Why you should bag a water stock
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Associate Editor
David Stevenson Jun 11, 2010
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They sell the most precious commodity on the planet. So why aren't Britain's water companies making more money?
For starters, the UK water industry is heavily regulated. Indeed Ofwat, the regulator, has been much too tough on firms that distribute the stuff, says Neil Woodford at Invesco Perpetual. It's "been behaving like Robin Hood", he says, ordering cuts in household bills. That hasn't helped water utilities' shares. Yet the outlook is now brightening.
Woodford is the big-hitting fund manager of Invesco Perpetual's Income and High Income funds, which together top £17bn. So his views really matter. And he's not a trader, but a long-term investor - "a dying breed these days". At end-April this year, over 15% of his funds were invested in water stocks. Yet he believes Ofwat has "taken for granted" shareholders like him by failing to recognise the importance of business owners in providing the equity capital that utilities need.
Building and operating supply systems, and repairing leaking pipes, is expensive. Compared to their net assets, most utilities - not just those in water - have high debts. But unlike industrial or retail businesses, whose cash flows can be highly volatile, utilities can normally handle their capital expenditure (capex) and borrowing needs because they get steady and predictable income streams from customers, enabling those firms to fund debt interest. But they still need a decent equity base from which they can pay their shareholders an adequate dividend return. Otherwise they won't get banks to finance their capex programmes. As Woodford asks, "will the hedge funds" - often shorter-term traders - "be there to subscribe to rights issues"?
Woodford's outburst stems from last November, when Ofwat issued final proposals on what UK water suppliers could charge customers between 2010 and 2015. The resulting demand for a 0.9% 'real' (inflation-adjusted) fall in water bills was much better than the regulator's earlier demand for a 4% drop in average household bills. But it still forced dividend cuts in a sector bought largely for its income stream. It's now crystal clear that Woodford and his ilk must be kept 'onside' by Ofwat. Unless the regulator lets suppliers make high returns to fund rising dividends, long-term income-seekers won't hold the stocks.
Woodford's comments are being taken seriously. Shareholders were consulted extensively during the recent review. Ofwat tells the FT: "We allowed water companies an appropriate rate of return including a return on equity of 7.1%. And we've made sure there are incentives in place to ensure that efficient, well-run companies can continue to deliver on their investment promises." Indeed, the sector's fundamentals already look strong, says Edmund Reid at JP Morgan Cazenove. Apart from "limited regulatory risk following the 2009 review, revenues are linked to the UK RPI (retail price index) which continues to surprise on the upside", he says. Meanwhile, "most companies' debt is fixed rate and long duration".
What's more, dividends are on the up again. Take Severn Trent (LSE: SVT), which supplies 3.7 million customers in the Midlands and North Wales. It has just hiked its payout by 7.4%. That's helped the sector - which tends to do well during times of market turmoil - to outshoot the FTSE All-Share index by 11% in the last month. But we prefer a second cheap water supplier.
The best bet in the sector
Northumbrian Water (LSE: NWG) provides water and sewerage services in northeast England and water services in the southeast to 4.4 million customers. One shareholder, the Ontario Teachers' Pension Plan (OTPP), owns 27%. Another - Invesco Perpetual - holds 16%. And while OTPP said earlier this year it wouldn't be launching a full bid, Northumbrian still has to keep these major investors happy. Otherwise a bidder could grab 43% of the stock in just two phone calls.
For now, shareholders should be feeling pretty content. Pre-tax profits for the year to end of March 2010 rose 11.5%, while earnings per share grew almost 16%. Compared with Severn Trent's multiple of above 14 and United Utilities (LSE: UU) on 13.5, Northumbrian already looks cheap on a p/e of just over 12 for the current year. And analysts' consensus estimates see the p/e dropping to 11 for the following year.
Meanwhile, the prospective yield of just under 5% is forecast to rise to 5.2% in 2011/12. With a policy of increasing the payout by 3% in real terms, "in an uncertain market environment", says The Telegraph's Questor column, "the prospect of dividend growth makes Northumbrian one to keep in the tank".
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