bernstein uk water primer_5.20.2014

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May 20, 2014

Deepa Venkateswaran, ACA (Senior Analyst) [email protected] +44-207-170-4915Mayan Uthayakumar [email protected] +44-207-170-0510Raj Hans, ACA [email protected] +44-207-170-5171

See Disclosure Appendix of this report for important disclosures and analyst certifications.

Industry Primer: UK and German Utilities: UK water sector primer

Ticker Rating CUR

16 May 2014ClosingPrice

TargetPrice

TTMRel.Perf.

EPS P/E

2013A 2014E 2015E 2013A 2014E 2015E YieldUU/.LN O GBp 837.50 950.00 2.0% 39.05 44.61 47.10 21.4 18.8 17.8 4.3%SVT.LN M GBp 1909.00 1900.00 -15.2% 101.10 85.50 88.90 18.9 22.3 21.5 4.2%MSDLE15 1392.81 87.10 94.33 105.98 16.0 14.8 13.1 3.3%

O Outperform, M Market-Perform, U Underperform, N Not Rated

Highlights

Following our coverage initiation on 8 UK and German Utility companies (UK and German Utilities:Initiating Coverage with a Positive Stance on UK Regulated Names and German Utilities ) we provide a primer on the UK Water sector and illustrate our reasons for a positive sector outlook. Relevant companies in our coverage include United Utilities (Outperform: PT 950p) and Severn Trent (Market-Perform: PT 1,900p).UK Water Sector: Positive Outlook (1) The sector offers robust organic growth opportunities driven by the need to replace/maintain an

ageing infrastructure (pipes, sewers) as well as changing patterns of demand and supply trends which will continue to the 2030s. This investment is expected to generate c.3-4% CAGR in regulated asset growth for United Utilities (UU) and Severn Trent (SVT) which flows immediately into earnings as they earn a regulatory return on this expanding asset base.

(2) Regulation now rewards companies that manage capex more efficiently: From April 2015, UK Water regulation will shift towards incentivising companies to spend less on capex to deliver the same outputs by allowing any savings to be split equally between shareholders and customers. We see this as a win-win outcome for all stakeholders. While financing efficiencies (beating the regulator's allowed cost of debt) will still be relevant, it will be a smaller driver for company outperformance in the future. Other changes to the regulatory regime also include:- Separate price controls for wholesale and retail activities (no significant impact)- A lower allowed return versus the previous price control- More tools for companies to manage credit ratings by adjusting the ratio of expenditure capitalised

(3) Acquisition interest in the water sector is an additional upside: We believe the sector with its steady inflation protected cash-flows and dividends will remain attractive to pension and infrastructure funds, and we anticipate renewed acquisition interest once the regulatory settlement is finalised (Dec 2014). Our analysis suggests c.30% premium to regulated asset values remains relevant driven by lower cost of equity, financial gearing and efficiency savings.

(4) Dividend policy is an important balancing tool to manage optimal gearing: Debt has been very important for financing the sector's capex growth and will continue to be so. The regulator has a duty to ensure that regulated water companies are financeable (i.e. able to maintain an investment grade rating

For the exclusive use of CAMERON COHEN at III CAPITAL MANAGEMENT on 17-Apr-2015

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after allowance for reasonable dividends) while assuming a notional gearing ratio that the regulator considers efficient. Dividends are the main tool to manage the sector's gearing and therefore dividends have always been in excess of free-cash flows. Therefore, we don't consider high dividend payout ratios or dividends in excess of free cash flows as unsustainable given the regulatory framework.

Investment Conclusion

We are positive on the UK water sector given its organic growth opportunities, change in regulation rewarding more efficiencies and exposure to acquisition interest. Within our coverage we rate UU as Outperform and SVT as Market-Perform, given stock specific considerations.Details

Background on our water coverage

Our coverage includes two UK water stocks that are pure-play regulated companies that operate right across the water value chain (Exhibit 1).

