Pennon moves first in M&A race

Thought it was all over? Well, PR14 may have reached its end (for all but Bristol Water), but the real change in the UK water industry is only just beginning.

The acquisition of Bournemouth Water by Pennon Group, listed parent company of South West Water, blew the whistle on a long-anticipated period of M&A in the sector as it gets to grips with its tough new price settlements and prepares for the opening of the market for non-household customers in 2017.

Indeed, Ofwat chairman Jonson Cox signalled the scale of the anticipated change early this year, when he set out a vision of a “much more dynamic and differentiated” water sector, and one where “vertical integration no longer works”.

While the Bournemouth acquisition may look fairly traditional on paper, the reasons Pennon has given for the purchase shows it has its eyes firmly fixed on the future.

The £100.3 million deal between Singapore-based Sembcorp, Bournemouth Water’s former owner, and Pennon – funded by a new share issue to “allow flexibility rather than increase group leverage at this time”, according to Pennon group finance director Susan Davy – was completed as Pennon eyed the non-regulated side of Bournemouth Water. The regulated water supply business, which supplies 440,000 people, was also acquired by Pennon.

The deal includes a developing non-regulated business providing a platform for retail expansion, which “forms part of Pennon’s broader strategy to re-organise South West Water’s operations ahead of market liberalisation and prepare for the statutory reform of the non-household retail market from 2017”.

One key Bournemouth Water customer that may have appealed to Pennon is the Fawley oil refinery.

HSBC analyst Verity Mitchell told Utility Week that Pennon’s acquisition of Bournemouth Water, and its business customer base, will help the company build on its current, limited, non-household experience.

“South West Water is pretty rural and the non-household customers it has are pretty small. To have a large industrial customer to service would increase their product expertise. They can learn about the Fawley contract.

“Clearly they are serious about retail competition – non-household retail competition. And so they are diversifying their customer base in order to learn and compete better.”

Whitman Howard utilities analyst Angelos Anastasiou called the deal “a sensible, proactive move”, and Investec analyst Roshan Patel agrees the takeover “offers some strategic benefits” looking ahead to market opening, but “limited scope for cost efficiencies”, at least in the next price control period.

During the AMP6 period, staff at both Bournemouth Water and South West Water are unlikely to see and significant changes. The only real change so far has been two Pennon appointments to the Bournemouth Water board, replacing the departing Sembcorp members. The Competition and Markets Authority rubber stamping of the deal could take up to six months, in which time, the company’s management teams will have to keep strictly apart.

After that, the merging of the licenses is one possibility, and South West Water chief executive Chris Loughlin hinted this may happen: “Longer term beyond 2020 you may have different arrangements, but at the moment it’s too early to say.”

In the meantime, each company remains committed to delivering on its own business plan, and even if there is closer integration of the two companies for PR19, the separate branding looks set to remain, at least in some form.

This change will no doubt be the first of many, as the water sector evolves into a more dynamic and differentiated market.
UU and Severn Trent remain candidates for potential takeovers – or perhaps to acquire themselves – whilst smaller water only companies, in particular Bristol, also represent attractive propositions for investors.

But, with Cox saying “bigger isn’t always better” and that vertical integration is not necessarily the best solution, separation between wholesale and retail arms of the water companies is expected to be a feature of M&A activity in the coming years.

Anastasiou told Utility Week that “individual bits of companies could be sold off” as market opening approaches, with some water companies deciding to focus purely on the wholesale side of things.

Mitchell added that “not all of the water companies want to retain their retail operations” so may sell them off to new or existing companies within the sector, and that “the merger regime will evolve as the market develops” allowing for more “flexible” takeovers of parts of companies.

More M&A is expected, but who and what remains uncertain at the moment, especially as the non-household market continues to be developed. The Pennon deal is only the start.