Shares in United Utilities Group PLC (LSE:UU.) were higher after RBC Capital shifted its preference in the UK water sector, upgrading the stock to 'outperform'.
In the same note, it downgraded Pennon Group PLC (LSE:PNN, OTC:PEGRY) due to concerns over its balance sheet, which now faces strain from increased capital expenditure (capex) requirements.
Severn Trent PLC (LSE:SVT), though performing well, is not seen as offering further upside, despite strong operational performance.
RBC expects UU to benefit most from the water regulator Ofwat's final determination in December for the next five-year period, particularly from favourable regulatory adjustments. A stronger balance sheet makes the north-west England water group more resilient in handling future capital requirements, unlike PNN, which may require equity financing.
For Pennon, a change in its guidance means higher capex in the financial year 2025, placing its debt at the top end of acceptable limits. As the company grapples with financing pressures, the possibility of needing to raise equity looms larger. RBC sees its near-term performance hindered by these financial constraints despite its operational strengths.
Severn Trent continues to perform well in terms of regulatory return on equity, but its valuation already reflects much of its upside. RBC expects the final determination to offer limited further benefits for Severn Trent, keeping its rating at “Sector Perform” due to a relatively high valuation premium compared to UU.
The broader UK water sector is poised for improvements in operating cost allowances and regulatory returns, with an expected increase in the weighted average cost of capital (WACC) at the final determination.
However, the sector still faces challenges from ongoing environmental investigations and the unresolved financial future of Thames Water.
In afternoon trading, United Utilities stock was up 1.5% at 1,021p. Pennon was down 1.2% at 552.5p.