Reservoirs Dogged
Shares in several UK water companies suffered a setback in early
June thanks largely to the restructuring plans ? or rather the
scrapping of them ? of Pennon Group. Ironically, shares in Pennon
Group, owner of South West Water (SWW), have held up well following
its announcement that restructuring would do nothing to solve the
problems of its SWW subsidiary. Shares in two of Pennon's
competitors ? AWG (owner of Anglian Water) and Kelda Group (owner
of Yorkshire Water) ? were, however, hit by the news and its
implications for the structure of the UK's water sector in the
future.
Exeter-based SWW took over the assets of the former South West Water Authority when the industry was privatized in 1989. When the water industry was regulated it was split up into 10 regulated monopolies, responsible for both operations and the maintenance of infrastructure. SWW is the fifth-largest water utility in the UK. It has a customer base of around 1.5 million (rising to 2 million in the summer) for its water supply services and has diversified into waste management and environmental equipment.
Like all UK water utilities, SWW was hit by the decision by the UK water regulator OFWAT to impose a blanket 12.2% price cut on its supply business in April 2000. When the company released its interim results for the six months to September 2000 the new regime had already prompted a 32% fall in interim profits to £41 million.
The company's final results, released at the end of May, show that the cost of the price cut to South West Water for the full year is a full £32.6 million. Turnover is down 7% to £128 million and pre-tax profits are down 37% to £76 million.
Because of this many in the industry expected Pennon to restructure some of its water supply business, to improve its future performance. A number of water utilities have restructured themselves as a way out of the difficulties caused by OFWAT's pricing regulations.
Of the 10 water utilities that were created in 1989 just three are independent ? Pennon, Kelda and AWG. Two others, United Utilities and Severn Trent, have transformed themselves into integrated utility groups. The rest have been sold. It is these three independents (Pennon, Kelda and AWG) that are under the most pressure to restructure. AWG reported a 33% drop in annual profits last year and Kelda's profits were down 30%.
One solution for these independents is to merge, but any proposed mergers between UK water companies have been automatically blocked by OFWAT.
An attempt was made to buy SWW in 1996 by Severn Trent and Wessex Water but the conditions placed on the deal by the regulator made it unworkable.
One alternative strategy is of separating the ownership of assets from their operations. This would enable the operating company to be unregulated and merge with another operator and enable the asset-owning company to achieve a higher credit rating and, therefore, cheaper funding.
OFWAT has so far blocked Kelda's plans to transfer its assets to a mutually owned company. But when Glas Cymru was successful in its bid to run Welsh Water last year it indicated that separation of assets may be a way forward in the industry. Indeed, this February Scottish Power appointed Credit Suisse First Boston to advise it on a restructuring of its water subsidiary Southern Water.
It is not as if Pennon decided to reject a restructuring. Immediately after the OFWAT price cuts' introduction last year, Pennon Group chairman Ken Harvey announced the company was undergoing a strategic review. Its plans to replicate the Kelda Group mutualization model were, however, rejected by the regulator in July 2000. The company then turned to the idea of selling its customer base and water operations business. But this plan would necessitate changes in primary legislation covering licence-holding rules.
It was therefore with interest that the industry awaited Pennon's final results at the end of May, intrigued by what route out of its difficulties the company was planning next. The answer to that question caught everyone off-guard: nothing.
?Having explored the extensive range of potential options, the board has concluded that the current structure of South West Water will be retained,? said Harvey. The market immediately read this news as the death knell of financial restructuring schemes across the industry and hammered water shares. AWG fell 32p to 563p on the day of Pennon's announcement and Kelda shares dropped 15.5p to 372p. Ironically, Pennon shares held up well thanks to the company's decision to sell its Viridor Instrumentations business for around £100 million.
?We have spent many months considering this issue,? says Pennon Group director of finance Ken Hill. ?We concluded that a restructuring would not add value. The existing integrated utility is performing well.?
But South West Water's turnover was down £30 million to £251.4 million last year and operating profit down £39.5 million to £107.3 million. The company also has a target £725 million capital expenditure imposed by OFWAT that must be financed. In addition to the OFWAT price cut, profits have also been hit by a much larger number of customers than anticipated switching to metered charging. This hit profits last year by £4.7 million.
Although not a rosy picture, Hill remains upbeat about SWW's prospects. ?The value in the company comes from its regulatory contract,? he says. ?Our regulatory asset base (RAB) is £1.4 billion and over the next four years this should rise to £1.8 billion. If we can perform to our regulatory contract then the value of the company should be equal to its RAB.?
