We look at why private equity companies and pension funds may be eyeing up water companies.
Should we be surprised that someone wants to buy AWG
(LSE: AWG)
-- lock, stock and barrel?
I'm not too surprised. In fact, I have for some time seen the attraction of water companies, and wrote about them here, here, here, here and here.
That said I am a tad surprised that AWG's suitor, which is reckoned to be a consortium made up of pension funds and private equity outfits, homed in on it first. After all, there are other quoted water companies which are less burdened by borrowings that look more attractive.
Thing is, the modus operandi of private equity buyers is generally to acquire assets, then load them up with as much debt as possible. But as the table below shows AWG is already hocked up to the eyeballs.
| Company | Market Cap (m) | Borrowings (m) | Gearing* |
|---|
| AWG
(LSE: AWG)
| £2,200 | £3,265 | 2,502% |
| DeeValley
(LSE: DVW)
| £47 | £33 | 216% |
| Kelda
(LSE: KEL)
| £3,004 | £1,863 | 128% |
| Northumbrian Water
(LSE: NWB)
| £1,360 | £2,033 | 679% |
| Pennon
(LSE: PNN)
| £1,768 | £1,427 | 246% |
| Severn Trent
(LSE: SVT)
| £4,693 | £2,961 | 156% |
| United Utilities
(LSE: UU.)
| £6,099 | £4,187 | 159% |
*Gearing is borrowings divided by shareholders' funds.
Source: Company Refs
The massive debt that AWG is already carrying means that any new private equity owner won't be able to use the tactic of supplementing every pound of investors' money with £4 of debt. Additionally, water regulator Ofwat has strict guidelines that limit borrowings to 50% to 60% of the company's regulatory asset base.
But maybe AWG's suitors are eyeing up its reliable dividend stream instead. After all, pension funds need reliable cash flows that will allow them to match their liabilities. And this is where essential infrastructures such as ports, airports and utility companies are useful -- over the last five years, AWG's cash flow has improved year on year.
The improving cash flow at utility companies has allowed them to service their debts and lift dividend payouts at the same time. In the case of AWG, interest payments are covered 1.3 times and dividends are covered 1.1 times. That's low cover for many companies, but given the predictability of earnings in this sector, it's fine here. What's more, AWG's yield, which stands at 3.4%, is expected to grow around 4.5% annually. And this compares favourably with long-term gilts that currently yield 3.9%.
In my view, it is not unreasonable to expect pension funds to target other utilities, too. But even if they don't, shares in water companies would not look out of place in a private investors' portfolio given that they yield as much as 6.5% in some cases.
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