Fair Value Estimate: 546p | Uncertainty Rating: Medium | Economic Moat: Narrow
Thesis (Last Updated 30/11/10)
Although its restructuring should help United Utilities Group (UU.) reduce business risk in England and support its dividend, the economic downturn and a downward revision of regulated growth through 2015 will weigh on performance. After selling the majority of its nonregulated businesses, United Utilities will be 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 United Kingdom water utilities, plans to invest roughly £3.6 billion between fiscal 2011 and 2015 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. The plan that United Utilities accepted incorporated a rate cut of more than 4% in 2011 and meagre growth thereafter through 2015. These rates include a smaller investment programme and a cut in real allowed posttax returns on capital.
Despite this slower growth beyond 2010, 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.
United Utilities had been trying to develop a competitive advantage in operating and managing other utilities' systems. Although this is a business with domestic and international growth potential, the company faced strong pricing competition, relatively easy entry from competitors, and little operating leverage--all of which hampered returns and prevented it from establishing an economic moat in this business. Unsurprisingly, this business is being disposed of.
United Utilities' regulated water-distribution monopoly leads us to assign the firm a narrow economic moat. But we caution investors to beware of regulatory risk in Britain's five-year price reviews, as the company must meet performance targets, along with the threat of a continued contraction in economic activity.
Valuation
We are increasing our fair value estimate to 546p per share from 528p after incorporating better-than-forecast first-half 2011 results, adjusting our cost projections for 2011-15 at the regulated segments, and incorporating the sale of most of United Utilities' remaining nonregulated businesses, which we estimate will bring in roughly £470 million. Ofwat's plan will lower rates by more than 4% 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. Divestments of the remaining nonregulated businesses have continued through fiscal 2011, and we assume management will hit its target of a total of £600 million in proceeds, including the roughly £130 million achieved in fiscal 2010. We expect lower investment rates and a less accommodative regulatory stance will slow gross margin growth to 5%. 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 451p. If we were to decrease it by 50 basis points, our fair value estimate would rise to 672p.
Risk
Regulatory, operating, and financing risk lead us to assign a medium fair value uncertainty rating. England's 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 that water utilities can earn through better service. Green's experience in shipping, 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
Financial Health: United Utilities Group took advantage of the past few years' low interest rates 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 near 2 times.
Profile: United Utilities Group is primarily a holding company for United Utilities Water, a regulated water and wastewater utility serving 3.2 million customers in northwest England, with a very small remaining nonregulated services division.
Bulls Say
-- A balance sheet filled with cheap debt financed for 30 years and beyond should boost returns on invested capital for many years.
-- Relatively favourable regulation for UK water utilities currently benefits United Utilities directly through its utility operations and indirectly through its outsourcing business.
-- 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.
-- The group reduced its head count by nearly 500 from March 2009 through March 2010, as part of an overhaul of operations to become a leaner, more efficient company.
Bears Say
-- Without constantly achieving cost savings and efficiencies, the company will have a hard time earning more than its cost of capital.
-- Management has underperformed some of regulators' operational targets in the past few years, which hurts shareholders directly because of the regulatory pricing structure.
-- The latest rate review was ugly, lowering rates by more than 4% in 2011 with little growth through 2015. This could signal a shift toward the rate payer in regulatory politics.
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