Changing face of water utilities
Chris Webb reviews the likelihood of UK water industry reform, as regulatory constraints limit water companies' competitiveness in the global market and credit profiles weaken
No southern comfort
November was a nerve-racking month for Scottish Power, whose planned sale of its Southern Water subsidiary hung by a thread. Italian power company Enel had already withdrawn an offer to acquire Southern, which the firm had seen as an alternative to the difficult acquisition of Acquedotto Pugliese, but said the £1.8Bn deal was too big to swallow. The path is now clear for Centrica, in alliance with Vivendi of France.
There were fears, however, the two may find it difficult to secure regulatory clearances, while Scottish Power may have difficulty raising the £1.7Bn it wants from the sale. It paid £1.68Bn for Southern in 1996.
There is generally anxiety and dismay among water companies who feel their hands are tightly bound when it comes to any prospect of organic growth. As a result, Standard & Poor's (S&P) believe the UK water industry could be entering its first major wave of reform since privatisation. S&P has been reviewing a number of restructuring proposals, ranging from simply gearing up balance sheets, to splitting assets ownership from operations, to a full demerger of the asset company from operations. One of the main drivers for restructuring, S&P believes, is that since privatisation, most operating and capital efficiencies have been fully realised.
So what might the sector look like after the reforms are complete? The short answer is that it may never be complete, although there are some likely outcomes.
It is not difficult to see why disaffection among shareholders is on the rise. All ten water and sewerage companies started life after privatisation as stock exchange listed holding companies owning 100% of shares in the regulated utility company. Starting with virtually debt-free balance sheets they proceeded to spend billions of Euros on capital investment, primarily owing to the water and wastewater quality requirements imposed by various European Union directives. While the quality of water and wastewater has generally improved, however, the companies' credit profiles have weakened, and credit ratings have suffered because of higher debt and gearing levels.
Frustration prevails in Britain, where most water utilities feel they must sit back and watch while giant utilities such as France's Suez Lyonnaise des Eaux and Germany's RWE lead an accelerating global consolidation in the water industry. RWE, which already owns Thames Water and considerable assets in the USA, said last month it was to pay a premium of 36.5% to take over American Water Works (AWW), paying $4.6Bn in cash and assuming $3.0Bn in debt, valuing the company at $7.6Bn. AWW's operations will be bundled with Thames' existing US assets. Although still the subject of regulatory clearances, RWE chief executive, Dietmar Kuhnt, was confident the deal would cement the company's position as a global player in the industry. It is thought the deal will not affect the company's plans to acquire Azurix North America, or the wastewater assets of Citizens Communications.
Meanwhile AWG, formerly Anglian Water, is putting the final touches to plans that will see it pull out of selling water and become an environmental and infrastructure support provider. The company already manages utility assets in China, Chile, the Czech Republic and Thailand. It is believed a break-up of the group, through a spin-off of its regulated water assets, could unlock capital worth £1.6Bn. Both Centrica, the gas-to-credit cards group, and Innogy, the domestic power utility formed by the break-up of National Power, are thought to be interested in the water business.
Certainly Centrica would be a favourite. A rising star in the utility firmament, it has emerged as one of the most successful implementers of the multi-utility model. To date, it appears to be the company that has gained the best understanding of what its customers value. Even so, there rem-ains a question mark over the degree to which consumers are intersted in the multi-product concept.
Key to the AWG break-up will be regulatory approval, but insiders believe Philip Fletcher's stance may differ from his predecessor's in the wake of clear and growing indications that the existing equity-based funding structure of the industry is simply unsustainable.
Ofwat blocked a bid by Kelda to set up a mutual structure last year. But there is speculation that the AWG deal could be waved through in order to stimulate restructuring of the industry in advance of the tariff review scheduled for 2005. Such a restructuring is likely to see water companies moving to reduce their cost of capital by switching funding from the equity to the debt market.
British companies such as AWG must be envious of their French counterparts, which enjoy relative freedom to expand. Utility group Suez Lyonnaise des Eaux, for example, saw its net profits rise by 11% to ¤1.41Bn. The group's 16% rise in operating profit reflected strong revenue growth from both energy and water projects, particularly related to multi-utility contracts, the company said. Multi-utility contracts for commercial customers are growing rapidly, representing about half of group revenue by the end of the year. Suez said it won no fewer than 30 major contracts with a variety of multinational clients and foreign municipalities.
Only Credit Lyonnais, it seems, is upbeat about the UK water industry, having
upgraded its recommendations on several stocks, including AWG, Kelda and Pennon
from 'add' to 'buy'. The move had an immediate, though small, effect on shares.
Yet the UK water industry is coming under increasing pressure from both shareholders
and regulatory bodies. Ofwat National
Consumer Council (ONCC) chairman Maurice Terry stressed his organisation intended to underline the key criteria that companies should meet. Realism, stability, affordability, value for money and ongoing service improvements were essential, he said. At a recent Foresight Conference he told delegates he saw no reason why further improvements should not be forthcoming.
But utilities such as Severn Trent have a different view. As a result of Ofwat-imposed rate cuts Severn Trent says it is having difficulty maintaining its UK water operations and has announced 1,100 job cuts to trim overheads. While its waste businesses, such as Biffa and the recently acquired UK Waste, continue to do well, water services are struggling.
There are also foreign would-be buyers that balk at the last hurdle, sending a clear message that UK companies might not be the hot assets that they may appear to some.
A new senior management team has bolstered United Utilities' (UU) fortunes. Aside from the provision of water and wastewater services, the company is involved in electricity distribution, telecommunications services and business process outsourcing. Like Centrica, UU is pressing ahead regardless with fine-tuning its own multi-utility model in the belief that it will deliver increased shareholder value. Recently, ratings' analysts responded to the group's improved strategic focus by giving it a 'positive' rating. The move follows UU's sale of Norweb Energi and renewed focus on the monopoly regulated water businesses which analysts say are subject to modest business risk and believe should deliver predictable cashflows up to the end of the current price control period in March 2005. UU plans to secure the combined Ofwat (£300M) and Ofgem (£100M) cost savings targets by improving efficiency of the regulated businesses.
UU is actively participating in the current wave of operational outsourcing contracts in the UK water sector, notably with Welsh Water, but management has maintained its opposition to following the Glas Cymru capital model. The £1.9Bn Glas Cymru Cyfyngedig bonds, issued to fund the acquisition of Dwr Cymru marked the first highly geared water financing to reach UK shores.
Whatever restructuring option is chosen ultimately, however, S&P believes
the overall trend will be towards higher levels of debt financing in the water
sector. Whether this translates to lower credit ratings - and that, of course,
will filter through to share values - will depend on the ability of the companies
to mitigate the higher financing risk. But there is no magical formula that
will enable a highly geared entity to achieve a solid investment grade credit
rating. Restructuring, as S&P points out, cannot turn a bad business into
a good one. For a highly geared water company to achieve a solid investment
grade credit rating, genuine