The water sector has been enjoying the same low borrowing costs and steady inflation as its energy utility twin and it also had the added benefit of a calmer regulatory environment last year. But investors got a nasty reminder of the potential impact of regulation when Ofwat's proposed license modifications knocked 10-20 per cent off sectoral share prices in October. Prices have since staged a recovery, but as the sector moves towards price reviews in 2014, the current ratings could come under pressure.
Water sector shares have had a great run since 2010, but as Mark Freshney, utilities analyst at Credit Suisse, points out, stocks tend to peak out at the midpoint in the regulatory period. It's therefore worth noting that we are fast approaching that juncture as the current AMP5 five-year regulatory planning period runs from 2010 to 2015. Historically, water shares have tended to struggle after the midpoint in the regulatory period and 2013 looks likely to be no different.
Ofwat's proposed license modifications published last October prompted sharp share price falls as investors feared for returns under the new regime. Many water companies rejected the proposals in late November and Ofwat has since returned with a compromise which has calmed fears and allowed the shares to recover. But the incident hints at the wrangling in store.
United Utilities (UU.), our favourite last year, put in the strongest share price performance. As bid rumours swirled in August, shares in the company hit highs which valued the equity at an eye-watering 20 times earnings and prompted us to downgrade our advice to hold on valuation grounds. The dividend is guaranteed to beat inflation by 2 per cent until 2015, but we think the share price is likely to stagnate at best from here on.
Pennon (PNN) has enjoyed something of a premium derating due to analysts getting hot under the collar over the prospects for its recycling arm, Viridor. Last year, Viridor was hit by a double whammy of falling prices and volumes of recycled material. Pennon was one of our outsiders for last year and it lived up to its posting as the shares struggled from July and crashed in October.