Exhibit 1Our UK water sector snapshot

Source: Bernstein estimates and analysis; Company reports; wikimediacommons

United Utilities (UU/.LN): The ugly duckling will turn into a swan Outperform (950p PT)We expect strong financial and operational performance in the next price control period. We forecast RCVgrowth of +3% p.a (2014-20E) with potential to increase to +4% p.a. if UU is able to resolve scoping of waste water project capex with the regulator. UU has good scope for financial outperformance (+75 bps ROE) due to historic funding decisions and operational outperformance (+230 bps) from totex savings and other incentives linked to the delivery of outcomes. In our view, UU remains attractive to infrastructure investors even after allowed returns have been lowered under the new price control. We do not expect uncertainties in the new price control to have a significant impact (retail cost to serve c.1% EBIT impact p.a.; capex challenge results in +3% p.a. RCV growth vs +4% p.a). In our view, the current valuation is attractive with UU trading at a c.17% FY15E P/E discount to SVT despite relatively higher dividend growth under the new price control (+3% vs +1%) and similar RCV growth (+3%). Our 12 month PT of 950p is based on an average of a DCF and DDM methodology and implies +13% upside potential. We rate United Utilities Outperform. SVT (SVT.LN): Fairly valued, absent another takeover bid Market-Perform (1,900p PT)SVT, like UU also has ~3% asset growth p.a and similar scope for operational outperformance but the scope for financial outperformance is lower given its historic funding decisions (~15 bps ROE vs 75bps for UU). Its current dividend policy at RPI+3% growth (vs UU at RPI + 2% growth) is aggressive and will need to be revised in 2016 (15% cut per our calculations) to reflect one-off change in earnings from a lower allowed WACC (3.8% real vs 5.1% real) and safeguard its balance-sheet strength. In our view, a financial


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player is less likely to bid for SVT, given that they were not particularly receptive to an earlier bid in summer 2013 which was in line with valuations in prior deals in the sector. We prefer UU to SVT and rate SVT as Market-Perform.


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UK Water Sector Primer

Overview

The water sector was corporatized in 1974 and under Government ownership until the sector was privatised in 1989. There was substantial under-investment in the UK water sector in the mid-1970s and throughout the 1980s due to fiscal pressures.The water sector was privatised in 1989 in line with the broad privatisation agenda of the Thatcher Government when other firms such as British Telecom and British Gas were already privatised. There was also a clear desire for private capital to fund the substantial future capex needs in the underinvested sector to improve the quality of water and waste disposal in line with EU directives that would be in force in the 1990s (Bathing Water Directive, Drinking Water Directive, Urban Waste Water Treatment Directive, etc).To enable the privatisation to be attractive to investors at privatisation, the Government wrote-off 5bn of existing public debt as well as provided additional 1.6bn of cash. At this point it was envisaged that private capital (equity and debt) could support additional capital programmes through additional debt over the course of the next decade.At privatisation as well as in the mid 1990s, it was considered that the industry would reach a steady state with the scale of capital investments coming down substantially after 2000. In reality, however, the scale of investments has continued to grow since 2000 due to tightening environmental standards and enhanced legislation. Since privatisation, a system of economic regulation (RPI +/- K factor) was introduced with the building blocks of Regulated Capital Value (referred to as RCV in this note), allowed returns (WACC), and price limits (K) which continue to date. The RCV concept enabled the industry to move from charging customers on a Pay as you Go basis to a system where capital costs are recovered over a period of time by way of return on the RCV and capital maintenance charges. We have illustrated the economics in Exhibit 2 and Exhibit 3. The RCV is a regulatory construct of the economic value of the assets which will be remunerated over the future and can be viewed as an important reference point for the valuation of a company. Growth in RCVincreases operating earnings, as allowed returns are earned over a higher asset base. Water and waste companies in England and Wales are regulated by the Office of Water (Ofwat).


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Exhibit 2How is the allowed revenue for the regulated water utility sector calculated?

Source: Bernstein analysis

Allowed revenues

Opex allowance (till 2014/15) orFast money f rom 2015/16

Capital maintenance charges1 (depreciation)

Return on capital

Allowed vanilla WACC (real)

Regulated Asset Base (RAV)Cash taxes

Opening balance of RCV

Capex allowance/ Slow money

Capital maintenance charges1 (~

depreciation)

RPI inf lation adjustment

Real cost of debt (pre-tax)

Real cost of equity (post-tax)

Notional gearing

(1- Notional gearing)

Real year on year price increase (K)

Inf lation change (RPI)

1 Current cost depreciation and Infrastructure Renewal Charge (15 year smoothed average of the infrastructure renewals expenditure)

Incentives/ penalties

Market cap at privatisation plus investments, depreciated at current cost accounting basis and inflated by inflation each year

Typically based on relative performance in the previous price control period

Regulators view of efficient level of capex determined after challenging business plans

Regulators view of efficient level of opex determined after challenging business plans

% change in revenue needed each year, after allowing for Inflation to realise the allowed revenue key driver of earnings


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Exhibit 3What determines profits for the regulated water utility sector?

Source: Bernstein analysis

This regulatory framework is currently under review with significant changes to the drivers of allowed revenues from April 2015 onwards these changes are outlined later in this note. The timeline of the transition to the next price control effective from April 2015 to March 2020 is outlined in Exhibit 4.

