The water sector has been under the investment microscope this week, with a particular focus on Thames Water.
The group’s CEO, Sarah Bentley, suddenly stepped down on Tuesday 27 June, and soon after, reports began emerging that the company was in deep water.
The UK government’s held emergency talks in recent days over the fate of the heavily indebted company. If it can’t secure new funds from shareholders, the government’s prepared to place the company in temporary state ownership, a process energy firm Bulb went through last year.
Thames Water’s a giant in the water industry, supplying more than 15 million households and having a customer base ten times the size of Bulb’s. So, it’s likely to prove more difficult to find a buyer if that ends up being the scenario that plays out.
As things stand, Thames Water’s debt amounts to roughly £14bn, or reportedly around 80% of the value of its business. That makes it the most heavily indebted of England and Wales’s water companies.
But Britain's water regulator, Ofwat, issued a statement on Thursday 29 June to reassure the government that the country's biggest supplier, Thames Water, was not on the brink of collapse. Ofwat said that while it had issues to address, including its environmental record and leakage performance, it still had strong liquidity, with £4.4bn of cash and committed funding.
What does this mean for other water utilities?
The Thames Water saga has put a spotlight on what is a debt-laden industry. According to the regulator, the sector’s total debt reached £60.6bn last year.
Thames Water’s privately owned by overseas investors. In fact, of the 11 companies that provide water and sewage services in England and Wales, six are owned or controlled by overseas investors.
Critics claim that this setup can increase the incentive for owners to load water companies with debt and pay themselves handsome dividends at the expense of investment.
Arguably, publicly listed companies like Pennon, Severn Trent and United Utilities have fewer shadows to hide in when it comes to transparency about dividend payments. These ranked among the most financially resilient water companies in the regulator’s latest annual report.
That offers some degree of comfort in a challenging environment. The sector’s been hit by higher costs for things like chemicals and energy in recent years.
With the next regulatory price review looming, there are set to be much bigger demands from regulators on improving infrastructure to help reduce sewage spills, increase capacity, and meet net zero targets. That points towards increased capital expenditure and rising debt levels across the sector.
With inflation remaining at elevated levels, the cost of servicing this debt becomes more expensive. As a result, we could see margins come under pressure and cashflows get squeezed, raising questions about the sustainability of dividend payments. As always, remember that all dividends are variable and not guaranteed.
However, longer term, high levels of inflation are likely to be a net benefit for a lot of water companies. That's because inflation increases the amount of revenue the group's allowed to earn on its assets, which cushions the impact of rising costs.
This article isn’t personal advice. If you’re not sure an investment is right for you, seek advice. Investments and any income from them will rise and fall in value, so you could get back less than you invest. Past performance is not a guide to the future. Ratios shouldn’t be looked at on their own, it’s important to understand the big picture.
What does it mean for investors?
As always, we’d encourage investors to take a long-term view, and not to jump into any rash decisions.
Despite the noise surrounding privately owned Thames Water, we think there’s little likelihood of a repeat right across the water sector. The immediate financial situation of publicly-listed Pennon and United Utilities looks strong to both us, and the regulator.
The valuations of these two companies are above the long-term average on a price-to-earnings basis. That’s not surprising given the defensive characteristics of the sector, but it does increase the risk of ups and downs should any missteps occur. Especially given the heightened regulatory scrutiny in the sector.