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30 August 2023

Severn Trent

Water utility companies have been back in the news headlines, with Thames Water, the utility serving most of London and much of the South East, recently under the spotlight for all the wrong reasons. Poor operational performance, management resignations, a debt-laden balance sheet and a ballooning interest bill due to the structure of its debt profile raised questions around the complexity of the underlying business model.
 
As with any utility company, understanding the role of the regulator is of utmost importance. The Water Services Regulation Authority, or OFWAT, regulates all UK water and sewage companies. Each year it publishes a report on the performance of all companies falling under its remit, but most importantly, it sets allowable price increases through distinct five-year blocks or Asset Management Plan (AMP) periods. At the top end of the reported performance tables comes Severn Trent (SVT), one of three listed water utility companies and an inflation-linked dividend payer.
 
At the core of profitability for regulated water companies comes Regulatory Capital Value (RCV), a measure of the company’s market value plus the value of accumulated capital investment assumed at each price review. Developed for regulatory purposes, its primary use comes in setting price limits for AMPs and assessing the revenues water companies need. Expected to be in the region of 4% of RCV in the financial year 2022/23, the base return provides consistent revenue with inflation adjustments each year.
 
Away from the base return, Outcome Delivery Incentives (ODIs) provide additional revenue opportunities. Outlined before the upcoming AMP, OFWAT considers deliverables on a common, comparative, and bespoke basis with rewards and penalties administered on performance. These ODIs, on a common basis, include performance metrics such as unplanned outages and leakage, with strong performance rewarded. Comparatively, performance in areas such as supply interruptions and internal sewer flooding are measured relative to other water companies, with top quartile performance rewarded. With strong operational performance rewarded, the likes of Severn Trent have the ability to meaningfully enhance earnings, with £175m earned through ODI rewards in the prior AMP.
 
Given the large capital base, visibility of future income and expenditure and the highly regulated nature of utility companies, high levels of debt are a consistent theme. Add in a sustainable finance framework and large operational asset base, and the proposition becomes attractive from a debt perspective with a strong investment grade rating from credit agencies. As an indication, SVT’s November 2022 £400m bond issue at a rate of 4.625% was eight times oversubscribed, making it the year’s “most successful sterling company bond,” according to Bloomberg.
 
The mix of this debt remains of utmost importance for financial sustainability and avoiding potentially ballooning interest expense costs experienced by the likes of Thames Water through high levels of inflation-linked debt. With just 28% of debt inflation-linked against the sector average of 54%, Severn Trent looks in a strong position relative to peer averages but is still not immune as the effective cost of interest crept higher in the financial year 2022/23 to 6.2%.
 
For income investors, an inflation-linked income stream is a gold-plated feature. Through the recent AMP, a dividend policy of growth of at least Consumer Price Index (inc. housing) linked to the prior November’s data point. Lasting through to the end of the current AMP in 2025, further guidance regarding the path of future dividends is eagerly awaited.
 
Research analyst opinions remain divided, with the likes of Goldman Sachs and JP Morgan affirming their “sell/ underweight” recommendations but Société Generale and Morgan Stanley pushing their target prices higher. With business plan submissions for the upcoming AMP expected in October, we will have to wait before forming expectations for the period 2025 through to 2030. In anticipation, a stable financing plan and consistent strong operational performance through the current and past AMP periods look to provide SVT with a strong base going forward.
 
This article was taken from the Summer 2023 issue of 1875. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications.

Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. The value of investments and any income derived from them may go down as well as up and you could get back less than you invested.
 
 
Severn Trent

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