How to meter water stocks' profit flow
Phil Oakley Aug 13, 2012
Water companies’ shares are popular because they pay big dividends and are seen as low risk. But these companies are far from risk-free. Regulation, in particular, has a big impact on the returns you get. So here’s my guide to working out which companies offer the best value.
How regulations affect water companies
This can be a confusing sector. Some companies have been taken over while others have cut their dividends. In order to get a clear picture of the sector, it helps to know the basics of utility regulation and how these companies’ finances work.
Regulator Ofwat sets customer bills so that water companies can earn a fair return on their assets. These assets are known as the regulated asset value (RAV). The RAV is quite a complicated term and has little to do with the asset values of pipes and reservoirs on company balance sheets.
Instead, RAV is the amount that shareholders paid for the businesses when they were privatised in 1989. Added to this number is all the money that has enhanced and maintained water-company assets since then. The annual depreciation expense (an estimate of annual wear and tear) for all the company’s assets is then subtracted. After this, the resulting RAV is adjusted for inflation every year.
Ofwat says that a fair return on water companies’ RAV is 4.5% after tax, but before inflation. Added to this figure is an efficient level of operating costs, depreciation, tax and inflation. This gives the amount of allowed turnover each year that then gets translated into customer bills. A separate figure for improving the asset base is also agreed (ie, investing in infrastructure upgrades). This is known as a capital-expenditure allowance.
This may all sound a bit fiddly, but the bottom line is this: if a company spends exactly what Ofwat says it can and meets its targets on issues such as water quality and leakage, it will earn a return on its assets of 4.5%.
Which profit figure?
Water companies produce two sets of accounts – one for shareholders and one for the regulator. The challenge for private investors in water companies is knowing which of those are reliable. The one that most commentators talk about is the profit figure in the annual report for shareholders.
But there’s another number, known as ‘current cost profit’, that is usually a lot different from the one you read about in the annual report or the newspapers. This profit figure is usually lower because it contains an expense to maintain the company’s assets based on what they cost now, rather than what was paid for them many years ago. This is known as current cost depreciation. For example, United Utilities’ current cost water profits were £120m or 25% lower than its reported profits last year.
It is therefore a much better indicator of true profitability. This is the profit figure that the regulator looks at. It means that a water company’s reported profits and its ability to pay dividends may not be as good as you first think.
How are water companies valued?
Professional investors value water companies based on RAVs, not profits. They look at what drives the value of the business in a regulated environment. They reason that 4.5% adequately reflects the risks of investing in a water company and, if a company spends exactly what the regulator expects, then a business should be worth its RAV.
A water company can be worth more if it can either deliver its investment plans for less money or finance its business more cheaply – that is, below 4.5%. If this is the case, it will generate bigger profits and earn higher returns than 4.5%. Bear in mind that any efficiency gains can only be kept for five years before they are given back to customers. This means that you shouldn’t really pay a lot more than RAV for a water company.
How can I do a valuation?
With a bit of digging, you can find a company’s RAV buried in the notes to its annual accounts. You then follow the procedure shown in the table.
|Water companies August 2012||UU||SVT||Pennon|
|Share price (p)
|Market value (A)
|Net debt (B)
|Enterprise value (C) = A+B
|Premium to RAV = C/D
|Dividend per share
|Other business post-tax profit
|Value if water = RAV (C-D)
United Utilities (UU) is the only pure quoted UK water company. As you can see, its current enterprise value is 11% more (9,726/8,724) than its RAV. Given that it expects to do slightly better financially than its regulated target, this might be reasonable. But the shares are not cheap.
But what about the other two stocks? Both Severn Trent (SVT) and Pennon have other unregulated businesses that will be reflected in its enterprise value – hence the bigger premiums to RAV. In this case, you can conduct a ‘sanity check’ by looking at the implied value of these businesses, assuming that over the long run the water business is worth its RAV. As you can see, their unregulated businesses trade at very high profit multiples, suggesting that their shares are expensive.
So when should you buy water stocks
First answer: whenever Ofwat is seen to be cutting profits. Water companies have an uncanny ability to do better than their targets and the shares have historically done well after being sold off.
The other situation is when inflation is high. This means that income tends to rise more than costs and asset values faster than debt, causing profits and equity values to go up. Perhaps this is why foreign pension and infrastructure funds have been willing to pay a lot more than RAV for some water companies.