The strong performance of the three listed UK water companies may be limited in coming years as regulator Ofwat flexes its muscles, said JP Morgan Cazenove.
Analysts at the bank downgraded Severn Trent PLC (LSE:SVT) to an 'underweight' rating and put its share and those of Pennon Group PLC (LSE:PNN, OTC:PEGRY) on its 'negative catalyst watch' list, with United Utilities Group PLC (LSE:UU.) the preferred name, keeping its 'overweight' rating.
READ: Five water companies facing action over sewage spills
The potential negative catalyst is on 7 July, when Ofwat will be publishing a draft methodology for the next regulatory period.
All three listed companies have delivered strong returns and asset growth, while maintaining dividend growth at least in line with inflation since the start of the current regulatory period in April 2020.
"However, we are turning cautious on the subsector," said the JPM analysts.
This is based on the belief that the company's shareholder returns from April 2025 will be lower than the market currently expects, as Ofwat is expected to "challenge the companies to be more efficient while meeting environmental objectives – this may require further reinvestment in the coming years, limiting outperformance".
READ: Tougher water regulation needed as chemical cocktail polluting rivers, MPs say
UU, Severn Trent and Pennon are all expected to be able to manage cost inflation, given that revenue and asset growth are both indexed.
From a broader UK utilities sector perspective, the JPM analysts prefer shares with "positive exposure to power prices", namely Drax Group (LSE:DRX) PLC, Centrica PLC (LSE:CNA), both rated 'overweight' and SSE PLC (LSE:SSE), rated 'neutral', "in that order".