United that there is value

The water industry regulator, Ofwat, has now sorted out the pricing regime for water companies over the next five years. During this new regulatory period we believe United Utilities can make a splash. You'll have to bear with us, though, as valuing water utilities can be complicated. But, if you persevere, there could be a nice reward.

A water utility's revenues depend on the prices that Ofwat sets for it over a five-year period. These prices are based on the regulator's estimate of the industry's cost of capital - both debt and equity payments combined. For the five years to March 2015, Ofwat says water companies can earn a real return on their capital of 4.5 per cent after tax, and has set each company's prices accordingly.

Once these prices are set, the only way a company can increase its profits is by reducing its costs or its financing charges. So, if the actual cost of capital turns out to be less than the regulator calculates, water companies can surprise on the upside. For the new regulatory period, analysts at the investment banking arm of Royal Bank of Scotland think that Ofwat has got it wrong and suggest the cost of capital could be as low as 2.7 per cent, a difference of 1.8 percentage points. If we're cautious and suppose that the gap will be just 1 percentage point, that's still significant.

It means that United Utilities' regulated assets, which account for about 90 per cent of the enterprise value of the business, could be worth usefully more than Ofwat's estimates predict. But is this chance already in the share price?

It does not look like it. To cut a long story short, using RBS's estimates and our assumption that financing costs will run out lower by a percentage point per year, then the shares should trade at nearly 600p, compared with their current level of 553p. Analysts at RBS, using a still-lower cost of capital, reckon the shares should trade at 676p. UBS, another investment bank, is less optimistic. Its workings point to a 575p share price. But even at the bottom end, the shares look cheap.

This valuation technique is not the only reason we are bullish about United. The dividend yield also looks tasty. The group starts the new regulatory period with a 4.3 per cent price decrease in the first year, so it is likely to cut its dividend to 30p in 2010-11. But even that payout yields 5.4 per cent, higher than average for a utility, and the payout would be covered about 1.5 times by earnings.

What's more, rising inflation could prove to be a boon. Ofwat sets price rises in each year of the regulatory period based on estimates of the retail price index (RPI). For 2010, Ofwat predicts RPI at 2 per cent, which is low compared with many economists' estimates. A higher than expected inflation rate, therefore, should be good for water companies as it boosts revenues. Analysts at Citi estimate that for every 1 percentage point that inflation is above Ofwat's assumptions, United will receive an additional £15m in revenues.

There are some notes of caution, though. First of all, while forecasts for financing rates look favourable for United now, market conditions could change, or inflation might prove weaker than expected. In addition, there is also the chance that investors might move away from defensive stocks, such as United Utilities, to cyclical shares if a sustained recovery becomes evident. In addition, Ofwat has been criticised by the National Audit Office for being too soft on water companies’ efficiency with regard to issues such as water leaks from pipes. There are no firm plans in place, but serial offenders could be penalised, and United has been cited as one.