Investing.com -- Analysts at Barclays (LON:BARC), in a note dated Thursday, provide a detailed outlook on the UK water sector, focusing on key players such as Pennon (LON:PNN) Group, Severn Trent (LON:SVT), and United Utilities (OTC:UUGRY).
As regulatory developments unfold, these companies face changes in their operational and financial landscapes.
Barclays has upgraded Pennon to "overweight" with a revised price target of 800p, reflecting a 31% upside.
United Utilities has been raised to "equal weight" with a price target of 1,200p, and Severn Trent (NS:TREN) retains its "equal weight" rating with an increased target of 2,800p.
These adjustments stem from expectations surrounding Ofwat’s upcoming final determination, set to be published on December 19.
Analysts anticipate that this determination will offer a more favorable stance than the draft, potentially addressing concerns raised during earlier assessments.
The water sector’s challenges have been well-documented, with Barclays previously downgrading its outlook in August 2024.
Structural issues such as escalating capital expenditure, heightened regulatory scrutiny, and rising interest rates have placed considerable strain on the industry.
However, optimism is growing as analysts foresee Ofwat increasing allowed returns, relaxing Outcome Delivery Incentive targets, and potentially introducing an Out-turn Adjustment Mechanism to buffer against underperformance.
Among the listed companies, Pennon Group stands out as particularly undervalued, trading close to its regulatory capital value while peers like Severn Trent and United Utilities command premiums of about 15% and 13%, respectively.
Barclays says that Pennon’s high leverage as a key factor influencing its valuation. Should the final determination align with expectations, Pennon’s higher gearing could amplify the benefits of improved regulatory outcomes, making it a prime candidate for re-rating.
Barclays also notes the sector’s potential for robust returns on regulated equity, with projections exceeding 9% nominal by 2030.
This performance is contingent on several factors, including totex allowances, which are expected to rise, and regulatory adjustments that mitigate underperformance.
Analysts estimate that every 50 basis points increase in allowed RORE could enhance equity value by 6-10% over the long term.
Nevertheless, risks remain. Environmental and political pressures weigh heavily on the sector. Investigations into compliance breaches by the Environment Agency and Ofwat’s potential penalties add uncertainty.
Additionally, the government’s review of the water sector’s structure and its emphasis on enhanced environmental performance may introduce additional layers of accountability and investment requirements.
Severn Trent and United Utilities, while positioned as stable performers, also face their share of challenges. Totex allowances and ODI targets will be pivotal in determining their financial trajectories.
Both companies are likely to benefit from lower costs of debt compared to the sector average, potentially adding 60 basis points to achieved RORE. However, their ability to outperform regulatory expectations remains a critical question.