Prof its to equity holders

Allowed revenues (nominal terms) Includes yearly infaltion uplift and incentives for

outperformance

Actual opex

Depreciation based on historical cost accounting

assumptions

Infrastructure renewals expenditure

Cash + deferred taxes

Actual interest cost

Actual cost of debt

Actual gearing


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Exhibit 4Time-line of regulatory price-control

Source: Ofwat, Bernstein analysis

Out of the 10 original water and waste companies privatised and listed in 1989, only three are still listed (United Utilities, Severn Trent and South West Water which is trading as Pennon, not covered); the rest are largely under the ownership of financial investors/ infrastructure funds (Exhibit 5).

Exhibit 5M&A history of UK water companies

Source: FT, Capital IQ, Ofwat/Defra report, Bernstein analysis

2014 2015D J F M A M J J A S O N D J F M A MActivity

Next regulatory period begins

Dividend policy

Time period for companies to acceptor challenge with Competition Mkt Authority

Final determinations 12. Dec 2014

Draft determinations (cost allowances, incentives)

Aug determination29. Aug 2014

Refinements of business plan& submission of evidence

27. Jun 2014Submission for Aug decision

Regulatory assessment of business plans

WACC finalised

Business plans submitted

Original privatised players

Corporate name Comments Current owners Date

Anglian Water AWG PLC Owned by a consortium called Osprey since 2006. Acquired in Oct 2006 for 2.25bn equity (and assumed debt of 3.2bn ). Total EV of $5.5bn.

Industry Funds Management (19.8%), 3i (15%), Canada Pension Plan (32.9%), Colonial First State (32.3%)

2002, 2006

Yorkshire Water Kelda Group Acquired in Nov 2007 for 3bn equity (5.5bn EV) by financial consortium (Saltaire)

Citigroup (47.1), Infracapital (19.6%), GIC (26.32%)

2007

Southern Water Southern Water Acquired by Scottish Power in June 1996 (hostile bid) for 1.7bn equity and then sold to RBS PE/Vivendi in March 2002 for 2bn EV (1.9bn equity & 0.1 debt) then sold to other financial players (Greensands) in 2007 for 4.2bn

IIF International (28.1%), Future Fund (23.4%), UBS (15.6%), Australisian Super Ann Fund (15.7%), Sumaya (4.8%), Sky Brace (4.8%), Hermes (3.9%)

1996, 2002, 2007

Thames Water Thames Water Acquired by RWE in September 20, 2000 for 4.3bn equity; sold to Macquire on 16/10/2006 for 8bn EV (4.8 billion cash & net debt of 3.2bn)

Macquire (68.4%); CIC (8.68%); ADIA (9.9%); BT Pension (13%)

2000, 2007

Northumbrian water Northumbrian Water Acquired in 1995 by Lyonnaise (itself acquired by Suex in 1997) for 823m; sold in 2003 by Suez to a financial consortium consortium - 2.2bn equity & 2.5b EV and relisted; Acquired in August 2011 by Cheung Kong Infrastructure for 4.7bn EV (Equity of 2.4bn & debt of 2.3bn)

Cheung Kong Infrastructure (100%) 2011

Severn Trent Water Severn Trent Longriver consortium bid (5.3 bn EV) Public 2013Welsh Water Welsh Water WPD took over Hyder in 2000 and then sold water business to Glas

Cymru from 2001 onwards. Current ownership structure is mutualMutual 2000

Wessex water Wessex Water Acquired by Enron in July 1998 for $2.3bn equity & $0.5bn debt ($2.9 EV) then sold to YTL Power (Malaysia) on 21/5/2002

YTL Power International (Malaysia) (100%)

1998, 2002

South West Water Pennon Group Listed PublicNorth West Water United Utilities Listed Public


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Unsurprisingly, the Water sector is sensitive to M&A developments as well as changes to the regulatory metrics explained above (Exhibit 6).

Exhibit 6Water sector stocks have been sensitive to changes in regulation and M&A

Source: Media reports, Bloomberg, Capital IQ, Bernstein analysis

The next section outlines the 4 key areas that justify our positive outlook on the UK Water sector. These areas are: 1) Opportunities of continued robust growth, 2) Positive shift in regulation, 3) The M&A environment and 4) The interplay of gearing and dividends in our stock coverage in this sector.

