Once again, the attractions of the U.K. water industry have been highlighted by M&A in the sector. The latest deal bumps up valuations even further.
This time, unusually, it wasn't a sale of U.K. assets to a foreign bidder. The debt-ridden French Veolia Environnement has agreed to sell a 90% stake in its U.K. water business to Prudential and Morgan Stanley. At 1.2 billion pounds, the deal values the business at an astonishing multiple of 16 times its 2011 EBITDA.
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, Seven 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 upward. Foreign investors are hunting for U.K. infrastructure assets, attracted by the security of the income streams. Opportunities in the water sector are becoming increasingly scarce, and valuations are being chased up.
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 U.K. infrastructure assets. Earlier deals in the sector had been done at a 20% premium.
Recognized 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 that date, 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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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 second, 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 with the RAB a more palatable 60% or so. So shaving interest costs saves big bucks.
With a market cap of 4.6 billion pounds, United Utilities is the largest of the three. Its business is wholly focused on the water sector in the North-West, and it has promised to increase its payout by RPI +2% for the next three years.
Seven Trent is a little smaller, with a market cap of 4 billion pounds. Operating mainly in the U.K., it has interests in Spain and Italy, on which it took writedowns last year, and a U.K. 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 pounds. 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.
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 Price (Pence)
Dividend Yield %
Price: RAB (Estimate)
|Veolia Water Sale||130%||16.0|
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