United Utilities Severn Trent fizz after Ofwat ruling

Water shares were among the best-performers on London’s Stock Exchange on Friday, shrugging off new limits on the amount of money water utilities can make from consumers.

It looks like investors were expecting Ofwat to make swingeing cuts to permitted water company returns, so when the new regulations, published this morning, proved less severe than feared, a relief rally ensued.

Shares of United Utilities and Severn Trent, firms which run the largest-listed water utility in the UK and the fourth-largest privately-owned water company in the world respectively, traded more than 3% and 1% higher respectively.

Ofwat cut the return water firms can make on assets–weighted average cost of capital (WACC) — to 3.74% from the 3.85% it initially proposed.

Also, tariffs set for each utility on Friday will result in an average 5% drop in consumer bills.

It appears the market had been primed for cuts which could have amounted to an average cut which was at least 2 percentage points higher. In the event the cuts were in-line and in fact a bit softer than feared.

Ofwat conditions well in line with existing plans

The regulator’s announcement follows a price review lasting several months which will set tariffs for 5 years.

The review also introduces a system whereby companies outperforming their peers will receive additional incentives, making some of the biggest changes to the water sector since privatisation 25 years ago.

Additionally, Ofwat ordered water suppliers to invest a total of £44.3bn between now until 2015, around £700m higher than initially proposed given that several companies appear to have voluntarily committed to spend more money on certain projects.

It’s worth bearing in mind that financing costs are at all-time lows, although it should also be noted large utilities tend to be highly indebted.

Average total debt-to-equity is well above 200% in a closely-matched UK group, with Severn Trent’s at 434.8%.

Not all UK water firms were favoured by the market in the wake of the news.

Pennon Group stock traded 1% lower.

Its South West Water was not afforded the £50 per customer government allowance in Ofwat’s determinations, and the regulator also noted a significant investment in infrastructure that the firm inherited at privatisation.

Water firms now have two months to assess and respond to Ofwat’s decisions and can if they wish seek a referral to the Competition and Markets Authority.

United Utilities said it was considering whether to accept Ofwat’s final decisions.

More froth

There has been another dimension adding froth to this sector in recent months.

A number of major investment banks have been suggesting for several months water M&A would reach the UK, with a number of infrastructure-focused investment funds waiting in the wings to take advantage of the newly enhanced dividend policies water firms are likely to announce early in 2015.

There also appears to be potential for an additional capital return from United Utilities, the water provider with the strongest balance sheet of its peers.

UU leads its peers on net margin too.

Finally, with about 50% of regulated UK water assets already owned by infrastructure-focused funds, if speculation of further acquisition interest waiting in the wings holds any water, it’s likely to be clear by the first quarter of the New Year whether such pent-up demand will lead to fresh M&A.

United Utilities already gained about 37.5% during the last 52 weeks.

Severn Trent is up about 15% over the same period.

It appears Severn Trent is being ranked more highly in the bid speculation stakes, mostly because of its fuller operating revenues and possibly its more internationally-facing profile than UU.