For a long time, water stocks have been a haven for cautious investors, offering predictable dividends and a sense of safety.
But the tap of easy returns may be tightening for United Utilities Group PLC (LSE:UU.), according to UBS analysts, who have just downgraded the shares from 'buy' to 'neutral'.
UU, which supplies water to around seven million people in the North West of England, has secured its five-year regulatory settlement and set a dividend policy linked to inflation.
On the surface, that should offer certainty. Yet UBS believes much of the good news is already reflected in the share price, with little obvious upside unless bond yields fall sharply or regulators allow fatter returns.
Regulated utilities like United Utilities operate under five-year price controls set by Ofwat, the industry watchdog. These rules cap what they can charge and the returns they can make on their investments.
UBS points out that although United Utilities plans to spend £13 billion upgrading its network over the next five years, the expected returns on that investment, around 8.5 to 9% a year, are only just enough to keep investors happy in today’s higher interest rate world.
While operational performance is getting better, particularly in tackling storm overflows, UBS warns there will be no meaningful growth in earnings per share after 2028. The company’s heavy investment programme and rising debt levels could also limit financial flexibility later in the cycle.
Valuation is another sticking point. The shares trade at a premium of about 7% to their regulated asset base, a rough proxy for the value of the physical network.
That compares with a small discount for rival Pennon, which UBS now prefers. United Utilities’ dividend yield stands at a respectable 4.9%, but this is broadly in line with the wider utilities sector.
A couple of key dates lie ahead. The outcome of a regulatory review led by Sir Jon Cunliffe, due around June, and the company’s Capital Markets Day later that month could move the dial.
For now, though, UBS sees limited room for share price gains unless the regulatory or interest rate backdrop changes in United Utilities’ favour.