Investment Column: Fierce headwinds buffet United Utilities

HomeServe; Nanoco Group


Our view: Sell

Share price: 455.2p (-0.2p)

It's a funny time in the water industry. Traditionally held to be one of the safest sectors (even the credit crunch can't stop people drinking and washing, after all), there are stronger, more uncertain gusts than usual ruffling the surface of the mill pond. Alongside recession-related issues such as rising bad debt, the biggest concern is the industry regulator Ofwat's five-year price review for the years 2010 to 2015, which is due to be published in its final form in November.

United Utilities, which released a trading statement yesterday, is predicting that half-year profits to the end of September will be broadly in line with last year. Despite the 6 per cent regulatory price increase allowed for 2009-10, it thinks falling industrial demand for water, as well as more power cuts and bad debts, will push down revenue growth.

After 2010, things are unlikely to get much easier. The draft determination published by Ofwat in July demanded that United Utilities produce an average annual price cut of 0.6 per cent over five years – 2.4 per cent lower than the company's business plan had allowed for – along with capital expenditure of £3.4bn and a return on capital of just 4.5 per cent.

Although the final ruling is unlikely to be much tougher than this, and may even be slightly better, the stock will not do much before the November ruling. But then there is a danger to the dividend. Analysts at JP Morgan are not optimistic: "Ofwat decreases the current price limits and this appears likely to put the company under pressure to cut its dividend by more than 20 per cent, which we believe is not currently priced into the shares." So the prospective yield of 7.5 per cent is under threat.

Even at eight times next year's forecast earnings, United is not a stock to be buying, and is probably not even one to hang on to for investors looking to cash in any time soon. Water is a decent backbone for a portfolio, but United Utilities looks the weakest link among its peers. Sell.

HomeServe

Our view: Hold

Share price: 1542p (+28p)

HomeServe provided further evidence yesterday that Britons are still willing to sign up to annual insurance policies that protect them from the painful cost of household repairs (such as for broken boilers or burst drains) despite the recession.

The company, which also operates in Spain, France, Belgium and the US, forecast that first-half profits for its core membership operations would be better than last year and in line with expectations. For the six months to 30 September, HomeServe was buoyed by high retention rates of 83 per cent among its UK members and gross new policy sales of 750,000, a similar level to last year. Similarly, HomeServe toasted high customer retention rates in the US and France, at 80 per cent and 88 per cent respectively.

Analysts said the shares, which trade on a forward 2010 price-to-earnings ratio of 14, were fairly valued compared to the broader services sector.

On the downside, HomeServe said its UK emergency services business, which provides household repairs on behalf of insurers, was still suffering from lower volumes and would post a loss for the period. While the company is in talks about selling the unit, a deal has not been finalised.

HomeServe's business has proved resilient in the recession. The shares are not exactly cheap, but this makes them worth holding on to.

Nanoco Group

Our view: Buy

Share price: 74p (-0.5p)

We were excited to hear about quantum dots for the first time yesterday, as they conjured up images of James Bond and science-fiction heroes. While the reality is more prosaic, they could prove a good investment opportunity through Nanoco Group.

Quantum dots are tiny particles of semiconductor materials, about one-thousandth of the thickness of human hair. They produce a very bright light that can be used in devices from light bulbs to televisions, but are much more energy-efficient than traditional methods and emit very little heat.

Nanoco is the first to commercially mass produce them, and yesterday announced a significant contract win. It has agreed with an unnamed Japanese company to jointly develop the dots for use in light-emitting diodes in liquid-crystal display televisions. This is its second such contract with a major Japanese corporation.

Nanoco started life as Evolutec Group, using technology from Manchester University and Imperial College in London. It will licence that technology to these companies and the chief executive, Michael Edelman, says there are more deals in the pipeline.

Yesterday's contract provides a solid revenue stream and analysts reckon that with some more buzz, Nanoco could well be profitable next year. Those feeling brave should take the quantum leap.

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