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A tough new pricing regime for United Utilities
The tough new pricing regime for United Utilities (LON:UU) has seen an initial four percent cut in water bills. As would be expected this has caused profits to fall back but cost cutting should serve to mitigate the damage in the medium term. The group also remains committed to its dividend ensuring investors receive a solid income and as such we rate the stock a hold.
With volatile markets of late defensive shares have performed well as investors look for reliable dividend income. The dividend for this year is 30p in total which gives an historical dividend yield of just under 5% (the ex-dividend date for the final 20p dividend is the 22nd June). Going forward the group aims to increase the dividend by two per cent per annum above RPI inflation through to 2015 which is the period of the new regulatory regime.
As such the stock offers a predictable income stream for investors and as water utility is one of the most defensive investments available. However, against this backdrop the new five year pricing regime does provide challenges for the group with the 4% water bill pricing cut in the first year.
With United Utilities having disposed of non-core assets (completed November 2010) the group is now focused on regulated UK water and wastewater. Thus the company is dependent on the regulatory environment but can look to cost cutting to boost returns.
For the year ended 31st March 2011, revenues fell by 4% decrease in 2011 due to the 4% reduction in water rates mandated by the regulator. Operating expenses increased by 7% reflecting higher infrastructure renewals expenditure and some higher costs. As such EBITDA fell by 10%.
Looking at the key drivers of these results and the water rate cut is most severe for the first year of the new pricing regime. Thus we should see profits growth from here for the group provided it can cut costs sufficiently.
The operating side of the business is progressing well and few will not have noticed the driest spring for 100 years. Last winter was also the coldest for decades but on both counts the group has managed to hold up ok and there should be no hosepipe ban this summer for customers.
An interesting infrastructure project is the water connector between Manchester and Liverpool that would allow Manchester to be supplied by reservoirs in Wales. The company is also looking at a system for generating biogas from sludge which would serve to generate electricity.
A £100m sludge processing centre is due for completion by 2013 and this will be one of the biggest bio-processing combined heat and power plants in the UK. The power generated from renewable energy is expected to be £4m. The group currently generated 111GWh of renewable power which is 14% of its total use.
On the regulatory front there has been much movement with Defra reviewing the water regulator Ofwat. United Utilities views the process favourably in terms of potentially allowing less regulation and providing incentives for innovation - the Government’s Water White Paper is scheduled for the end of 2011.
The new five year pricing regime has clearly had a notable affect on United Utilities last year. However the group outperformed on the cost cutting front and is committed to its dividend payout plan which underpins the return for investors. The prospects of a friendly regulatory regime may also see a better environment for the group going in the long-term.
This report was produced by Senior Research Analyst, Andrew Latto
