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Capital punishment

Of the 17 companies that supply England and Wales with water services, just three "sector leading" operators – that’s the assessment of Ofwat, the water-industry regulator – have been given fast-track status so that their pricing plans for the five years to 2025 have already been sorted out.

Most likely those three were willing to give away the most upfront. But it’s probably no coincidence that their parents are also the only three listed water companies on the London market; the other 14 are all wrapped up in privately-owned or overseas corporates of one sort or another. In other words, the ones in the public – and mainly critical – gaze were the ones most willing to please their industry regulator.

With pricing levels settled, it’s easy to wonder which, if any, offers a good investment opportunity. The intuitive response might be the group that’s least dependent on regulated water services for its profits and/or the one giving away the least in price cuts.

That could favour Pennon (PNN), the holding company for South West Water, which serves 1m customers in Devon, Cornwall and Bournemouth. The presence of its rubbish management subsidiary, Viridor, means regulated activities contribute ‘only’ three-quarters of profits. By contrast, the biggest of the three, United Utilities (UU.), relies wholly on regulated activities, supplying water services to about 3.2m customers in north-west England.

So South West Water’s notoriously high water prices – average annual bill £527, according to Ofwat – means it has to promise the biggest price cuts of the three – 15 per cent over the five years to 2025. Yet, because Pennon generates a quarter cent of its profits in unregulated activities, even if that eventual 15 per cent reduction in water revenues were simply lopped off 2017-18’s results, that would chop £86m or 33 per cent off the group’s pre-tax amount. Meanwhile, on the same logic, the effect of cutting prices by just 11 per cent would have a worse effect on United Utilities, knocking 44 per cent off its pre-tax figure for 2017-18.

Obviously, real life won’t be that simple, but the exercise offers a glimpse of the potential for damage to profits that the forthcoming price cuts might do.

Even if Pennon suffers the least damage, that’s not a recommendation to buy its shares. That’s because of the inexorable rise in the group’s debt and the pressure that exerts on the company’s ability to maintain the dividend. Not once in the past six years has Pennon generated any free cash. In the period 2012-18, outflows net of all operating costs, including dividends, have totalled £1.1bn; very roughly, that matches the £800m increase in the net debt to £3bn over the same period.

Nor has United Utilities produced anything to write home about. Annualising the 12 months to September 2018, United paid out in dividends 2.1 times more than it generated in free cash (see table). If that looks poor, it is actually the best ratio United has managed in the six years 2012-13 to 2017-18. In those years it failed to produce any free cash three times and its least poor full-year pay-out ratio was 2.5 times in 2013-14.

The listed water suppliers
 Severn TrentPennonUnited Utilities
Share price (p)1,961731822
Market cap (£m)4,6463,0705,594
Dividend yield (%)4.45.44.8
Regulated profits (%)*9577100
Return on assets (%)3.53.43.3
Return on equity (%)24.914.512.8
Net debt/ebitda6.76.27.0
Cap-ex/revenue (%)37.526.638.2
Payout ratio*2.3see text2.1
Average water bill£343£527£427
Bills set to fall by 5%15%11%
Source:  Ofwat and S&P Capital IQ (data for latest 12 months) *Regulated profits/group total; payout ratio: dividends paid/free cash flow

Only Severn Trent (SVT) emerges with half-decent ratios. It has produced free cash in each of the six years 2012-13 to 2017-18 and only once did it pay out more in dividends than it produced in free cash, although that was its most recent full year.

It follows from this that the lowest increase in net debt among the three was at Severn Trent, where the figure rose 21 per cent from March 2013 to September 2018, and the highest was at Pennon, where the figure rose 48 per cent.

Arguably, however, no company can prosper if it has to spend as much on its capital account as these listed water suppliers. Set against their revenues, their capital spending is huge. To put into context their ratios for capital spending to revenue (see table), among partially-regulated utilities, SSE (SSE) spent 5.7 per cent of revenue and Vodafone (VOD) spent 11.1 per cent.

When a combination of Victorian-era infrastructure and regulatory pressure forces such heavy capital spending on a company it calls into question whether its shares can possibly be a good investment. For Pennon and United Utilities, the answer seems to be ‘no’. For Severn Trent, it’s a ‘maybe’ and perhaps worth proper digging.