Golden share held by the Govt

M&A activity by strategic buyers (Scottish Power, SAUR,

Lyonnaise/Suez, RWE, Enron)

M&A activity by financial players (Macquire, CKI, etc)

100

150

200

250

300

350

400

450

500

550Sector privatised with zero debt (Govt debt written-off prior to floating). 10 Water & Waste Companies listed

Price limits set for 10 years by the Government - real price increase of 5%

Windfall tax on utilities by new labour Government

First price control by regulator: Regulator resets original price limits reducing the price increases to 1%

Second price control by regulator: Regulator further slashes price-limits with a 12.3% in the first yearPower to disconnect non-paying households removed

Third price control: Positive price control with a first year increase of 9.6% and average increases of 2.9% after that

Fourth price control: harsher control with a first year decrease of -0.6% and modest increases after that

Significant M&Aactivity with a number of acquisitions by financial p layers

Longriver financial consortium takeover of Severn Trent -rejected & withdrawn

Dispute with regulator on modification of licence resolved amicably in the 3rdround of drafting

ONS review of inflation metric RPI retained

Price movements of the water sector (Mkt cap weighted index of SVT, UU, PNN prices) since privatisation

27TH Jan: WACCconfirmed at 3.8% vs4.1% bid


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(1) The sector offers robust organic growth opportunities

Sector growth is driven by the need to replace/maintain ageing infrastructure (pipes, sewers etc) as well as changing patterns of demand and supply trends which we expect to continue to the 2030s. The industry has invested 70 bn since privatisation on maintenance, quality improvements and addressing supply/demand changes which has consequently increased water bills (Exhibit 7, Exhibit 8 and Exhibit 9).

Exhibit 7Water bills have risen by more than inflation

Source: Ofwat documents, Bernstein analysis and estimates

0

50

100

150

200

250

300

350

400

450

1990 1995 2000 2005 2010 2015

Bill per household (, real todays prices)Bill per household (, nominal)

Water & waste bill per household, per annum,

4.7%1.7%

CAGR


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Exhibit 8 due to significant amount of capex in the sector

Source: Ofwat documents and estimates, Bernstein analysis

Exhibit 9Breakdown of historic capex investments over time

Source: Ofwat documents and estimates, Bernstein analysis

AMP 5 (projections)AMP 4AMP 3AMP 2AMP 1

Capex spend of the industry (nominal values), bn

4.6

2010

4.2

2009

4.7

2008

5.1

2007

4.4

2006

3.4

2005

3.6

2004

3.7

2003

3.5

+4%

4

1.8

2002

3.0

2001

2.7

2000

3.6

1999

3.6

1998

3.6

1997

3.2

1996

2.4

1995

2.2

1994

2.5

1993

4.5

1992

3.1

1991

2.5

1990 2014

2.8

5.2

2013

5.7

2012

5.8

2011 2015

EnhancementsMaintainance

43% 42% 46%53% 59%

37% 41%39% 26%

25%

13% 12%13%

18% 11%7% 5% 5%Enhance service

Quality improvements

Supply demand balance

Maintainance

2011-15E

25,811

2006-2010

21,6934%

2001-2005

16,3772%

1996-2000

16,436

1990-1995

14,874100%

Mandatory investments to improve drinking water andenvironment. Significant portion of this is driven by EU directives. Examples treatment of drinking water to remove traces of pollutants and treatment of waste to further improve quality of discharges.

Maintaining and replacing assets such as mains & pipes and treatment plants to sustain the same level of service and quality to consumers now and in the future.

Investments to reduce leakage, ensure adequacy of water supply, metering, new connections

Investments to enhance services to customers such as reducing pressure problems and sewer flooding


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We expect organic growth drivers for capex to continue and forecast 140 bn of investments to 2030 (Exhibit 10).

Exhibit 10We expect investment levels will continue due to strong drivers for future investments

Source: Bernstein analysis and estimates, Ofwat (2011-2015 capex estimates)

Investment going forward will be broken down as follows: Maintenance: Will increase with the installed asset base of the industry Demand and supply drivers: A combination of climate change, over abstraction and population growth

will put a number of regions under water stress requiring investments to improve the supply-demand balance. Climate change is impacting flood and drought patterns and parts of the country are expected to have substantial water shortages. This will require investments in better interconnections and other solutions such as desalination. The growing population in the UK, especially in predicted water stressed areas will exacerbate the need for continued investment (Exhibit 11).

Quality: Despite significant investments in quality, current level of investments are set to continue to meet ever tightening standards. The EU Water Framework Directive which came into force in 2000 requires that all EU water bodies achieve good ecological status by 2015. The UK is currently only at 27% of the target and is likely to take until 2030 to reach the target (Exhibit 12). Ofwat estimates it could cost 30 bn to 100 bn to 2030 to comply with EU Water Directive. Therefore we are comfortable with our assertion that investments are expected to continue long term.

