Much of Britain's water infrastructure is around 200 years old and could require major upgrades during the next decade. We project that United Utilities (UU.) which is one of 11 U.K. water utilities, will invest roughly £1.6 billion during the next two years in its water and wastewater system to address these needs.
Unlike in the United States, where regulators frequently approve utility rates only after the capital is invested, regulators in Britain approve capital budgets and utility rates once every five years based on utility budget forecasts. Utilities then must stay within that budget to achieve sufficient rates of return. United Utilities is currently under review for its upcoming 2015-2020 rates with a decision expected in December 2014. The current revised plan calls for average household bills falling by 4.1%.
United Utilities' regulated water-distribution monopoly leads us to assign the firm a narrow economic moat. But we caution investors to beware of execution risk in Britain's five-year price reviews, as the company must meet performance targets, along with the threat of continued conservation.
We are increasing our fair value estimate to £7.30 per share, from £6.50 per share after incorporating time-value appreciation since our last update.
Our valuation incorporates the company's capital expenditure plan and Ofwat's rates. We expect all of these factors will lead to 8% annual growth in operating profits – earnings before interest and taxes – from fiscal years 2013 to 2017. We forecast 41% average operating margins during this period.
Our total capital expenditure budget is £3.5 billion. We expect United Utilities will hit some operational incentives, amounting to 300 basis points of additional regulated margin annually out of a potential of 320 basis points of incentives. We currently don't expect any customer usage growth through fiscal year 2015. Finally, we assume a 2.0% average inflation rate, in line with Bank of England forecasts, which is added to allowed real price caps in calculating the company's allowed nominal price increases.
We use a 6.0% weighted average cost of capital based on a 8% cost of equity in our discounted cash flow valuation.
