Come On In, The Water's Safe!

Published in Investing on 4 July 2012

Another deal in the water sector supports share prices.

Once again the attractions of the UK water industry have been highlighted by M&A in the sector. The latest deal bumps up valuations even further.

That's good news for the three listed water companies: FTSE 100 (UKX) members United Utilities (LSE: UU) and Severn Trent (LSE: SVT), and the smaller Pennon (LSE: PNN).

This time, unusually, it wasn't a sale of UK assets to a foreign bidder. The debt-ridden French Veolia Environnement has agreed to sell a 90% stake in its UK water business to Prudential and Morgan Stanley. At £1.2 billion, the deal values the business at an astonishing multiple of 16 times its 2011 EBITDA.

Premium

More significantly, the price represents a premium of 30% to the business's Regulated Asset Base (RAB), a common yardstick for valuations in the industry. With United Utilities, Severn Trent and Pennon trading at premiums of around 7-10% to their RABs, it's a strong underpinning of their share prices.

And importantly the trend is upwards. Foreign investors are hunting for UK infrastructure assets, attracted by the security of the income streams. Opportunities in the water sector are becoming increasingly scarce, and valuations are being chased upwards.

Northumbrian water group was taken private by Hong Kong tycoon Li Ka-shing last year, at a premium of 25% to RAB. Both the Abu Dhabi Investment Authority and the China Investment Corporation have bought stakes in Kemble, the holding company for Thames Water. China is explicitly looking for more UK infrastructure assets. Earlier deals in the sector had been done at a 20% premium.

Defensive

Recognised as a defensive sector, the water industry stocks have markedly outperformed the FTSE 100, with each up about 8-9% over the past 12 months while the index has dropped 5%.

Apart from the potential M&A upside, the sector offers a secure, inflation-proofed yield. Inflation-linked price rises have been agreed with Ofwat, the regulator, up until 2015.

Until 2015, each company has promised to raise its dividend in excess of inflation. While inflation has eased recently, I'm not alone in thinking that repeated bouts of quantitative easing can only stoke the long-term trend.

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Sympathetic

Consultations have begun on the pricing regime for the following five-year period, with both Ofwat and the Government sounding sympathetic to the need to secure financing at attractive prices. The industry is investing heavily in additional capacity and reducing leakages. That bodes well for future profitability.

Water companies can increase their profits in two ways. First, by reducing operational costs, and secondly by reducing financing costs. The stability of earnings allows companies to gear up highly, with balance sheet net gearing typically 200%-400% but gearing compared to the RAB a more palatable 60% or so. So shaving interest costs saves big bucks.

United

With a market cap of £4.6 billion, United Utilities is the largest of the three. Its business is wholly focused on the water sector in the north-west, and has promised to increase its payout by RPI +2% for the next three years.

Severn Trent is a little smaller with a market cap of £4 billion. Operating mainly in the UK it has interests in Spain and Italy on which it took write-downs last year, and a UK laboratory business that also dragged down performance. It is proposing to pay a special dividend, which will ramp up its regulatory gearing.

Pennon's market cap is £2.8 billion. It operates a water business in the South West but also has a significant non-regulated waste management business. That contributed 62% of revenues but just 29% of profits last year. Both volumes and margins in the waste management business fell, reflecting its cyclical nature, but the business is generally on a growth path with plans to double EBITDA contribution over the next five years.

Ideal

For me, Pennon offers the ideal combination of a defensive, inflation-hedged water business that just might get taken out at an attractive premium, with a good quality cyclical growth business. But all three companies have attractions. Though they trade at a premium to the FTSE 100's average price-to-earnings (P/E) ratio of 9.8, their defensive characteristics and generous yields make them sound investments in any portfolio.

 Share priceP/E (ttm)Div Yield %Price:RAB (est)Price:EBITDA
United Utilities679p16.65.1%110%5.2
Severn Trent1,662p16.64.6%109%5.0
Pennon768p16.53.8%107%6.8
Veolia Water sale   130%16.0

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> Tony has shares in Pennon but no other stocks mentioned in this article.