Hill is more than confident that SWW will outperform its regulatory contract, which stipulates that it must make £22 million cost savings by 2005. Operating costs increased by £1.2 million to £92.7 million over the last year, but the company managed to make efficiency savings of £5.8 million. ?If we saved £5.8 million in one year I am confident that we can save more than £22 million over five,? says Hill.
But if the company is now not going to restructure, how will cost savings be made? SWW is introducing two cost-cutting measures. The first is a new billing and customer contact software system that was implemented in February. The system is being supplied by Rapid Systems Ltd, a subsidiary of the South Staffs Group. The second initiative is the purchase of a integrated systems company, MIMS, also in February, which Hill says will enable SWW to ?operate its assets more efficiently?. He also says there is good scope for cutting the company's power bill.
But there is a huge capital improvement programme to be paid for which has generated a total borrowing requirement over the next five years of £500 million to £550 million.
Raising money via the equity markets is not possible for a company whose stock has underperformed the water sector by 9% (and the market as a whole by 15%) over the last year. SWW has existing bank bilaterals amounting to £120 million, which will be rolled over, and has cemented a £100 million loan from the EIB. But a large chunk of its funding requirement ? £170 million ? has been met through finance leasing.
SWW has been an enthusiastic participant in the finance leasing market since privatization and has put around £500 million of equipment on leases since privatization. The most recent series of leases were arranged by Babcock and Brown at the end of last year and covers a range of assets from sewerage equipment to computers. Lease terms range from five years to 28 years.
?We have done a range of conventional leases, collateralized leases and defeased leases,? says Hill. ?In general using this type of structure knocks about 100bp off our [OFWAT] approved cost of capital.?
Despite the existing facilities, there is still a £100 million to £150 million hole in SWW's funding programme, which Hill says the company will have ?no problem filling?. But while leasing is likely to form an important part of this requirement, a bond issue will, not surprisingly, be a last resort. SWW retains CSFB and Merrill Lynch as financial advisers but did not appoint a third party adviser for its strategic review. ?We know the business,? says Hill. ?We looked at mutualization and didn't think it would work and the regulator didn't think it would work either.?
But no matter how positive a spin SWW can put on beating the regulator's targets, there is little doubt that UK water companies are in trouble. And, in their view, this is trouble of the regulator's making. By imposing price cuts and one-off taxes and then hampering any form of consolidation in the industry, the regulator, they say, is making it impossible for the water companies to raise the funds required for the capital investment programmes with which they are charged.
In announcing his company's final results in early June, Kelda Group chairman John Napier said ?Without a change in thinking from government to regulator there is a real danger the amount of investment available in the future to meet improving services and environmental standards will be less than required.?
Napier has called on the government to undertake a review of the way in which the water industry is regulated, saying that an equity-based model for fundraising cannot work without a dynamic rate of return. ?In the meantime, the UK water industry is slipping slowly into overseas ownership,? he warned. The UK's largest water utility, Thames Water, is German-owned, Northumbrian Water is French-owned and Wessex Water is US-owned.
The problem that the water companies face is that the capital markets view the sector as high risk (due to regulatory change) and the regulator views the industry as low-risk (and therefore imposes strict regulatory guidelines). ?This industry should not be high risk ? it is a fundamental utility,? says Hill.
?The political risk is minimal but it is the regulatory risk that is the problem,? he says. ?We don't object to having a tough regulatory programme but the 1998 £104 million windfall tax was too harsh and the price cuts imposed last year were too high.? Hill believes that the existing structure of the industry is right but that the regulator has been too heavy-handed.
?The original model of privatization was right ? whether or not we were floated at the right price is not for me to say. But the correction since then has been too severe. This now needs to be corrected so that equity investors can invest in the industry at the right level,? he says.
Although Pennon has ruled out any restructuring of SWW for the time being, the market has been too harsh in viewing that as the end of a separation of activities in this industry. The Glas Cymru deal was approved because the assets were transferred to a non-profit making company and is seen as a special case in the industry.
Pennon may believe that this form of restructuring cannot deliver, but Kelda remains convinced that it is the answer. ?We will return to that as a means of delivering long-term value if we cannot get some common sense and a change of thinking,? says Napier.
