The boom in asset-backed deals by the private-equity industry has pushed the share prices of many utilities far beyond their profit expectations. Take this water company. Its shares, and those of its peers, have been buoyed by takeover fever; in the past year alone, both AWG and Thames Water have been bought out.
Severn Trent (SVT), rated a BUY by Evolution Securities
Ofwat regulates the UK water industry to protect consumers and improve the overall quality of the service. Every five years it calculates a fair value (regulatory capital value, or RCV) for each business, and specifies the price that each can charge, how much it should invest, and what level of return shareholders can receive. So this RCV figure, rather than the p/e ratio, is the prime indicator of underlying value. If actual returns are greater than specified, water bills will be cut by Ofwat at the next pricing review (due in 2010) to ensure consumers gets value for money.
So how does this apply to Severn Trent? Ofwat has set a March 2007 RCV of £5.53bn. On top of this, the firm’s non-regulated assets are worth about £150m. Together with net debt of £3.2bn and a pension deficit of £220m, this gives a sum-of-the-parts valuation of about 970p per share – or 40% below the current levels. Severn’s shares are only being kept afloat by bid mania, which also explains its lofty 2007 p/e ratio of above 21.5. But unless a takeover is forthcoming, this premium will erode. I think the tipping point is likely to be sooner rather than later.
Why? Because with interest rates rising, the cheap finance that’s been driving the private-equity boom is becoming dearer. Even if cheaper funds from infrastructure investors can still generate returns above the allowed RCV, then much of this profit will be clawed back by Ofwat at the 2010 pricing review. So although Severn’s dividend yield at 4% is attractive for income seekers, at £15.77, the share price looks over-bought.
And there is another potential thunder cloud on the horizon. The Serious Fraud Office is investigating claims of inaccuracies in the leakage data Severn Trent submitted to Ofwat between 2000 and 2003. If found guilty, the firm could be fined up to 10% of revenues – or around £150m. This is on top of a penalty that Ofwat already plans to impose for Severn’s poor customer service record.
Full-year results are scheduled for Wednesday 6 June.
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments