Shares in regulated water companies hit the rapids last week when regulator Ofwat published a stormy assessment of price hikes proposed for the next five-year regulatory period (2010-2015).
The water companies had proposed increases to customer bills at more than the rate of inflation to fund a collective £21bn infrastructure and investment programme, but the regulator pulled the plug. Instead, it wants companies to cut consumers' water bills by 4 per cent in real terms by 2015, and analysts now fear dividend cuts ahead.
Ofwat's actions are the latest wet blanket for water companies, which, along with the utilities sector as a whole, have been battling against strong political and financial undercurrents. But, while there are challenges ahead, investors shouldn't pour cold water on all utility shares. If anything, recent price falls could offer a long-term buying opportunity.
UNDER PRESSURE
So what exactly is threatening the defensive merits of the utility companies? To begin with, revenues have been reducing as the recession hits industrial demand for power and water; the impact of domestic water metering is also trickling through. As unemployment rises and businesses fail, bad debts are having an impact, too. And with consumers under pressure, regulators are taking a tough stance on bills.
For the power companies, failure to pass on the benefit of wholesale price cuts to consumers has lead to threats of increased regulation - fuel poverty is a very hot political potato. And the political obligations don't stop there - the looms large, with the challenges of carbon credits, increased renewable generation capacity and retiring coal-fired plants lurking on the horizon.
But, by far, the most pressing problem for all the utilities is finance. The reliable, long-term nature of income streams in the sector means most companies are highly geared, and the higher cost of debt in a post-crunch world is a major problem. That could mean reduced profits and potential short-term dividend cuts, which is hitting share prices across the sector.
ELECTRIC SHOCK
The backdrop may be challenging, but there's a growing argument that shares in certain utility companies are being unfairly punished. For example, last week's trading statement from (SSE) forecast that first-half underlying profits would be "significantly higher" than last year, and that the company was on course for 4 per cent annual dividend growth. So did its shares rise? Did they, heck.
A week previously, credit rating agency Moody's placed SSE on review for possible downgrade. It cited a weak operating environment along with an "ambitious capex plan" as the trigger and noted that its dividend growth policy "leaves little flexibility to retain cash within the business".
Although any downgrade would only bring SSE's credit rating down one notch - it would retain its investment grade rating. Having successfully raised £479m in a placing at the end of last year, the company has also denied that it needs to raise fresh equity. Furthermore, Citi utilities analyst Peter Atherton sees no need for SSE to reduce its £6.7bn capital expenditure plan.
"SSE intends to double its renewables generation capacity to 4GW and we believe the wind portion of this alone to be worth around 16p of earnings by 2013," he argues. Citi research forecasts that SSE's planned investment case will generate earnings in excess of 145p a share by this point, up from 108p at 2009's full-year results, showing its long-term credentials.
is the latest utility company to fall under Moody's gaze; its share price has powered down as fears of a credit downgrade prompted speculation about a fund-raising. The fears proved unfounded, and when its rating was upgraded to 'stable' from 'negative' last week, the shares rose 2 per cent. However, the gains were all but wiped out when Ofwat's negative ruling for the water companies dragged the entire utilities sector lower.
WATER TORTURE
Ofwat's draft proposals for the next regulatory period (2010-2015) were harsher than the industry expected. The key figure is the cost of capital - the level of return that water companies are permitted to make on their regulated asset base. Ofwat is proposing a level of 4.5 per cent; that's at the bottom end of the range of consensus expectations.
By contrast, the water industry commissioned economic consultant NERA to report on the cost of capital prior to the draft review. It concluded that a range between 4.6 and 5.1 per cent was needed, and water companies are expected to lobby hard between now and Ofwat's final price control announcement, which is due on 26 November.
"Often, the draft proposals are considerably more negative than the final proposals as Ofwat seeks to begin negotiations from a low starting point," says Elaine Coverley, utilities analyst at Brewin Dolphin. She notes that water companies Northumbrian and Pennon had modelled a cost of capital of 4.7 per cent and 4.78 per cent, respectively, into their business plans, so they will feel the pain less. Nevertheless, Pennon's shares fell 3 per cent and Northumbrian's by 2 per cent on the day of the announcement.
The biggest to fall was Its shares sank 5.5 per cent and it is believed to be the most likely to cut its dividend when the new regulatory period begins in 2010. In a trading statement issued last week, the company fought back, saying it would increase dividends by 5 per cent this year, making for a final dividend of 32.67p - a yield of 7 per cent.
Analysts note that a pattern is emerging in the Ofwat review process - favourable for one period, and foul for the next. In 2004, the regulator over-estimated the cost of capital at 5.1 per cent, only for a wave of cheap debt to engulf the sector, resulting in higher-than-average returns. But now there's pressure for the regulator to come down hard. However, if Ofwat is too harsh this could defeat the object. While a lowered cost of capital may decrease bills in the short term, given the perilous state of the financial markets, such a large hole-in-the-bucket of water company business plans could increase borrowing costs, and these would have to be passed on to consumers at some point.
"We are not overly pessimistic about the prospects of the sector, and see Ofwat's draft price controls as providing a base level from which the companies are liable to gain some ground," says Angelos Anastasiou, utilities analyst at Pali International.
Fears of deflation have also heaped negative pressure on water company share prices. But analysts warn that long-term inflation is actually an issue. "The long-term impact from the unprecedented amount of fiscal stimulus the government has been undertaking is inflationary," argues Ms Coverley. "The water sector is one of the only equity sectors where investors can gain protection from inflation. As all prices are set with regard to RPI, in our view, this makes the sector attractive for the longer term."
IC VIEW:
For a long-term defensive play, we still believe that the utilities sector can't be beaten - even though dividend cuts remain a short-term concern. The more efficient water companies are bound to see their shares float upwards following Ofwat's final determination in November and, although returns aren't as frothy as in previous years, they offer a good inflation hedge.
