Severn Trent ready for next cycle

Political pressure on the water sector has been high in recent years, due in large part to poor performances on pollution and prices, as well as the swing in favour of renationalisation by the revived Labour party. With the Conservative government keen to prove its credentials as a champion of consumers, the public utilities have become targets. As a result, Ofwat has pushed to make customer service, affordability and resilience of supply the central themes by which companies will be judged.

The upshot will be lower returns in the future. Ofwat published its final paper for the 2020-25 pricing period last December and, based on analysis from broker RBC Capital Markets, it will mean an allowed cost of equity and weighted average cost of capital around 140 and 110 basis points lower respectively in the coming cycle. That means efficiency will be key. Now the companies are in the process of preparing their business plans for submission in September. The regulator will rate business plans and those that achieve higher ratings are permitted higher returns. While investors may balk at the prospect of tighter controls, strengthened regulation – particularly that which increases the focus on consumers – will weaken support for renationalisation, which would ultimately prove more costly.

The main focus for retail investors will, understandably, be the safety of the dividend. Many were alarmed by the change from RPI to CPIH – a measure of inflation that includes the cost of housing – as the regulator’s primary measure of inflation. CPIH is structured to rise more slowly than RPI and all water companies pledge to increase their dividends in line with retail inflation – Pennon (PNN) and Severn Trent promised inflation plus 4 per cent annually. However, even with tightened regulation, analysts at broker JPMorgan Cazenove project that dividends will still grow at 7.5 per cent a year between 2018 and 2020, pushing the dividend yield at today's price clear of 5 per cent. Similarly, RBC calculates that the commitment to inflation-plus dividend increases could be maintained if not improved.

True, the impact of rising government bond yields remains a concern given that rising gilt yields tend to depress share prices. However, JPMorgan notes that the spread between UK gilts yields and the water sector dividend yields has widened lately, so perhaps the link is becoming less important.  

Severn Trent’s approach over the current cycle means it is well positioned to perform. Management has been focusing on generating cost efficiencies, increasing the forecast total to £870m at the most recent full-year results. The £100m additional savings are being reinvested into the water business to aid preparations for the coming regulatory period.  

The regulatory review will be tough on the companies involved, but RBC estimates a business plan allowing a steady return on equity of around 5 per cent is well within Severn Trent’s reach, even before taking into account incentive payments for outperformance. The company is also likely to supplement returns by selling surplus property, which is expected to deliver up to £15m a year over the next 10 years, for a total of around £100m. The programme got off to a strong start, adding £18.7m to 2017-18's pre-tax profit.