Northumbrian all washed up

Northumbrian Water's share price has been on a steady run since the start of the latest regulatory price regime for water suppliers, and it's up 55 per cent since last November. But we think it's now ready to take a bath. True, Ofwat's price determination was less harsh than anticipated, but the Durham-based supplier's shares trade at a hefty 18 per cent premium to the value of its regulated assets.

This is the widest premium among London's four listed water companies. It's more, even, than the 15 per cent premium to regulated assets that broker Liberum Capital deems the current fair value for water shares. So the share-price rally looks overdone.

True, the price has also been buoyed by bid chatter, but we think that's likely to quieten down. Ontario Teachers, the pension fund rumoured to be interested, already owns 27 per cent of Northumbrian and has had many opportunities this year to buy the utility at a lower price than its current level. The fund even formally rebuffed speculation back in February. Yes, a bid could come, but, even if one were made, the average take-out level in the sector is a 25 per cent premium to regulated assets. So the opportunity loss from selling the shares isn't likely to be large. Moreover, a takeover is not likely until credit markets ease and a number of regulatory issues are cleared up.

The first of these is a review of Ofwat's role. Due out next summer, the government is putting together a white paper examining the regulator’s remit and the challenges facing the water industry. Since privatisation in the early 1990s, Ofwat's job has been to protect consumers and ensure that companies can finance themselves and carry out their functions, while at the same time promoting sustainability and efficiency. That could change but, until it is clear how, the uncertainty may weigh upon share prices.

This will be compounded by the unknown cost to water utilities of the regulatory adoption of private sewers. The government estimated in 2008 that up to 50 per cent of households could be responsible for the upkeep of a private sewer. But in order to better regulate the system, Ofwat says it should be the water company's job to manage the sewers from 2011 onwards. Unfortunately, the costs of this responsibility are not yet known and Liberum estimates that, until Ofwat compensates Northumbrian for this extra expense in another price review, it could cut up to 7 per cent off the company's earnings.

Granted, these regulatory matters affect each of the four listed water utilities. But we reckon Northumbrian's shares are most likely to be hurt by the resultant investor anxiety because their dividend yield is the lowest in the sector. Northumbrian confirmed that it expects to be able to maintain its existing dividend policy over the next five years of 3 per cent per annum real growth. Based on this and the current share price, the dividend yield will grow from 4.0 per cent in 2010-11 to 4.4 per cent in 2012-13. That yield is little more than Pennon's, a company that boasts a growing waste management business to complement the safe returns of its water utility. One saving grace is that Northumbrian's yield is still above the average for the All-Share index.

A further concern is that we're not the only ones to have clocked a selling opportunity. Two of the company's directors have just offloaded sizeable holdings. Martin Nègre is a non-executive director and former group chief executive who is now chairman of Ecofin Utilities hedge fund, which invests in the equity of utility and utility-related companies in the UK, the eurozone, North America, and other developing countries. So he should know a thing or two about timing his investment decisions. He recently sold £175,000-worth of shares, two thirds of his holding. The other seller is the group's operations director, Graham Neave, who offloaded £60,000, which was half his holding.