Ofwat Issues Early Warning To Investors In Severn Trent Plc And United Utilities PLC

Shareholders in Severn Trent (LSE: SVT) and United Utilities (LSE: UU) should brace themselves for a rough ride over the next few months, in my view.

United UtilitiesLater this month, both companies will submit revised business plans to Ofwat covering their pricing and spending plans for the 2015-2020 regulatory period.

The outcome of these submissions is not a forgone conclusion: Ofwat issued a notice on Friday confirming that Northumbrian Water and Welsh Water have agreed new pricing plans which will see customers’ bills fall over the next five years.

This isn’t just a formality

Buried in Severn Trent’s and United Utilities’ final results are comments that make it clear that big differences still exist between the utilities’ pricing and spending plans and what Ofwat believes is appropriate.

Early signs suggest that Ofwat is going to be a tougher negotiating partner than it has been in the past — and I reckon that this could threaten the safety of both firms’ dividends.

United’s woes

There is currently a ‘£1.1bn difference’ between United Utilities’ expenditure plan and Ofwat’s view. Given that United’s total regulatory expenditure was £836m in 2013/14, a difference of £1.1bn over five years is very significant.

United is also concerned that Ofwat will assume a lower cost of borrowing than in previous years. This could reduce United’s profit margins, as regulatory pricing is generally linked to the cost of borrowing.

Severn Trent quibbles

Severn Trent says that it ‘has a number of challenges to address’, the biggest of which is a £255m disagreement with Ofwat over planned expenditure on its Birmingham strategic resilience project.

Severn Trent also highlights the passing of the Water Act into law. This means that by April 2017, retail water customers will be able to choose their water supplier, as with gas and electricity.

This change should lead to increased competition in the water market, and could put further downward pressure on prices.

Dividend pain?

Both Severn Trent and United Utilities have committed to maintain their existing inflation-linked dividend policies until 2015.

There’s no word yet on what to expect from 2015, but in my view, the RPI link will have to go. Maintaining the current rate of dividend growth would leave dividends rising faster than prices, which is unlikely to be affordable for either firm, especially debt-laden Severn Trent.

I rate both companies as no more than a hold. Both firms’ shares are trading near all-time highs, and I believe there will be better buying opportunities in the next 3-9 months.

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> Roland does not own shares in any of the companies mentioned in this article.