Last week, water regulator Ofwat published its draft proposals for the next regulatory review period, which will run from March 2010 to 2015. The draft proposals stage is the most important point in the five-year regulatory cycle, as it removes considerable uncertainty for the water sector and provides more clarity on future earnings and dividends. Overall, the headline numbers are more negative than the market had been expecting - this caused the sector to reverse its recent rally.
On a company-by-company basis, there are substantial differences between the allowed returns proposed by Ofwat - as the regulator seeks to differentiate between what it perceives to be efficient and inefficient water companies.
Of the four quoted water companies, the draft proposals appear to be far more negative for the more inefficient companies like United Utilities, with the more efficient companies, Pennon and Northumbrian Water, faring better.
In order to protect investors' returns we have been recommending a flight to quality. South West Water (SWW), owned by Pennon, is the quality water business in our opinion. The management is first class and over the last five years it has continued to come towards the top of the regulator's league tables. In March 2009, SWW achieved Ofwat's operating efficiency target a year ahead of schedule - a first for the industry. Ofwat has rewarded Pennon for its past performance by proposing an overall price increase of RPI plus 1 per cent for the next five years, to fund the £642m capital investment programme. This compares to an overall price adjustment of RPI minus 1.5 per cent for United Utilities.
Viridor, Pennon's waste management business, continues to report double-digit earnings growth, despite the recession. Growth in landfill, power generation and recycling exceeded market expectations, and two recent recycling acquisitions should spread earnings more evenly between the three divisions. Landfill in the UK remains an oligopoly with scope to push through yet higher fees.
Pennon's shares are currently rated on 12 times earnings and we forecast 5 per cent dividend growth to March 2010. Going forward, the dividend remains secure and the 4.7 per cent prospective dividend yield for 2010 is attractive. The recent share price weakness provides an attractive buying opportunity.
Elaine Coverley is divisional director of Brewin Dolphin
