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United Utilities - costs expected to rise

United Utilities full year revenues were previously expected to be 1% lower this year.

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United Utilities' full year revenues were previously expected to be 1% lower this year. This guidance has been lowered by another 1% today due to lower consumption, which the group expects to fully recover in future years.

Underlying operating costs are expected to increase by £130m. Meanwhile, underlying finance costs are expected to be around £175m higher than last year, and £10m higher than previously forecast because of elevated inflation.

It's anticipated that net debt will also increase from half-year levels. This largely reflects the impact of inflation on the group's index-linked debt.

A period of extreme weather in December 2022 caused burst pipes and short-term supply disruptions for some customers. As a result, Outcome Delivery Incentives (ODI) will be negatively affected. Net ODI outperformance for the year is expected to be in the range of £20m to £25m.

The shares were broadly flat following the announcement.

View the latest United Utilities share price and how to deal

Our view

United Utilities is a utility as pure as the water that flows through its pipes. In return for providing a reliable and affordable water supply to North West England, Ofwat (the regulator) allows UU to earn an acceptable financial return.

With prices set by the regulator and reviewed every five years, utilities' earnings have tended to be stable and predictable, which has supported a reliable dividend. However, UU could find itself in a sticky situation if inflation remains elevated.

The group's expecting core costs to be higher than previously anticipated because of inflationary pressures and the dry spells of weather experienced in the first half of the year. Revenue is also expected to take another hit as customers were actively encouraged to save water. Both of which are likely to hurt the bottom line.

Falling revenues should only be a transitory problem, since over the medium term the group's able to increase prices alongside inflation. If the amount of water it bills its customers for falls below a certain threshold, the regulator will pay United Utilities the difference. But the funds are only received two years later. In the short term, cash flows and earnings still feel the impact of rising costs and declines in water usage.

Our bigger concern comes from its inflation-linked debt - meaning the cost to service it rises alongside the Retail Price Index. As a result, United Utilities has seen its average interest rate on debt double to 9%. Fortunately, a large chunk of this relates to non-cash charges. If inflationary pressures prove fleeting as some have forecast, this shouldn't be more than a blip on the radar. But if the new elevated finance costs stick around, it could start to chip away at the Group's balance sheet.

Inflation could also impact customers' ability to pay as the cost-of-living crisis intensifies. So far this looks under control and there's government support in place. But United Utilities is calling for this to be more fairly distributed, with some of the country's most deprived communities being within the areas it services.

The group's ability to flex its prices alongside inflation means the dividend policy, which calls for growth in line with CPIH inflation, looks likely to remain for now. But a prolonged period of inflation would cause some challenges, and no dividend is guaranteed.

The valuation's currently above its long run average on several metrics. Understandable considering it's seen as one of the more defensive stocks on offer. And should inflation come under control, the negative accounting impact to earnings is unlikely to repeat. But if high inflation turns out to be here for the longer term, United Utilities' customers, cost base and interest charges will all come under further pressure.

United Utilities key facts

All ratios are sourced from Refinitiv. Please remember yields are variable and not a reliable indicator of future income. Keep in mind key figures shouldn't be looked at on their own - it's important to understand the big picture.

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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Written by
Aarin Chiekrie
Aarin Chiekrie
Equity Analyst

Aarin is a member of the Equity Research team. Alongside our other analysts, he provides regular research and analysis on individual companies and wider sectors. Having a keen interest in global economics, he knows how macro-events can impact individual companies.

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Article history
Published: 28th March 2023