Maintenance

Demand and supply

Others

Quality

Maintenance spend (~60%) of the spend will continue as in the past and increase slightly as the overall asset base of the industry continues to expand

Annual average capex levels, m (2013 real prices)

While substantial investment has been made to improve the quality, the UK is still lagging behind EU ambitions transposed into national laws and will have to continue to invest in quality improvement

Investments will continue on other areas such as improving water pressure, adoption of private sewers, etc

Climate change is impacting flood and drought patterns and parts of the country are expected to have substantial water shortages. This will require investments in better interconnections, other solutions such as desalination

Growing population in UK specially in water stressed areas UK is one of the few European countries with growing population

0.2

0.5

1.1

2.6

0.3

0.6

0.8

2.8

2016E-2030E2011-2015

Drivers of water sector investment


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Exhibit 11High levels of water stress predicted

Exhibit 12Only 27% of UK's water bodies are at 'good or better' standards

Source: Environmental Agency Source: Environmental Agency

With this need for continued investment comes the growth of water companies' asset base (c.3-4% pa for both UU and SVT) which in turn maximises return on capital/allowed revenues as per Exhibit 2. (2) Regulation now rewards companies that manage capex more efficiently

From April 2015, UK Water regulation will shift towards incentivising companies to spend less on capex to deliver the same outputs by allowing any savings to be split equally between shareholders and customers (Exhibit 13). We see this as a win-win outcome for all stakeholders. While financing efficiencies (beating the regulator's allowed cost of debt) will still be relevant, it will be a smaller driver for company outperformance in the future.


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Exhibit 13The regulator has moved to a new regulatory model focused on Outputs, Incentives and Innovation


Specifically, Ofwat's new price review (PR14) will have four key impacts (1) lower allowed returns (2) separate price controls for wholesale and retail activity (3) a stronger focus on incentivising operating /capital cost efficiency and service quality and (4) more tools to manage credit ratings.- (1) Lower allowed returns: The new price control (AMP 6) focuses more on operational

outperformance following significant financing outperformance under the two previous price controls. Ofwat has reduced the allowed cost of capital (Vanilla WACC, real) in the next price review from 5.1% to 3.8% driven by a 22% lower real cost of debt and a 20% lower cost of equity (Exhibit 15). This change reflects the regulator's view that the cost of equity and debt have fallen since the last price control reset in 2009 and a higher level of gearing is more appropriate. This rebasing of allowed returns is not new (Exhibit 6) and has been a feature since the first price control (Exhibit 14).

Outputs

Incentives

Innovation

Operational performance over financial

Focus on Outputs on reliability and environmental performance.

Stronger incentives than before to gain share with shareholders (e.g 50% shareholder sharing of capex savings now vs ~20% before)

Create opportunities to innovate leeway for a solution with high opex and low capex vsprevious regime where only capex heavy solutions were incentivised

Reduced incentives on financial outperformance

Higher incentives on operational outperformance


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Exhibit 14Allowed returns have reduced over most periods reflecting falling real yields and high gearing assumptions

Source: Ofwat, Bernstein analysis and estimates * Vanilla WACC = Post-tax cost of equity * Equity weight + Pre-tax cost of debt * debt weight

Allowed returns, % real

1 Post tax cost of equity and pre-tax cost of debt

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020

60

50

15

40

2530

5

20

35

10

109

876

1

0

5

45

4

32

55

65

Real spot risk-f ree yieldGearing (RHS)Cost of debt

Cost of equityAllowed WACC (Vanilla)1

Notional gearing, Net debt/ RCV(RHS)


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Exhibit 15Ofwat has reduced its allowed cost of capital for the next price review reducing the scope for financing outperformance

Source: Bernstein analysis, Company data

- (2) Separate price controls for wholesale and retail activity: The new regulation will separate price controls for water companies' wholesale and retail operations into four distinct segments as compared to the current singular price control overall (Exhibit 16). The rationale for this change is to enable full competition in non-residential retail from 2017 and provide the residential retail business with greater incentives to deliver efficient services under a new 'average cost to serve' approach (i.e. water companies can only charge based on average cost of industry). We do not expect the impact of liberalising the non-residential retail sector to be significant as it is less than 3% industry revenues (Exhibit 17).

Allowed vanilla WACC (real)

Real cost of debt (pre-tax)

Real cost of equity (post-tax)

Notional gearing

(1- Notional gearing)

Equity risk premium

Equity Beta

Risk f ree rate

Ofwat assumption: 2010-2015

New Ofwat determination: 2016-2020

0.80.9

5.55.4

1.252.0

38.542.5

62.5 57.5

7.15.7.

