Today I am looking at why I believe Severn Trent (LSE: SVT) could be a profitable contrarian play for courageous investors.
Ofwat’s stance beginning to soften?
A number of brokers believe that Ofwat’s most recent price guidances not only provides the water sector’s major players with 
improved visibility, but that the final decision over returns will also be much more flexible than initially suggested.
Under the AMP6 regulatory regime, due to run from 2015-2020, the regulator previously said that the weighted average cost of capital (WACC) must be no higher than 3.85%. This is higher than the current industry average of 4.3%.
However, RBC Capital recently commented that “Ofwat has left the door open for companies to achieve additional meaningful financial incentives for outperformance, which means achievable returns could be as high as 5.55%.”
Takeover talk back on the agenda
Possible signs of loosening rules over cashflow and returns has led to speculation that the water sector could be the subject of fresh takeover approaches once again. A number of sovereign wealth funds have previously shown great interest in acquiring British utilities, so an improving earnings outlook could very possibly lead to renewed overtures.
Indeed, Deutsche Bank commented last month that “within a year we believe the sector will have regulatory and dividend visibility and a resumption of bid speculation is possible.” And the broker added that “these factors could drive a re-rating of listed water stocks to levels comparable with UK and US regulated peers.”
Dividend forecasts set for rosy revisions?
And with signs that the regulatory backdrop may be on the mend, the dividend outlook at Severn Trent and its peers in the water sector — historically safe havens for those seeking plump payouts — could be set for a solid upgrade.
Indeed, even though the legislative backdrop remains precarious, City analysts still expect Severn Trent to shell out above-average payouts during the medium term. A full-year dividend of 85p per share is expected for the year ending March 2015, creating a yield of 4.8% which comfortably surpasses the current FTSE 100 forward average of 3.3%.
And even though a double-digit earnings drop in 2016 is forecast to push the payment to 81p, this projected dividend still creates a big-cap beating yield of 4.6%.
Make no mistake: the water sector’s big players remain hugely dicey investments given that the enduring furore over escalating household bills continues to dominate the regulator’s actions. But for risk-tolerant investors the likes of Severn Trent could ultimately prove a shrewd stock purchase.
