A proposed 125bps return cut for the UK water utilities
Ofwat, the UK water regulator, published on Jan 27 its view on key financial parameters for the 2014 price review. This is relevant to CKI, given it holds a 40% stake in UK Water (which owns Northumbrian Water) whose profit contributions accounted for c.12% of CKI’s reported net profit in 2012. The key highlight of Ofwat’s announcement is that it is proposing a 90-100bps lower real cost of equity (Ke) of 5.6-5.7% and a point estimate for the real vanilla WACC of 3.85%, a 125bps cut vs. the 5.1% in the current pricing control period ending March 2015 (Northumbrian Water is proposing 4.1%).
A possibility of an even lower return…
Ofwat has been explicit in its publication that the real vanilla WACC is expected to be “no higher than 3.85%”, which suggests an even lower return could be possible. We believe a change in Ofwat’s view looks unlikely though it seems that Ofwat would consider adjusting the WACC if there were changes in the financial markets during the review process. Our valuation for CKI’s stake in UK Water implies a 1.3x EV/RAB, which does not look conservative when compared to the 1.15x EV/RAB assumed by our UK water analyst James Brand for his UK water companies coverage. UK Water accounts for c.10% of our sum-of-the-parts valuation for CKI.
…though some scope for outperformance vs. the previous regulatory review
Ofwat will also allow for greater scope of rewards/penalties in its risk and reward guidance, offering the water companies the ability to outperform/ underperform by 1.3-1.7% on the allowed WACC or 3.5-4.5% on the allowed Ke of 5.6-5.7%. Ofwat may also allow water companies flexibility to adjust for their financial leverage which could help water companies to better manage its cashflows and mitigate the impact of a lower allowed return.
UK utilities regulatory review timetable; a likely lower real Ke for UKPN
Ofwat will rank the water utilities and announce the results on 4 April 2014 (fast-tracked companies will be notified and announced on March 10). On a separate note, Ofgem, the UK energy regulator, will likely decide on the allowed cost of equity in February 2014 after conducting a consultation its cost of equity calculation methodology. This is also relevant to CKI (and Power Assets, “PAH” as well), given each of them holds a 40% equity stake in the UK Power Networks (UKPN) whose profit contributions accounted for 37% of CKI's and >30% of PAH's reported net profits in 2012. For more details, please refer to our note: “CKI/Power Assets – UK energy regulator’s release highlights downside risk to return” dated 25 November 2013.