Water Industry News

Money keeps flowing into water despite credit crunch

Dec 26 2007
By Russell Lynch

While the global credit crunch may have put the brakes on a debt-fuelled buyout frenzy, a fresh surge of interest in water companies has seen the sector defy cooling takeover activity elsewhere.

Infrastructure funds assembled by major investment banks are on the prowl for companies coveted for stable cash flows and rich asset bases.

Yorkshire Water owner Kelda was the latest to succumb, agreeing to be bought for 3 billion by a consortium featuring HSBC, Prudential and Citigroup.

The deal follows Royal Bank of Scotland's 4.2 billion sale of Southern Water to a joint venture between JP Morgan and Australian infrastructure fund Challenger.

A recent report from ratings agency Standard & Poor's suggested they could have as much as $150 billion (72.5 billion) to spend.

Pension funds are backing the spree, with the longevity and steadiness of water assets seen as a good match for the funds' long-term liabilities.

As prospects for the economy darken with banking stocks under pressure and a host of retail profit warnings, water is seen as the safe haven likely to be unaffected.

This leaves the likes of Northumbrian Water, South West Water owner Pennon and Birmingham-based Severn Trent - the listed firms left from the ten regional English and Welsh water companies that emerged on privatisation in 1989 - in the spotlight.

Dresdner Kleinwort analyst Geraint Anderson said: "I think any of the other companies could be vulnerable. All have the attributes sought after, such as steady cash-flows and regulated returns.

"It does seem the credit crunch has not impacted the ability to raise funds to buy them. They are an attractive asset class."

It is much more difficult to buy utilities in Europe, which has turned the attention to the potential UK targets.

While regulator Ofwat is likely to drive a tougher deal from utilities ahead of the next review period beginning in 2010, big infrastructure funds are ready to splash out despite inflated share prices.

"They have got to spend now - you don't earn fees sitting on your hands," Mr Anderson adds.

The recent sale of Southern Water raised eyebrows among UBS analysts because of the high premium paid compared to the value of regulated assets - 41 per cent, according to the investment bank.

UBS's Rohit Agarwal said: "While we believe the sector should trade at a discount to the Southern Water bid, the current discount is too large.

"We believe the supply of new funds to private equity and infrastructure investors remains strong, which could lead to increased competition for a limited number of assets."

He added: "We have had six leveraged buyouts in two years and believe there is a good chance this will continue."

Alongside Southern, other water companies changing hands include Anglian, Thames, Walsall-based South Staffordshire, South East and Bristol Water. South East and Mid Kent Water are currently merging to create the second largest water supply company in England and Wales.

Deals such as investment bank Macquarie's 8 billion swoop for Thames Water last year have already revealed the potential gains.

Thames reported a 50 per cent rise in profits to almost 200 million in the six months to September 30.

The excitement surrounding the industry is reflected in the share prices.

Pennon, Northumbrian Water and Severn Trent have all seen shares stronger in recent months - a remarkable performance highlighting the attraction of the sector given stock market turbulence.

According to sector watchers, Severn Trent could be the next water company to fall into the hands of the infrastructure firms.

Charles Stanley analyst Jeremy Batstone said the company is an attractive bid play despite the prospect of tens of millions in fines hanging over the firm due to customer service data misreported to industry regulator Ofwat - as well as three criminal charges over allegedly false leakage data between 2000 and 2002.

Severn Trent is trading at a relatively low premium to regulatory asset value, adding to potential takeout gains, while the culmination of action over the data issues would put an end to the uncertainty hanging over the business,

Mr Batstone argues. He added: "We do not think executives are wedded to independence like others in the sector."

Stripping out losses from the summer floods, Severn Trent cheered investors with first-half profits of 161 million, beating market expectations.

Charles Stanley rates the stock favourably compared to Pennon, which the broker argues now looks expensive - even for the tastes of infrastructure funds - after takeover talk inflated shares earlier this year.

UBS also fancies Severn Trent but highlights the potential of Northumbrian Water due to its low trading premium to regulatory assets.

A major hurdle is the 25 per cent stake held by the Ontario Teachers Pension Plan.

Mr Agarwal said: "It is debatable whether Ontario Teachers would be willing to sell its stake, launch a bid itself or hold on to its current investment."

Despite its 6.4 billion market value, United Utilities could even feature on the shopping list after its 1.8 billion sale of the North West electricity distribution network.

"The disposal could make the company a target "if size is not a constraint", Mr Agarwal adds.

In the current explosion of activity, few - if any - are betting against further deals. Although merger and acquisition activity has dried up elsewhere, in the water sector at least it may be some time before the big-spending funds are ready to turn off the taps.