Thursday, 14 August 2014

The Water Utilities - Waiting for Ofwat

And Dee Valley Group PLC

Cathryn Ross, Chief Executive of Ofwat, courtesy
One of the first stops for the investor seeking income is the water utilities. Currently, they yield between 3.8% and 4.5%. But every five years British water companies must negotiate their terms of business with the regulator, Ofwat, and this can be a source of grief for investors. Both United Utilities and Severn Trent reduced their dividend payouts after the last 5-year review.  
However, the Gas & Water sector (in blue) has performed better than the FTSE All Share (in black) over the last five years and these indices do not take into account the higher income that shareholders have received from this sector:
Graph courtesy www.Interactive Investor, click to enlarge
The corollary is that the water utilities are highly valued. Income stocks have seen their prices bid high by investors looking for alternatives to the low yields available elsewhere in the financial markets.
Further, one way that the water companies have found to improve their performance is to borrow at low interest rates. They have relied heavily on loan financing to meet their capital requirements and to pay generous dividends. The result is that they are all heavily indebted.
PE Ratio
Market Cap pounds Mn
United Utilities
Severn Trent
Dee Valley Water
The water companies are now facing another 5-year review from Ofwat for the period 2015 to 2020. What is in store for them? The regulator has stated that it intends to reduce the regulatory weighted average cost of capital (WAAC) for the water companies from 5.1% to 3.85%. The WAAC is one of the inputs for the financial model Ofwat uses to set prices. If all other factors remain unchanged, this would imply a reduction of 24.6% in the companies' post-tax earnings. However, in part this reduction reflects the declining cost of debt. And Ofwat offers incentives to the water companies to meet certain performance targets.
But it comes as something of a shock to shareholders that Ofwat proposes that the cost of equity (post tax) should fall by 20%, from 7.1% to 5.65%, when using the model to calculate prices for the next five years.  
In broad terms, water company revenues can only grow by:
Ø  Ofwat-approved price increases. But Ofwat is looking for price increases below the rate of inflation.
Ø  Large projects that require new capital to, for instance, replace water mains or water treatment plants. Ofwat permits an increase in price to provide a return on new capital.
Ø  Growth in household and business use of water. The number of households is growing by 1% per annum.
In practice, average revenues of the four quoted water companies have risen by exactly the rate of retail price inflation in the past four years - 3.2% per annum. Meanwhile, earnings per share, once adjusted for extraordinary items, have stagnated.
Before investing in the water sector investors should consider:
1. Ofwat's final decisions will most likely be published in December 2014. The uncertainty running up to then will most likely be reflected in share prices.
2. The water sector is rated very highly by the market in historical terms. In part, this is the search for income and in part, the result of last year's bid for Severn Trent. Three institutional investors offered a 15% premium to the market price for that company.
3. The outlook for the next five years is determined largely by the regulator. And the indications are that Ofwat wants to keep prices low. There is political pressure on all regulators to restrict price increases at the cost of shareholders. This could mean that some of the companies would have to cut their dividends, just as United Utilities and Severn Trent did in FY 2011. Some might have to raise new capital from shareholders.

Dee Valley Group PLC (DVW)

The River Dee at Chester, courtesy Wikipedia
The Dee Valley Group (Dee) is by far the smallest of the four water companies quoted on the London Stock Exchange. This has, for the individual investor, some advantages. The company is so small - it has a market capitalization of 63 million pounds - that only one analyst bothers to cover it. As AXA S. A., the general insurance company, holds 35% of Dee's shares, the free float is further reduced. As a result, perhaps, Dee is on the lowest PE ratio and yields the highest dividend of any of the water companies and it has the lowest debt to equity ratio.
Dee provides a pure water service to 113,000 homes and 8,000 businesses in southern Cheshire and northern Wales. It does not offer a sewage service or run any other business than providing water to its market. Its small size enables the company to keep in close contact with the local authorities, agencies and its customers.
Financial Results
Ø  Earnings per share have increased by 3% pa over the 2007-14 period and dividends by 4%. This is slightly ahead of retail price inflation and indicates the bond-like nature of the regulated water business.
Ø  Return on equity is a healthy 15% reflecting in part the highly leveraged nature of the company's balance sheet.
Ø  Debt to equity ratio has remained fairly stable and it is currently 185%. Based on its regulatory asset value of 74 million pounds, debt financing is 68% compared to equity financing of 32%.
Ø  Net operating cash flow, including capital expenditure, was 12.4 million pounds over the period 2010 to 2014, just falling short of dividend payments of 13.5 million pounds. The company has not issued or bought back any of its shares in these five years.
Ø  The main risk to the business is probably the company's defined benefit pension scheme (DBPS). Although the scheme is currently in surplus, it could require substantial funding at some time. Because of the open-ended obligation of such schemes, nearly all companies with DBPS have closed them in favour of defined contribution schemes.
Dee's share price (in blue) has outperformed the FTSE All Share Index over the last five years, without counting its superior yield.

Graph courtesy Yahoo, click to enlarge.
Ofwat's review is influenced by the Customer Challenge Panels (CCP) that monitor the water utilities. Dee's CCP has supported the company's plans that it has lodged with the economic regulator Ofwat. The company proposes an increased capital spend for the next five-year period coupled with a small increase in prices above the rate of price inflation. Dee's customers are currently paying one of the lowest tariffs in the country. It has also argued that it should receive a small company premium for its cost of capital, on the grounds that smaller entities do not have the scale or credibility of larger entities. On the debt side, this is covered by Ofwat's intention to include the cost of 'embedded debt' - debt the company has already contracted.
However, Ofwat's decision on pricing will not be known until December 2014. The Company states, "Future dividends will be considered in the context of the results for the period and the outcome of the current price review process."
Assuming that Dee's business continues on its past trajectory, then my model values Dee's shares at around 1170p.* This is 16% below the current share price of 1385p. At 1385p the company's shares trade on a PE ratio of 15 and yield 4.5%.
*Assumptions: Eps growth of 2% p.a.; dividend payout of 66% of earnings; 15% return on equity; equity per share growth of 5% p.a.; average PE ratio of 13; discounted at 8.8% p.a. for the five years to 2019.
The cautious investor will:
1.       Wait until Ofwat's review is complete, which should be at the end of this year. The company is sure to make a statement on the impact on its business of the regulator's decisions.
2.       Note that Dee's share price reached a 12-month high of 1610p in April and a low of 1308p earlier this month.
3.       Consider that Dee's shares are close in nature to an index-linked bond with the risk of unfavourable quinquennial reviews by the regulator Ofwat.
4.       Keep an eye on the company's contribution to its DBPS.
Disclosure: I hold a long position in Dee Valley Group.