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UK Water
Jamie Tunnicliffe 29 January 2009
jamie.tunnicliffe@rbs.com
Important disclosures can be found in the Disclosures Appendix.
†ABN AMRO group companies are subsidiary undertakings of The Royal Bank of Scotland Group plc.
A-LIST Equity Research A-LIST
We expect real regulatory capital value (RCV) growth of 3-4% per
annum for 2010-15F, taking industry net debt/RCV to 72-73% if
cash outflows of £8bn-11bn were 100% debt-financed. With
Ofwat seeking to avoid revenue uplifts adding to customer bills,
we argue that financing RCV growth could become untenable
without new equity.
We show that cutting dividends to ease financing constraints is
not a viable option. Are rights issues priced in? That’s a very
difficult question to answer as we won’t know what the allowed
cost of equity is likely to be until July.
What we can say is that it seems odd that two companies that
we identify as most likely to have to raise new equity (United
Utilities, Sell, target price: £4.68 and Severn Trent, Sell, target
price: £10.20) are trading at RCV premia of 4-8% compared to
our least likely candidate trading at a 9% discount (Pennon
Group, Hold, target price: £5.25).
Debt-financed growth has put pressure on credit ratios
UK water companies are often described as low-risk – that’s often not true in price-review
years like this one. The sector’s cost base has become more capital intensive and mature in
the 20 years since privatisation. Debt-financed growth in the sector’s regulatory capital value
(RCV) (7.3% real CAGR since 1989) has put pressure on credit ratios and amplifies the
effect of price limit decisions on equity values.
We estimate the industry will need to raise £11bn-14bn of new finance during 2010-15
We expect real annual RCV growth of 3-4% for 2010-15F, taking industry net debt/RCV to
72-73% if cash outflows of £8bn-11bn were 100% debt-financed (we believe another £3bn of
existing debt may need to be refinanced over the same period). We argue that financing
RCV growth could become untenable without new equity (with Ofwat seeking to avoid
revenue uplifts adding to customer bills). Dividends represent the UK water companies’
largest cash outflow after capital expenditure. However, we do not think cutting dividends to
allow more equity formation is a viable option: we argue that equity investors are unlikely to
be content to see a reduction in the level of dividend yield and we see only a marginal credit
ratio benefit from constraining dividends in 2010-15F in any case. This leads us to conclude
that a water company facing a financing constraint will need to raise new equity.
Avoid a combination of high enhancement and high initial RCV gearing
We think Severn Trent and United Utilities are more likely to have to raise new equity than
Pennon Group (we see Pennon’s regulated subsidiary incurring a smaller proportional
enhancement capex programme than its peers). In principle, there is nothing wrong with
raising equity through rights issues to finance enhancement capex. The question is whether
Ofwat’s allowed return will be sufficient to attract new equity. This uncertainty will remain for
another six months (Ofwat will announce draft determinations in July). We estimate that
Pennon Group is currently trading at a 9% discount to its RCV, while Severn Trent and
United Utilities are trading at premia of 4-8%. We initiate coverage on Pennon Group with a
Hold and 525p target price, United Utilities with a Sell and 468p target price, and Severn
Trent with a Sell and 1,020p target price. We estimate that at our target prices all three
stocks would trade at 2-3% discounts to RCV.
Contents
Riding the cycle 6
Our scenario analysis suggests Severn Trent and United Utilities are more likely to
have to raise new equity than Pennon. We estimate the sector.s MAR is close to 1,
suggesting to us limited appetite among investors to participate in rights issues to
fund capex.
Higher volatility in review years 6
Rights issue sensitivities . Pennon least exposed 8
Fair values 10
At our target prices, we estimate all three stocks would trade at 2-3% discounts to RCV.
Valuation summary 10
Playing the regulatory cycle 12
Water companies are described as low-risk; that tends not to be true in price-review
years. Twenty years on from privatisation, the sector.s cost base is more capitalintensive
and more mature. Debt-financed RCV growth (7.3% real CAGR 1989-2010F)
has put ratios under strain.
The regulatory contract 12
The regulatory cycle and uncertainty 16
How much external finance will be required? 20
We estimate the industry will need to raise ￡11bn-14bn of new finance during 2010-15
(including ￡3bn refinancing). We are concerned that Ofwat.s new capex incentive scheme
could make it hard for most companies to achieve Ofwat.s allowed return in AMP5.
How much enhancement? 20
What rate of RCV growth? 24
The options for easing financial constraints 28
We expect sector RCV gearing to rise to 72-73% by 2015 if cash outflows of ￡8bn-11bn
are 100% debt-financed. Low inflation puts further pressure on financial ratios. With
Ofwat likely to wish to avoid revenue uplifts adding to customer bills, we see high
prospects of rights issues.
What is financeability? 28
Would cutting dividends be sufficient? 31
Cutting dividends to allow more equity formation doesn.t seem a viable solution to us
(the steady-state nirvana of cash generation still appears a dim prospect). Our
calculations suggest there is only a marginal ratio benefit from constraining dividends in
AMP5 in any case.
Cutting existing dividend doesn.t do it 31
Who needs to raise it? How much? 35
Using scenario analysis we think Severn Trent and United Utilities are more likely to
have to raise new equity than Pennon. Under a tough case scenario . 0% inflation,
100bp reduction in vanilla return and DBP capex . we estimate the three would need to
raise about ￡1.9bn in total.
Scenario analysis 35
Scenario 1: Inflation 2.5%, 5.2% return, 89% of DBP 35
Scenario 2: Inflation 0%, 4.9% return, 100% of DBP 39
Scenario 3: Inflation 3.0%, 5.4% return, 79% of DBP 40
Rights issue sensitivity analysis 41
Raising new equity is fine as long as the allowed return is sufficient 45
Allowed returns set by other regulators have been falling. Setting the return is very difficult
as it is unclear whether long-term trends in capital markets have changed or whether we
might see a return to more normal conditions. Big call . will Ofwat get it .right.?
A big call to make 45
Do share prices reflect relative risk? 47
We estimate that Pennon Group is trading at a 9% discount to its RCV compared to
Severn Trent and United Utilities trading at premia of 4-8%. We think Pennon’s
dividend is the most secure of the three and suggest its relative rating appears odd
Actual versus expected dividends, the MAR and current yields 47
Company profiles 49
United Utilities 49
Severn Trent 54
Pennon Group 59
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