Thesis
Although its restructuring should help United Utilities Group reduce regulatory risk in the UK and support its dividend, the economic downturn and a downward revision of regulated growth through 2015 will weigh on performance.
After selling its telecommunications operations, business outsourcing unit, and electricity distribution assets, United Utilities is primarily a regulated water utility. Much of Britain's water infrastructure is around 200 years old and could require major upgrades during the next decade. United Utilities, which is one of 11 water utilities in the UK, plans to invest roughly £3.6 billion between 2010 and 2015 in its water and wastewater system to address these needs.
Unlike in the US, where regulators frequently approve utility rates only after the capital is invested, regulators in England and Wales 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. In July 2009, regulators proposed a rate cut of more than 6% in 2011 and meagre growth thereafter through 2015. These rates include a smaller investment programme and a cut in real allowed post-tax returns on capital. United Utilities accepted the proposal, as economic pressures took their political toll.
Despite this slower growth beyond 2009, we do not think current and proposed rates will threaten the company's solid current per-share distributions after "rebasing" the distribution to £0.30 per share in early 2010.
In addition, United Utilities is trying to develop a competitive advantage in operating and managing other utilities' systems. Its five UK contracts could bring in nearly £1 billion of revenue in 2010. But this business still contributes only 10% of operating profits and earns lower returns than the water utility. Although this is a business with domestic and international growth potential, we think the company could face strong pricing competition, relatively easy entry from competitors, and little operating leverage--all of which could hamper returns and prevent it from establishing an economic moat in this business. Unsurprisingly, this business is rumoured to be on the sale block.
United Utilities' regulated water-distribution monopoly leads us to assign the firm a narrow moat. But we caution investors to beware of regulatory risk in Britain's five-year price reviews and the uncertain returns in the firm's contract services business, along with the threat of a continued contraction in economic activity.
Fair Value Estimate: 528p ¦ Uncertainty Rating: Medium ¦ Economic Moat: Narrow
Valuation
We are increasing our fair value estimate to 528p from 488p after adjusting our projections for 2010-15 at both the regulated and nonregulated segments and tweaking our assumptions for staff costs and regulatory incentives. Ofwat's (The Water Services Regulation Authority) plan will lower rates by more than 6% in 2011 with only meagre growth through 2015. We anticipate that United Utilities will hit some operational incentives, amounting to 1% of regulated margin annually. Management has openly discussed selling some remaining nonregulated businesses, though we do not explicitly model any further sales. We expect lower investment rates and a less accommodative regulatory stance will slow operating earnings growth to under 2% through 2014, including a 9% decline in 2011. We use a 10% cost of equity and a 6.7% weighted average cost of capital to arrive at our fair value estimate. Our estimate is highly sensitive to our assumed WACC. If we were to increase our WACC by 50 basis points, our fair value estimate would fall to 448p. If we were to decrease it by 50 basis points, our fair value estimate would rise to 624p.
Risk
Regulatory, operating, and financing risk lead us to assign a medium fair value uncertainty rating. The five-year utility rate structure adjusts annually for inflation, but that does not always move in the same way as the company's costs for metals, labour, and other components. Regulated rates also require companies to cut as much as 3% of their costs annually to hit targets. To minimise financing risk, the company has taken on more index-linked debt.
Management & Stewardship
When CEO Philip Green and then-CFO Tim Weller took over in 2006, they made a 180-degree strategic turn. They sold off the company's nonregulated businesses and loaded up on cheap debt to maximise regulated returns. So far, this has proved successful because of favourable regulation in the water business. The second step is to improve operations to take advantage of regulatory incentives water utilities can earn through better service. Green's experience in shipping industries, where logistics are critical, suggests he could have the skills needed to make these operational improvements. We like that the bonus plans are based on earnings before interest and taxes, not earnings per share, and that executives receive only modest base salaries. The board has had three mandatory retirements and one resignation in the past year among independent directors. John McAdam took over as chairman in July 2008 from Richard Evans, who retired after serving his maximum nine years. We would like to see more board consistency and higher insider stock ownership.
Overview
Growth: Britain's water infrastructure build-out has supported 8% annual revenue growth and 14% annual profit growth since 2004. We expect that growth to slow substantially as operating profits should shrink in 2011 and capital investment and regulated rates fall through 2015.
Profitability: We expect operating margins to slip after 2010 and average 29%-30% through 2014 as new rates take effect. Low-cost debt financing and the asset-light contract services business should help keep long-run returns on capital above 7%.
Financial Health: United Utilities took advantage of the past few years' low-interest-rate environment by locking nearly a third of its debt at very low rates. The recapitalisation increased leverage and cut United Utilities' credit rating, but interest coverage should remain above 2 times.
Profile: United Utilities is a holding company for United Utilities Water, a regulated water and wastewater utility serving 3.2 million customers in northwest England, and an unregulated division that provides operations and management services to water, electric, and natural gas utilities worldwide.
Strategy: United Utilities' recapitalisation in August 2008 ended a restructuring process that took nearly two years to complete. The firm now focuses on just two areas: regulated water distribution and contracted utility services. Both businesses are strategically related in that each seeks to maximize the efficient use of owned or nonowned assets. The contracting segment could be up for sale.
Bulls Say
1. A balance sheet filled with cheap debt financed for 30 years and beyond should boost returns on invested capital for many years.
2. Relatively favourable regulation for UK water utilities currently benefits United Utilities directly through its utility operations and indirectly through its outsourcing business.
3. Regulated operations seem to be improving, increasing the likelihood that the water utility will meet regulatory incentive targets and reducing the likelihood of fines, which can be significant.
4. The group reduced its head count by nearly 500 from March 2009 through March 2010, as part of an overhaul of operations to pursue a leaner, more efficient company.
Bears Say
1. Without constantly achieving cost savings and efficiencies, the company will have a hard time earning more than its cost of capital.
2. Management has underperformed some of regulators' operational targets in the past few years, which hurts shareholders directly because of the regulatory pricing structure.
3. The July 2009 rate review was ugly, lowering rates by more than 6% in 2011 with little growth through 2015.
4. Management's move into the no-moat contract services business could increase risk for investors.
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