2.8 3.6

3.8 5.1

The determination is lower than National Grids determinations concluded last year (4.4%) but in line with the Competition Commissions rulings on Bristol Water and draft determination for a Northern Ireland based utility


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Exhibit 16The next price control is broken into 4 price controls to align with ambitions to liberalise the sector


Retail B2C-Water

Retail B2C-Waste

Retail B2BWater

Retail B2B -Waste

Distribution - Raw and treated water

Sewage collection and transport

Water treatment

Waste treatment

Waste disposal

Water resources (abstraction)

Waste value chain

Water value chain

Upstream Mid-stream/ Downstream Downstream

Monopoly no intention to liberalise

Could open to competition beyond 2020

B2B opening to competition in 2017

1

2

3

4

3

4

1 Wholesale Water price control 2 Wholesale Waste price control 3 Household (B2C) price control 4 Non-Household (B2B) price control


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Exhibit 17The portion being liberalized (non household retail) has minimal impact economic as it is less than 3% of revenues and less than 1% of profits

Source: Regulatory accounts; Bernstein analysis

- (3) Stronger focus on incentivising operating and capital cost efficiency and service qualityOfwat is introducing a 'totex' model of incentivising efficient operating and capital cost management ('totex' is equivalent to total expenditure or the sum of controllable opex and capex). Using independent assessment and information from companies, Ofwat will determine the efficient level of expected costs necessary to deliver the key outputs. A 'sharing factor' provides the incentive for players to outperform (under-spend) the allowed level of totex because it can keep a portion of the savings (50%) and pass the balance onto customers. The sharing factor encourages companies to innovate through for example the use of technology to deliver outputs more efficiently. Totex is split between fast and slow money, based on a specific percentage (typically 50:50 split but flexibility is given to companies to propose their own). Fast money is the amount of totex that can be recovered in the year and slow money is added to RCV. Other operational incentives will also increase or decrease allowed revenues and are dependent on performance against various operational / service quality measures. The regulator has made this change (Exhibit 18) to lower the reliance on historically 'easy' financial outperformance and focus on operational efficiency as well as encourage companies to reduce total expenditure, and overcome the previous capex bias (Exhibit 19).

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

75

90

60

45

30

15

0

Split

of as

sets

, %

Split of revenues, %

Retail - non-householdRetail - household

Sewage collection and transport

Water distribution

Sewerage & sludge Treatment

Sludge disposal

Water treatment

Water resources

Bubble size represents net margin~10%


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Exhibit 18In the current price control and the previous price control, companies have been able to capture financial outperformance by beating the allowed cost of debt

Source:Bernstein analysis, company reports

Exhibit 19The new price control offers upsides from operational efficiencies more challenging but possible for good management teams

Source: Ofwat, Bernstein analysis and estimates

4.7 4.6 4.0 4.0 4.1 4.1

5.84.7 4.8

5.7 5.5 4.95.8 5.6 5.6

6.4 6.4 5.9

8.2 8.67.3

3.9

8.3 8.8

2013A

5.3

2010A 2011A 2012A2009A2008A

5.8

United Utilities Allowed interestSevern TrentSouth West Water (Pennon)

Effective nominal interest rate, %

Range of allowed cost of debt in 2016-2020

5.9

Total

8.3-11

Business retail

0.2

Financing

0.1- 1.7

SIM

0.3

Performance incentives

1-2

Cost incentive

1-2

Base allowed return on equity

Real post tax return on regulated equity new price control (2016 onwards) theoretical upside, %

Real post tax return on regulated equity current price control (until 2015) upside, %

7.1

Total

10-10.5

SIM

0.3

Financing

2-2.5

Base allowed return on equity


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- (4) Greater flexibility to manage credit ratings: In the new price control, companies have the discretion to propose a faster or slower depreciation profile as well as decide how much of the totex is fast money (received in year) vs slow money (added to the regulated asset value). This has the impact of giving companies more flexibility to manage cash flows from operations. This can however create a disconnect between regulatory earnings and IFRS earnings if for instance the opex per IFRS and fast money amounts are significantly different. As a result, we would encourage investors to focus on both IFRS and regulated earnings going forward.

(3) Acquisition interest in the sector is an additional upside

Although the post tax real rate of return is now 3.8% under the new price control (2016-20), down from 5.1% previously, we believe the sector is of interest to infrastructure investors. These businesses are characterised by stable, inflation linked returns underpinned by a regulated asset which is attractive to infrastructure investors in a benign debt market (low real interest rates and low corporate debt spreads).We believe returns are attractive relative to very low rates on offer from other inflation linked assets (e.g. UK index-linked gilts are at negative levels in real terms). With the yield on government inflation-linked debt very low, the water sector's relative returns make an attractive inflation hedge. Secondly, we believe returns are stable because although rates are lower in the next price control period, the reduction takes place within a stable regulatory framework.How much have infrastructure investors been willing to pay in the past?

