Utilities
Risks around the regulatory
review not priced in; UU and
SVT most exposed
What's Changed
Severn Trent Equal-weight to Underweight
Watco trade could be a binary outcome, we remain
cautious: We do not believe that watcos are attractive,
trading at a small premium to RAB, because this is
expensive for this stage in the regulatory cycle. The
review kicks off with the initial determination from Ofwat
on 23 July – we think it will be tougher than expected.
This could send the stocks toward our bear case, and if
deflation persists past 2010, we even see potential for
equity issuances. A good outcome would imply watcos
trading to our bull case, raising potential for buybacks.
Bear case reality? Our base case assumes 4.3%
allowed return from the review. Although this implies fair
values around where the stocks are trading, we would
expect them to trade down as this would be a clear
disappointment to consensus. If deflation persists
longer than expected, this could force leverage levels up,
putting pressure on equity valuations.
Bull case possible: But if the regulator delivers a
generous review, with the allowed return somewhere
near 5%, this should justify the watcos trading up to our
bull cases, on average 30% upside. A strong rebound in
inflation would also bring down leverage.
But we may have to wait until November: Even
though Ofwat publishes its initial determination next
week, we may not get detailed numbers until the final
review, due 26 November. This increases uncertainty.
Regulatory risk looks greatest around SVT and UU:
We downgrade SVT to UW, and with UU it looks the
most vulnerable to a tough review. PNN remains our
favoured watco, and we think has least to fear, along
with NWG, on 23 July (or 26 November…).