the trading of water abstraction rights expected to be high on the agenda.

The trading of water would mean greater diversity of supply and economies of scale, with Severn Trent confident that excess water could be transferred from Wales to drier areas such as Essex, at a lower cost than building plants in the region. However, the advantages to giving consumers choice of supplier are still unclear. At the same time, Ofwat is also reviewing the industry, with the intention of producing a consultation on the next regulatory framework by 2012. So change is coming, but not before opportunities abound.

COMPANYPRICE (p)MARKET CAP (£m)PE RATIOYIELD (%)1 YEAR PRICE CHANGE (%)LAST IC VIEW
NORTHUMBRIAN WATER GP.3221,66712.44.119.0
PENNON GROUP6452,30015.53.620.0
SEVERN TRENT1,4193,36513.05.130.5
UNITED UTILITIES GROUP5653,84812.85.914.9

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