Since 2006 infrastructure investors have bid close to 30% RCV premiums for UK water companies (Exhibit 20). The premiums are calculated as the purchase price (EV) relative to the regulatory asset value. The unsuccessful offer for Severn Trent from the LongRiver consortium in 2013 was at around a 30% premium to 1-year forward RCV, in line with historical transaction premia. We note that these valuations were reached under the AMP 4 and AMP 5 (current) price controls.

Exhibit 20Financial players have bid close to 30% premiums to RCVPremium to trailing RCV (%), AMP 4 and AMP 5 (SVT failed bid)

Source: Bernstein analysis, Company data

Anglian Water Kelda Group

Southern WaterThames WaterNorthumbrian Water

Severn Trent

0%

10%

20%

30%

40%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014


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20

How were historical premiums to RCV of around 30% justified?

We have created a simple illustrative model to understand the key assumptions required to justify historical levels of premia paid. If a regulated company is expected to deliver returns exactly in line with its allowed returns, and if the allowed return is in line with market expectations, then the EV/RCV multiple should be 1.0x. We consider several key variables that could drive actual returns above allowed returns thereby justifying a premium valuation (EV/RCV >1.0x). The key variables in our model are (1) the level of gearing (2) the cost of debt and (3) the cost of equity: - 25% increase in gearing (up to 72% from the notional regulatory amount of 57.5% AMP 5) - 45% reduction in the cost of debt (-160 bps vs the allowed cost of debt of 3.6% AMP 5) - 11% reduction in the cost of equity (to 6.3% vs allowed 7.1% AMP 5)

The above combination can support a 30% premium to RCV under the current price control AMP 5 (Exhibit 21). We believe the spread between historical transaction premia of around 30% and the total premium to RCV implied by our sensitivity analysis indicates the value available for capture by infrastructure investors (c.25%). We base our gearing assumption of 72% on the industry average under AMP 5. Our 25% reduction in cost of debt assumption is supported by the industry average 160 bps cost of debt outperformance over 3 years of AMP 5 (2011-13). We expect infrastructure investors to arbitrage the different cost of equity vs public markets. Our 25% reduction in the cost of equity is based on an equity beta of 0.8 vs the regulator's equity beta of 0.9.

Exhibit 21Justifying historical 30% premium to RCVSensitivity analysis (AMP 5) premium to RCV (%)

Exhibit 22Water companies remain attractive to infra-investors Sensitivity analysis (AMP 6) premium to RCV (%)

Source: Bernstein analysis, Ofwat, Capital IQ Source: Bernstein analysis, Ofwat, Capital IQ

31%

17%

8%

56%

26%

30%

0% 20% 40% 60%

Value capture (buyer)

Premium paid

Total value

Gearing +25%

COD -45%

COE -11%

18%

8%

32%

66%

36%

30%

0% 20% 40% 60%

Value capture (buyer)

Premium paid

Total value

Gearing +25%

COD -21%

Incentives +200bps ROE

COE -11%


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21

We believe c.30% premiums to RCV for UK water companies can be justified under the new price control as well

Our illustrative analysis shows that the value available for capture by infrastructure investors has not been reduced by the lowered level of allowed returns (Exhibit 22). We make the following combination of assumptions and show that a 30% premium can still be justified under the new price control (AMP 6).- 25% increase in gearing (up to 75% from public company gearing level of 60.0% AMP 6) - 21% reduction in the cost of debt (-60 bps vs the allowed cost of debt of 2.8% AMP 6) - 11% reduction in the cost of equity (to 5.1% vs allowed 5.7% AMP 6) - Incentives: add 200 bps to ROE

We base our gearing assumption of 75% on the mid-point of the gearing range for highly geared private UK water companies. In our view a c.20% reduction in cost of debt under AMP 6 could be supported by raising new debt at a shorter maturity and lower cost and continued access to low cost funding options like the European Investment Bank. Our c.10% reduction in the cost of equity is based on an equity beta of 0.7 vs the regulator's equity beta of 0.8. Under the new price control, incentives provide scope for returns above the allowed level. We assume totex savings and other incentives add +200 bps to ROE. When would acquisition interest likely materialise?

