If you are not Thames Water, the water sector looks promising for investors, according to recent market movements. Shares of United Utilities (UU) and Severn Trent surged 11% and 7% respectively on Thursday, highlighting their status as standout financial outperformers in the industry.
Investor Confidence in Select Water Firms
While Thames Water, along with Southern Water and South East Water, often dominates headlines due to crises, the situation is markedly different for water companies operating further north. The new era of higher bills and increased spending on water infrastructure is proving beneficial for United Utilities, which serves north-west England, and Severn Trent, operating in the Midlands.
United Utilities' share price experienced an 11% surge on Thursday, an unusual occurrence for a utility where success is typically defined by predictability. This jump is particularly noteworthy given that the company was simultaneously issuing £800 million worth of new shares.
The surge was driven by a mini-stampede for UU's equity after Australia's sovereign wealth fund, Future Fund, and global infrastructure investor Atlas secured half of the allocation in the placing as cornerstone investors.
Regulatory Settlement Proving Generous
The rush is attributed to Ofwat's regulatory settlement on prices from a year ago, which increased water bills across England and Wales. This settlement appears more generous than initially anticipated, especially for firms not burdened by significant pollution fines, despite UU's issues at Windermere.
Critical numbers from UU's strategic update, which accompanied the placing and full-year results, include a target return on equity of 10-11% for the current five-year period, a full percentage point above previous guidance. This double-digit return is attractive, particularly when underpinned by inflation-linked bill increases. Some City analysts had forecast a return rate of 8.5%.
Additionally, UU believes it can secure approval from Ofwat for an extra £2.5 billion in spending, on top of an agreed £9 billion until 2030. This is due to the regulator's previous assumptions not accounting for all the new houses and datacentres the government plans to build around Manchester. The first £1.4 billion of this spending would increase bills by another £10 per household if approved. For UU, the overall £2.5 billion would mean its asset base growing at 10% annually to 2030, compared to 7% previously. These revised growth numbers explain the share price rise, as asset size is a key valuation metric for utilities.
UU's shares have risen 30% over the past year, outpacing the FTSE 100 index. Severn Trent saw a 7% increase in sympathy on Thursday, likely on expectations that it too can negotiate reopeners with Ofwat. Amid the crisis in the water sector, both companies' shares are at all-time highs.
Implications for the Sector and Government
While some may view these gains as outrageous given the wider sector crisis, it is important to recognize that Ofwat's approach aligns with the Labour government's preference for an investor-friendly setup to ensure infrastructure development, as opposed to nationalisation. This implicit bargain, though sometimes denied by ministers, underpins the regulatory environment.
Notably, five other water companies appealed to the Competition and Markets Authority, arguing that Ofwat was too stringent on bills. Most secured small upward adjustments, effectively endorsing Ofwat's original calculations.
The crisis at Thames Water appears to have benefited companies like UU and Severn Trent, which have been standout financial performers and are among the few water firms still publicly traded. In the regulatory and political panic over Thames, the regulatory dial has been turned further than expected a year ago. While not everyone benefits, the relative winners see larger financial rewards.
There is a lesson for the government, which is still deliberating over Thames's future. If the corporate calamity leads to special administration, shareholders are unlikely to flee the water sector en masse. Instead, international investors appear eager to deploy capital into well-run firms.
