Cost pressures are a drain on profits at United Utilities

United Utilities (UU.) wants markets to know that it’s intent on cleaning up its act. The water group, which operates in north-west England, was responsible for the highest number of sewage spill incidents in the sector last year. But management has vowed to take action – while admitting that change will “take sustained effort and investment over time”.  

It was confirmed in the group’s annual results that it would bring forward £200mn of planned investment in infrastructure to allow it to make an early start on improving storm overflows. In the year to the end of March, United Utilities said it achieved a 39 per cent reduction in “reported activations”, or sewage spills, from overflows compared with its 2020 baseline. 

Investors will want to see a meaningful reduction in pollution incidents given the attention that the so-called sewage scandal is currently getting from politicians and regulators. But following a fall in revenue and pre-tax profit, they will also want evidence that the company is committed to cutting costs and minimising the impact of inflation on its business. 

The fall in turnover was attributed to lower-than-expected customer consumption, while a 28 per cent drop in underlying operating profit was blamed on increases in the prices of power and chemicals. 

Although United Utilities’ reported figures reflect the foreseeable impacts of inflation on a company of its kind, the underlying numbers paint a slightly more concerning picture. It recorded an underlying loss before tax of £34mn, compared with a £302mn underlying profit for its 2022 financial year, partially due to an increase in its underlying net finance expense. 

Skyrocketing inflation significantly increased the non-cash interest expense on the group’s index-linked debt – in which the payment of interest income to holders is tied to a specific price index, often the consumer price index. At the close of the last financial year, United Utilities had £4.5bn of index-linked debt exposure, meaning it experiences a £45mn swing in its interest charge for every 1 per cent change in inflation. 

Regardless of these adverse effects, the company still managed to up its dividend in line with previously outlined plans. Bulls might also note that inflation won’t remain high forever, and that customer demand for water won’t ever dry up.  

However, we think that the company’s current valuation of 32 times estimated forward earnings for 2024 is unjustified given the intensifying regulatory risks it has to contend with. Sell. 

Last IC view: Sell, 1,082p, 27 April 2023