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Severn Trent: The thirst for UK water



A glance at the above chart of the FTSE 100 shows it has been a cautious week for equities, as anticipation surrounding the US Federal Reserve’s rate setting open market committee dominated the mood in the market.

Ben Bernanke, chairman of the Federal Reserve, said the central bank could begin scaling back its $85 billion a month asset purchase programme later this year, if the economy continues to improve. Bond purchases could halt completely by mid-2014, when the unemployment rate is expected to be as low as 7.0%, from 7.5% currently. The Fed also revised its forecasts that the first rate hike could come earlier in 2015 than previously thought, sending equities and bond prices sharply lower.

Many economists, however, argue that the tapering of quantitative easing is not a tightening of monetary policy and it is an essential element of the country’s recovery. Furthermore, with global markets stuttering recently, combined with weak wage growth and low inflation in The United States, it lessens the chance the Fed will take any action this year. 

Positive macro-economic developments continue, with the Empire State index of manufacturing activity in the New York region climbing to a three month high in June, easily beating expectations. Better news also came from the housing market, as the National Association of Home Builders sentiment index rose above 50.0 last month for the first time since April 2006.

In Europe, there was positive news from Germany, as the Zew economic expectations index edged up to 38.5 in June from 36.4, providing further evidence that the regions powerhouse economy is regaining momentum. 

On a domestic front, retail sales bounced back much more than expected in May, adding evidence of accelerating economic growth in the second quarter. Sales rose 2.1% from the previous month and 1.9% from a year earlier, reversing the negative sales growth experienced last month.

China, however, continued to unsettle investors, after factory activity weakened to a nine month low in June. The flash HSBC Purchasing Managers index fell to 48.3 in June from May’s final reading of 49.2, drifting further away from the 50-level that separates expansion from contraction, proving the weakest reading since September 2012.

The data heightens the risk of a sharper slowdown in the second quarter, bringing warnings the country could miss its growth target of 7.5% for this year. Many, however, argue that the chances of a much discussed hard landing are small. Asian business sentiment improved to its highest level in five quarters, while figures for infrastructure and property investment show the overall demand of the economy is not declining sharply.

Technical analysis illustrates that following the recent weakness, the FTSE 100 is attracting support from the 200-day moving average and historically significant 6200 level. The oscillators are also rising out of oversold territory, with the bullish divergence indicating a move higher is overdue. Further support is seen at 6105, with likely targets at 6400 and 6530.

In conclusion, the market’s reaction to the monetary policy tapering, signalled in the US, is surprising and perhaps an overreaction, given it is a necessary part of the recovery. It could even be a positive signal given the historic arguments over the effectiveness of QE and its longer-term side effects. Policy tightening remains a long way off and given the generally positive global data, combined with the bullish technical outlook for the FTSE, I am investing cash on the recent weakness.

Having outperformed the wider market over the last year, it is of little surprise that the gas, water and multiutility companies have been among the worst performers over the past month, with the sector average losing 12% during this period.

The water sector is of particular interest given British water companies have become targets for investors, such as pension funds, sovereign wealth groups and private equity firms, due to their monopoly over customers and stable real earnings. 

Yorkshire Water, Northumbrian Water and Thames Water have all fallen under foreign ownership, leaving Severn Trent, United Utilities and Pennon remaining on the public market. The first two have already been the prey of possible suitors recently.

Earlier this month, Severn Trent (Epic: SVT), which supplies water to 4.2 million customers across the Midlands and Wales, turned down three consecutive approaches from the LongRiver consortium. LongRiver, comprising Borealis Infrastructure, a Kuwaiti sovereign wealth fund and Britain's Universities Superannuation Scheme, said Severn Trent had refused to engage in meaningful talks, rejecting a £22 per share offer.

Management believes that the conditional proposal fails to value the attractions to Severn Trent’s shareholders, of the groups increasingly rare combination of yield, inflation linked business model and potential. Meanwhile, LongRivers said it would not table a new offer unless the board engaged with its representatives.



The above chart of Severn Trent illustrates the recent weakness, attributable to the declined bids and general sector weakness, with the shares falling 25% to below its pre-approach levels. The oscillators have slid into acutely oversold territory and appear to be bottoming-out, suggesting a turnaround could be imminent.

So is this a buying opportunity?

The inherent attractions of the utility sector, of strong cash flows and inflation linked returns, are likely to continue, while the predatory interest in the water sector will remain. The board must now work hard to prove that it is worth the £22 the suitors were offering, while Goldman Sachs upgraded them to buy, with a 2211p target price, offering a 35% upside to the current price.

The forthcoming Ofwat review on pricing and investment, scheduled at the end of 2014, is a headwind, but the strong fundamentals and perennial bid attractions should underpin the sector. Interim results on 30th May revealed little surprises, although the full year dividend was hiked 8.2%, representing a 4.8% yield for next year. 

In light of the earlier analysis of the FTSE 100, I believe the recent weakness at Severn Trent offers good value given the strong income and growth attractions. At the time of writing the share price is 1640p, with targets seen at 1743p, 1819p and 2070p, while a stop-loss at 1574p limits downside risk. 


This report was written by Mark Allen – Head of Derivatives at Simple Investments Stockbrokers. The writer does not hold a position in Severn Trent, but client accounts may. The material in this report has come from Simple Investments internal data sources, Simply Charts and Severn Trent’s corporate website.





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