In our view, acquisition interest is unlikely in the near-term as prospective investors are seeking clarity on the regulatory settlement for the next price control period. Once the price control is finalised at the end of this year (Dec 2014) and accepted by the company (Jan/Feb 2015) without a Competition and Markets Authority (CMA) appeal, we could see a renewed interest in the sector from infrastructure investors.


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(4) Dividend policy is an important balancing tool to manage optimal gearing

Debt has been very important for financing the sector's capex growth and will continue to be so. The regulator has a duty to ensure that companies are financeable (i.e. able to maintain an investment grade rating after allowance for reasonable dividends), assuming a notional gearing ratio that the regulator considers efficient (Exhibit 23).

Exhibit 23Evolution of the water industry Regulated Asset Value

Source: Bernstein analysis and estimates, Ofwat

Most equity comes from retained earnings and new equity has been very rare United Utilities rights issue in 2003 has been the only public issue. A few privately held companies have had small equity injections to avoid breach of covenants eg Southern Water, Anglian. Dividends are the main tool to manage the sector's gearing and therefore dividends have always been in excess of free-cash flows (Exhibit 24) for the following reasons: Firstly, the nature of the investment programme is such that a significant amount of capex is required and

asset lives are significant (50+ years) meaning depreciation (and therefore in year allowed return) is much lower than the level of capex. The entire model is to enable the industry to finance long-lived assets on behalf of consumers rather than charge on a PAYGO basis.

As the RCV grows with new capex and inflation, the absolute amount of debt will have to grow to maintain the same gearing (which companies will aspire to keep at least at the level the regulator considers efficient). If the industry did not pay dividends in excess of FCFs, it would never achieve the

10095

908580

757065

6055

504540

353025

201510

50

20302029202820272026202520242023202220212020201920182017201620152014201320122011201020092008200720062005200420032002200120001999199819971996199519941993199219911990

UK Water industry RAV, billion

Actual~70bn in capex (nominal)

~100bn in capex (real in todays money)

Forecasts~140bn in capex (nominal)

~110bn in capex (real in todays money)

0

5

10

15

20

25

30

35

40

45

50

55

60

65

70

75

80

UK Water industry gearing (Net debt/RAV), %

Gearing, %Implied equity - nominal, mDebt - nominal, m

Source: Bernstein analysis and estimates, OFWAT


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23

notional optimal gearing level implied in the regulator's determination of cost of capital. This is because each year the regulated asset base grows by the capex invested if some part of the capex were not funded by debt, the sector will not be able to maintain the efficient level of gearing implied in the regulator's cost of capital determination.

The capital structure, keeping in mind a target RCV gearing will evolve by:- Raising new debt and/or- Adjusting the level of equity in the business with dividend pay-out/ buy-backs

Separately, unlike other business, there is little opportunity to reinvest above and beyond the allowed investment so the safer alternative is return as much back to shareholders as is required to maintain the notional gearing

The only other boundary condition is the credit rating agencies' view of balance-sheet strength which would cause the pay-out ratio to be suboptimal

Likewise, if the regulatory target on efficiencies is challenging, management teams may prefer the pay-out ratio to be conservative till they get more comfortable with delivery

Therefore, we don't consider high dividend payout ratios or dividends in excess of free cash flows as unsustainable given the regulatory construct outlined above.

Exhibit 24The water industry has paid dividends in excess of free-cashflows since the 1990s

Source: Ofwat performance summaries, Bernstein analysis

54

444

3333

3

3333

4

44

4

3333

33

333

3

2

2

1

3

2

111

111

22

1

2002 20041998 20102006 200719991997 2003 20082001 20052000 2009

CFO Capex Dividends


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Exhibit 25As the regulator pushes up the frontier of what the notional gearing level should be, the industry has readjusted with increased dividends

Source: Ofwat performance summaries, Bernstein analysis

05

1015202530354045505560657075

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 20090

5

10

15

20Dividend as % of regulated equity (RHS)Gearing (actual)Gearing (notional - regulator)


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Disclosure AppendixValuation Methodology

We value our UK water companies based on an average of Sum of the Parts DCF and Dividend Discount Model.

Risks

UU:- Execution/ delivery challenges- Sharp increase in interest rates/ deterioration in access to credit- Regulatory / political interference tampering with any agreed regulatory deal

SVT:Key downside risks:- Execution/ delivery challenges- Sharp increase in interest rates/ deterioration in access to credit- Regulatory / political interference tampering with any agreed regulatory deal

Key upside risks:- Acquisition interest materialised immediately

European UtilitiesAdverse changes in regulation/policyAdverse credit conditions limiting access to credit


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bernstein uk water primer_5.20.2014

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