In the meantime, Hill at SWW is concentrating on beating his OFWAT targets and trying to halt the slide in profitability. The need for Pennon to sell its Viridor businesses (Viridor Construction was sold in December 2000 at a loss and Viridor Instrumentation is now up for sale) is entirely attributed to OFWAT's actions. The group is unlikely to continue selling off subsidiaries to offset the impact of the regulatory environment for its water business.
Exeter-based SWW took over the assets of the former South West Water Authority when the industry was privatized in 1989. When the water industry was regulated it was split up into 10 regulated monopolies, responsible for both operations and the maintenance of infrastructure. SWW is the fifth-largest water utility in the UK. It has a customer base of around 1.5 million (rising to 2 million in the summer) for its water supply services and has diversified into waste management and environmental equipment.
Like all UK water utilities, SWW was hit by the decision by the UK water regulator OFWAT to impose a blanket 12.2% price cut on its supply business in April 2000. When the company released its interim results for the six months to September 2000 the new regime had already prompted a 32% fall in interim profits to £41 million.
The company's final results, released at the end of May, show that the cost of the price cut to South West Water for the full year is a full £32.6 million. Turnover is down 7% to £128 million and pre-tax profits are down 37% to £76 million.
Because of this many in the industry expected Pennon to restructure some of its water supply business, to improve its future performance. A number of water utilities have restructured themselves as a way out of the difficulties caused by OFWAT's pricing regulations.
Of the 10 water utilities that were created in 1989 just three are independent ? Pennon, Kelda and AWG. Two others, United Utilities and Severn Trent, have transformed themselves into integrated utility groups. The rest have been sold. It is these three independents (Pennon, Kelda and AWG) that are under the most pressure to restructure. AWG reported a 33% drop in annual profits last year and Kelda's profits were down 30%.
One solution for these independents is to merge, but any proposed mergers between UK water companies have been automatically blocked by OFWAT.
An attempt was made to buy SWW in 1996 by Severn Trent and Wessex Water but the conditions placed on the deal by the regulator made it unworkable.
One alternative strategy is of separating the ownership of assets from their operations. This would enable the operating company to be unregulated and merge with another operator and enable the asset-owning company to achieve a higher credit rating and, therefore, cheaper funding.
OFWAT has so far blocked Kelda's plans to transfer its assets to a mutually owned company. But when Glas Cymru was successful in its bid to run Welsh Water last year it indicated that separation of assets may be a way forward in the industry. Indeed, this February Scottish Power appointed Credit Suisse First Boston to advise it on a restructuring of its water subsidiary Southern Water.
It is not as if Pennon decided to reject a restructuring. Immediately after the OFWAT price cuts' introduction last year, Pennon Group chairman Ken Harvey announced the company was undergoing a strategic review. Its plans to replicate the Kelda Group mutualization model were, however, rejected by the regulator in July 2000. The company then turned to the idea of selling its customer base and water operations business. But this plan would necessitate changes in primary legislation covering licence-holding rules.
It was therefore with interest that the industry awaited Pennon's final results at the end of May, intrigued by what route out of its difficulties the company was planning next. The answer to that question caught everyone off-guard: nothing.
?Having explored the extensive range of potential options, the board has concluded that the current structure of South West Water will be retained,? said Harvey. The market immediately read this news as the death knell of financial restructuring schemes across the industry and hammered water shares. AWG fell 32p to 563p on the day of Pennon's announcement and Kelda shares dropped 15.5p to 372p. Ironically, Pennon shares held up well thanks to the company's decision to sell its Viridor Instrumentations business for around £100 million.
?We have spent many months considering this issue,? says Pennon Group director of finance Ken Hill. ?We concluded that a restructuring would not add value. The existing integrated utility is performing well.?
But South West Water's turnover was down £30 million to £251.4 million last year and operating profit down £39.5 million to £107.3 million. The company also has a target £725 million capital expenditure imposed by OFWAT that must be financed. In addition to the OFWAT price cut, profits have also been hit by a much larger number of customers than anticipated switching to metered charging. This hit profits last year by £4.7 million.
Although not a rosy picture, Hill remains upbeat about SWW's prospects. ?The value in the company comes from its regulatory contract,? he says. ?Our regulatory asset base (RAB) is £1.4 billion and over the next four years this should rise to £1.8 billion. If we can perform to our regulatory contract then the value of the company should be equal to its RAB.?
