The rise and rise of Affinity Water

As Affinity Water’s first chief executive prepares to exit, Nigel Hawkins reviews the company’s evolution, its good standing in the eyes of the regulator and its prospects for the future.

The controversial privatisation of the ten water companies serving England and Wales in 1989 remains a landmark in the sector’s evolution.

It was touch and go at the time whether the privatisation would actually take place – a situation not helped by the fact that, two years previously, the French privatised water sector began buying up the smaller statutory water companies, led by the long-established Compagnie Générale des Eaux (CGE).

Indeed, it was the latter’s UK water holdings that, after various changes, morphed into Affinity Water, which first appeared on the scene in 2012 having been sold by CGE’s successor company, Veolia. It is now owned by infrastructure funds.

Affinity’s supply area is centred on north and west London, which was the original Three Valleys supply base encompassing the Colne Valley, Lee Valley and Rickmansworth water companies. Following acquisitions of other water-only companies, Affinity’s customer base embraces other franchises including north Surrey, Folkestone and Dover, as well as the old Tendring Hundred supply area in Essex. Affinity now supplies 1.5 million households with clean water (their sewerage requirements are generally undertaken by Thames or Southern).

Earlier this year, as part of its periodic review process, Ofwat set out its crucial weighted average cost of capital (Wacc) parameters, with a projected 3.85 per cent vanilla Wacc, a figure that was markedly lower than the 5.1 per cent Wacc prescribed for the 2010/15 regulatory period.

Then, in April, Ofwat surprised the market by confirming that the little-known Affinity was one of the two fast-tracked water companies – South West was the other – for the five-year periodic review, which will apply from April 2015. To be sure, the lack of any sewerage operations was probably an advantage for Affinity because it facilitated the compiling of long-term financial projections.

Ofwat’s fast-tracking decisions will have put some well-known noses out of joint among the larger water companies, with Wessex and Northumbrian having been widely – but erroneously – tipped as candidates for such status.

Ofwat’s rationale for fast-tracking Affinity, whose business plan it described as “high quality”, revolved around several factors, including promising material cost reductions. In its business plan, Affinity confirmed its agreement with the Environment Agency to reduce its abstraction levels by up to 5 per cent by 2020. With a local water shortage – and in line with the priorities specified by its customers – this policy undoubtedly hit Ofwat’s sweet spot.

Historically, Ofwat has been distinctly lacklustre in prescribing leakage reductions, notably in the last review, so that Affinity’s pledge to reduce leakage by 14 per cent by 2020 also went down well. In fairness, it is rather easier to cut water leakage in London’s wealthier outer suburbs than in many old industrial towns supplied by United Utilities, such as Blackburn and Burnley.

Furthermore, Affinity has introduced a social tariff to help the least well-off. To date, about 8,000 customers have registered for this scheme.

Affinity’s finances – restructured in February 2013 – seem solid, at least by the standards of predominantly debt-financed water companies.

In 2013/14, revenues were £293 million, slightly above the previous year. They will, of course, be affected by the implementation of the ongoing periodic review from April 2015.

Similar comments apply to pre-tax profits, which amounted to £45.7 million in 2013/14. Affinity plans to offset the proposed K-driven revenue cuts with additional reductions in costs.

In terms of net debt, Affinity’s 2013/14 accounts reported a figure of £793 million. While its gearing ratio may look high and its interest cover low, they are both sufficiently robust to merit an investment credit rating by the leading credit rating agencies.

Going forward, Affinity plans to spend almost £1.1 billion of totex – operating and capital expenditure – between 2015 and 2020. Nonetheless, Affinity’s future will lack the contribution of its highly regarded chief executive, Richard Bienfait, who will leave at the year end. In the meantime, chairman Phil Nolan, a former chief executive of Transco (now part of National Grid) will be instrumental in appointing his successor.

For investors, Affinity is something of a rare bird in that it is a water-only company with a regulatory system that is set to endure until March 2020 – and, given its fast track status, one that should secure a better regulatory deal than virtually any other water company.

With the major uncertainties overhanging Thames – with its near £9 billion net debt and its controversial Thames Tideway Tunnel scheme – and United Utilities, whose revised five-year sewerage investment projection are still way above Ofwat’s figures, Affinity is comparatively very well placed.

As a pure water play, Affinity is bound to attract considerable investor interest, especially from infrastructure funds, which may be prepared to pay the current owners a higher premium above the regulatory asset value (Rav) than is the water sector norm.

Affinity’s existing owners are presumably happy with progress and, seemingly, would sell their stakes only if the case, namely a very pronounced premium over Rav, were a compelling one.