Water sector interim results eclipsed by looming Ofwat determinations

Like Banquo’s ghost in Shakespeare’s Macbeth, Ofwat’s final determinations – due on December 12th – overshadowed the publication of the water sector’s interim results.

In the event, there were no major surprises for the three quoted water stocks, although Pennon’s share price did rise by over 5% on the basis of a distinctly more upbeat outlook for its troubled Viridor operations.

Aside from the unquoted Thames, most water sector attention on December 12th will focus on United Utilities and, to what extent, Ofwat has responded to its vigorous representations on future sewerage investment.

At its interim results presentation, United Utilities’ Chief Executive, Steve Mogford, confirmed that there was a £628 million gap in its five-year totex figures ‘which, we believe, are not accounted for in Ofwat’s model’.

Significantly, the implementation of Ofwat’s ‘upper quartile’ efficiency assumption has been a material factor in creating this formidable gap.

Otherwise, United Utilities’ interim results were in line with expectations.

Both revenues, at £859 million, and underlying operating profit, at £343 million, were marginally up on the 2013/14 first-half, whilst adjusted Earnings per Share (EPS) rose by 4.5% from 24.7p to 25.8p. The interim dividend increased similarly – to 12.56p per share.

Net debt at September 2014 stood at almost £5.7 billion, compared with £5.5 billion at March 2014. However, United Utilities’ core business gearing figure of 57% – based on net debt over its Regulatory Capital Value (RCV) – was at the lower end of Ofwat’s preferred ratio.

But bad debts due from customers, which – in total – were almost £5 million higher in this year’s interim figures, are more of an issue.

Importantly, United Utilities has negotiated an exceptional £19 million per year adjustment with Ofwat, which takes account of higher than average social deprivation levels in its supply region, especially in industrial Lancashire.

Severn Trent’s interim results were very solid, with a pronounced rise in underlying EPS of 12.6%, which was due to several factors including improved returns from Severn Trent Services and a £6.5 million finance cost saving.

Interim revenues at £948 million were up by 2.7%, whilst the 33.96p interim dividend increase represented a 5.6% rise over 2013/14.

Like United Utilities, Severn Trent’s core business gearing is at the lower end of Ofwat’s financing targets, with a net debt/RCV ratio of 57%: its latest RCV figure is £7.7 billion.

Severn Trent’s overall net debt is now just below £4.4 billion, 99% of which relates to the core water business.

Given its comparatively low prices, it was hardly surprising that Liv Garfield, Severn Trent’s new Chief Executive, pointed out that she was ‘confident of maintaining the lowest combined bills for the next five years’.

Clearly, if the controversial £4.2 billion Thames Tideway project proceeds, this should be comfortably achieved.

For investors, Garfield confirmed that Severn Trent will set out its future dividend policy next spring: Ofwat’s final determinations will be crucial in this respect.

Furthermore, given that Severn Trent’s board bravely turned down a £22 per share bid in the summer of 2013, potential bidders will also be sizing up its financial capacity to pay enhanced dividends.

Pennon’s interim figures were substantially impacted by the challenges facing Viridor, which – according to Chairman, Ken Harvey – has now reached an inflexion point. He forecast an EBITDA return of c£100 million in 2016/17 – a figure welcomed by the market.

As expected, Viridor’s returns from its landfill, re-cycling, collection and landfill gas-power generation businesses were all well down, due both to lower prices but more especially from notably higher costs.

Viridor’s contribution at the profit before interest and tax (PBIT) level fell from over £23 million to £8.2 million. 

Hence, despite a solid core water performance, Pennon’s interim adjusted EPS was down from 23.8p to 22.1p. Nonetheless, the interim dividend rose by 6.3% to 9.98p per share, whilst group net debt was £2.1 billion.

In fact, as Ofwat’s sole privatised fast-tracker, Pennon’s core water business is in good shape. No doubt, Ofwat liked, too, its 3.8% average financing cost, a figure markedly below that of many other water companies.

Having secured fast-tracker status, Pennon’s regulatory settlement is far more clear-cut than others; it is also receiving an £11 million boost to its RCV, which is now just under £3 billion.

Sector bid speculation has already begun and will assuredly develop further once Ofwat’s final determinations are disclosed.

All three quoted water companies remain bid favourites, with a real expectation that Severn Trent may well be the subject of a renewed offer at a similar price to the 2013 rejected offer.