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Comments

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F958B 04 Jul 2012 , 10:26am

The time to buy the sector was ten to twelve years ago (which I did - I also held KEL).
At that time, P/E's were half what they are today and dividend yields almost double what they are today.
Water was the among lowest-P/E sectors in the FTSE. Now it's among the highest rated. How fashions change - and they'll no doubt change again in the future.
With high valuations, limited growth, high debts, harsh regulation and the highest-ever valuations for the sector, I think that there's not much money to be made in the sector now, in the long term.

The only reason to have anything in water shares is out of necessity for diversification purposes, for those who feel the need to be well-diversified.

TRhere 04 Jul 2012 , 10:45am

F958B,

If only we could backdate investments ten to twelve years! Your analysis is maybe a little harsh but a fair comparison with 10 years ago I suppose.The attractions of the sector now are mainly defensive.

But you seem to imply that valuations could go downwards. There's a lot of foreign private sector capital coming into the sector that takes a long term view and has a different opinion.

Tony R

F958B 04 Jul 2012 , 11:07am

Trhere

In 1999-2000, GSK had a P/E around 1.6x that of the FTSE average (about 40 v 25).

Nowadays the water sector has a P/E around 1.6x that of the FTSE average (16 v 10).

GSK's profits and dividends plodded along just fine since the turn of the millennium; from a dividend per share of 36.0p in 2000 to 70.0p (plus 5p special) for the year just paid.
That's 7% annual average growth in the dividend, from what was considered, in 1999-200, to be a "solid" "must-have" company for any portfolio. So the company's operational performance was exactly as you'd expect: solid and respectable.

Despite good dividend progess, the shares remain well below the price of the year 2000. By 2010 investors had come to hate GSK for its share price underperformance - just as the shares began to show signs of life, after everyone had thrown in the towel in despair.

Why such poor share price performance in the face of decent operational performance?
Because they started out *relatively* very expensive compared to the FTSE, so were very likely to underperform as investors looked at better-priced opportunities elsewhere (such as the cheap water shares in 2000).

So unless it's "different this time" the water sector looks precarious to me.



Why should the water sector be any different?

QuantumDealer 04 Jul 2012 , 11:58am

I didn't realise that we named our rivers by numbers these days as in paragraph 2 of this article (in bold). Where is river Eight located, I wonder?!

UncleEbenezer 04 Jul 2012 , 12:05pm

QuantumDealer, you avon' a laff or extracting the piddle? It's near Seven but a lot further from Trenty.

TRhere 04 Jul 2012 , 5:23pm

QuantumDealer - thanks, I'll get that corrected. Oops!

Tony R

TRhere 04 Jul 2012 , 6:02pm

F958B,

I certainly agree with your general thesis about not buying in at too high a (relative) price. But I guess one difference is that GSK was yielding sub 2% in 1999 - so the yield grew to today's 5% as the payout grew and the share price didn't. With the water companies now yielding 4-5% ish, dividend growth ought to be reflected in share prices - or yield will get very out of line.

F958B 04 Jul 2012 , 6:32pm

What's the business case for venture capital to buy water?

Borrow a couple of £Billion.
Pay 5.5% interest.
Receive 6% earnings yield (reciprocal of 16.5x P/E).

So where's the gravy?
0.5% after interest costs doesn't inspire me to run the risk of borrowing those kind of large sums.

I'd much rather take Morrisons - or Sainsbury, or the big electric companies.
Pay 5.5% interest.
Receive 8-10% earnings yield (depending on company).

That gives me a 3-4% carry-trade (after interest costs) gravy train for me, earned with someone else's (borrowed) money.

When I look at investments, I do not look at absolute numbers; I look at relative numbers.
My capital is scarce and it needs to be deployed into what appears to offer me a relatively higher (but not too much risk) return over a 5-10 year period, accompanied by an acceptable risk:reward.

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