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Should You Buy United Utilities Group PLC And Severn Trent Plc After Ofwat Review?

Today’s final determination by Ofwat that the cost of water is set to fall by 5% (excluding inflation) by 2020 is great news for consumers. After all, it means they will have more money in their pockets in real terms, since the average annual bill is forecast to fall by around £20 to £376 over the next five years.

Of course, bills will still go up, since water companies are allowed to include inflation in their price rises, but it is nevertheless being billed as a victory for consumers at a time when disposable incomes are still being squeezed in real terms. In addition to demanding a decrease in real terms prices, Ofwat has announced that water companies across the UK will invest around £44 billion over the next five years, which equates to more service for less money.

Impact On Water Companies

Clearly, a reduction in pricing and an increase in investment generally means one thing for water companies such as United Utilities (LSE: UU) (NASDAQOTH: UUGRY.US) and Severn Trent (LSE: SVT): reduced profitability. In addition, Ofwat’s expected reduction in the allowed cost of capital (from 5.1% to around 3.9%) means that it will be more difficult for water companies to increase borrowings in order to boost shareholder returns. However, rewards for meeting targets on leaks and make improvements to household supply could mean they receive rewards moving forward.

Of course, there is a two month window for the water companies to refer Ofwat’s decision to the Competition and Markets Authority but, following the initial application made to Ofwat, potential savings have been found (for example £376 million in the case of United Utilities) and so shares in United Utilities and Severn Trent are up today on the news.

Looking Ahead

Having risen by 33% and 14% respectively during the course of 2014, the dividend yields of United Utilities and Severn Trent have been squeezed somewhat. For example, they now yield 4.3% and 4.4% respectively and, as a result, remain relatively appealing income stocks in the short term. However, in the case of Severn Trent, its dividends are due to fall by 10.4% next year, which means that its yield could fall to 3.9% in 2015 and, furthermore, dividends are forecast to be only just covered by profit. While this is not an issue in the short run, it could lead to further dividend cuts, as the company is required to reinvest moving forward.

Bid Potential

While United Utilities and Severn Trent are hardly cheap at the present time, with them having price to earnings (P/E) ratios of 19.3 and 21 for example, they offer a relatively high degree of stability for investors. For example, they do not suffer from the same degree of political risk as do domestic energy suppliers and, looking ahead, they are potential bid targets – as was seen last year when Severn Trent turned down an approach from a Canadian-led group of investors.

Looking Ahead

So, while neither of them are cheap, United Utilities and Severn Trent could offer upside potential in 2015. That’s especially the case if investor sentiment remains uncertain and bid rumours once again begin to circulate. Today’s Ofwat ruling may mean that further efficiencies are required and, in the case of Severn Trent, dividend cuts seem to be on the cards.

In fact, as a result of this and its higher valuation, Severn Trent does not seem to offer as much appeal as United Utilities as an investment over the medium term. As such, while Untied Utilities remains an appealing buy, Severn Trent’s share price could come under pressure next year, unless a bid approach materialises.

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Peter Stephens owns shares of United Utilities Group. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.