Hill is more than confident that SWW will outperform its regulatory contract, which stipulates that it must make £22 million cost savings by 2005. Operating costs increased by £1.2 million to £92.7 million over the last year, but the company managed to make efficiency savings of £5.8 million. ?If we saved £5.8 million in one year I am confident that we can save more than £22 million over five,? says Hill.
But if the company is now not going to restructure, how will cost savings be made? SWW is introducing two cost-cutting measures. The first is a new billing and customer contact software system that was implemented in February. The system is being supplied by Rapid Systems Ltd, a subsidiary of the South Staffs Group. The second initiative is the purchase of a integrated systems company, MIMS, also in February, which Hill says will enable SWW to ?operate its assets more efficiently?. He also says there is good scope for cutting the company's power bill.
But there is a huge capital improvement programme to be paid for which has generated a total borrowing requirement over the next five years of £500 million to £550 million.
Raising money via the equity markets is not possible for a company whose stock has underperformed the water sector by 9% (and the market as a whole by 15%) over the last year. SWW has existing bank bilaterals amounting to £120 million, which will be rolled over, and has cemented a £100 million loan from the EIB. But a large chunk of its funding requirement ? £170 million ? has been met through finance leasing.
SWW has been an enthusiastic participant in the finance leasing market since privatization and has put around £500 million of equipment on leases since privatization. The most recent series of leases were arranged by Babcock and Brown at the end of last year and covers a range of assets from sewerage equipment to computers. Lease terms range from five years to 28 years.
?We have done a range of conventional leases, collateralized leases and defeased leases,? says Hill. ?In general using this type of structure knocks about 100bp off our [OFWAT] approved cost of capital.?
Despite the existing facilities, there is still a £100 million to £150 million hole in SWW's funding programme, which Hill says the company will have ?no problem filling?. But while leasing is likely to form an important part of this requirement, a bond issue will, not surprisingly, be a last resort. SWW retains CSFB and Merrill Lynch as financial advisers but did not appoint a third party adviser for its strategic review. ?We know the business,? says Hill. ?We looked at mutualization and didn't think it would work and the regulator didn't think it would work either.?
But no matter how positive a spin SWW can put on beating the regulator's targets, there is little doubt that UK water companies are in trouble. And, in their view, this is trouble of the regulator's making. By imposing price cuts and one-off taxes and then hampering any form of consolidation in the industry, the regulator, they say, is making it impossible for the water companies to raise the funds required for the capital investment programmes with which they are charged.
In announcing his company's final results in early June, Kelda Group chairman John Napier said ?Without a change in thinking from government to regulator there is a real danger the amount of investment available in the future to meet improving services and environmental standards will be less than required.?
Napier has called on the government to undertake a review of the way in which the water industry is regulated, saying that an equity-based model for fundraising cannot work without a dynamic rate of return. ?In the meantime, the UK water industry is slipping slowly into overseas ownership,? he warned. The UK's largest water utility, Thames Water, is German-owned, Northumbrian Water is French-owned and Wessex Water is US-owned.
The problem that the water companies face is that the capital markets view the sector as high risk (due to regulatory change) and the regulator views the industry as low-risk (and therefore imposes strict regulatory guidelines). ?This industry should not be high risk ? it is a fundamental utility,? says Hill.
?The political risk is minimal but it is the regulatory risk that is the problem,? he says. ?We don't object to having a tough regulatory programme but the 1998 £104 million windfall tax was too harsh and the price cuts imposed last year were too high.? Hill believes that the existing structure of the industry is right but that the regulator has been too heavy-handed.
?The original model of privatization was right ? whether or not we were floated at the right price is not for me to say. But the correction since then has been too severe. This now needs to be corrected so that equity investors can invest in the industry at the right level,? he says.
Although Pennon has ruled out any restructuring of SWW for the time being, the market has been too harsh in viewing that as the end of a separation of activities in this industry. The Glas Cymru deal was approved because the assets were transferred to a non-profit making company and is seen as a special case in the industry.
Pennon may believe that this form of restructuring cannot deliver, but Kelda remains convinced that it is the answer. ?We will return to that as a means of delivering long-term value if we cannot get some common sense and a change of thinking,? says Napier.
In the meantime, Hill at SWW is concentrating on beating his OFWAT targets and trying to halt the slide in profitability. The need for Pennon to sell its Viridor businesses (Viridor Construction was sold in December 2000 at a loss and Viridor Instrumentation is now up for sale) is entirely attributed to OFWAT's actions. The group is unlikely to continue selling off subsidiaries to offset the impact of the regulatory environment for its water business.
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