Investment Column: Splashing out on water is now a risky bet

Homeserve; Media Square
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The Independent Online

Our view: Sell

Share price: 1004p (+7p)

Given that yesterday's half-year results from Severn Trent come just two days before the regulator, Ofwat, publishes its final ruling on five-year price controls out to 2014/15, it might seem a strangely uncertain time to be making investment decisions on the stock.

But since Ofwat's draft proposals on the subject were made public in July, and few significant changes are expected in the final scheme to be published tomorrow, the impact is already reflected in the share price.

Either way, the price review is unlikely to be what the water companies wanted. Collectively they asked for an 8 per cent price hike.

Instead, Ofwat's initial plan is to force prices down by 4 per cent. For Severn specifically, prices are scheduled to come down by 1.5 per cent, taking the average bill to £281, some 12 per cent less than the £318 Severn proposed.

Ignoring the looming regulatory changes, Severn has had a good year. The rather overshadowed half-year results yesterday showed pre-tax profits of £208m, a massive 51 per cent increase on last year, and revenues were also up by a healthy 4.6 per cent to £852m.

Mike McKeon, the finance director, says the boom in profits is down to a number of factors coming together.

"It is from a combination of historical price increases from last year, good control of costs and a slightly lower level of investment," he said.

But while the interim dividend payment of 26.7p is an increase of 1.6 per cent, and thus meets Severn's commitment to pay out at 3 per cent above retail price inflation, analysts are already predicting a rebasing of the dividend next year as the new price controls kick in.

For investors looking for the safety and predictability of a utility stock, water may not be the best sector, and we would look for better options elsewhere. Sell.

Homeserve

Our view: Hold

Share price: 1626p (+106p)

Homeserve, the repair insurance group, has had a lucky escape. The group used to provide fire and flood restoration services, but recently sold its emergency services business to concentrate on what it says are higher margin membership divisions, thus avoiding any charges relating to last weekend's floods in Cumbria.

Aside from avoiding charges relating to floods, which the Association of British Insurers says will top £100m, Homeserve have been making progress. In case there is any doubt, the company would like the market to consider only what it describes as "core" activities; its UK, US and European policy membership businesses, which recorded a pre-tax profit rise of 14.6 per cent. To avoid any doubt, the company kindly put a red box around its "core" results in yesterday's presentation.

For investors, there was more good news on the dividend, which was increased by 9.5 per cent. Given the uncertainty about the direction of equity markets, we reckon investors should increasingly seek yield.

But even considering yesterday's dividend increase, Homeserve still only yields 2.6 per cent, according to Panmure Gordon, which is adequate if not spectacular. Moreover, even though most analysts back the group to continue to pump out the good numbers, the shares do already appear to be fully valued. "The shares continue to trade on a full price earnings valuation at the calendar 2009 level of 14.4 times falling to 13.4 times... We recently instigated a 'take profits' call, moving to a sell recommendation, following a strong run-up in the share price."

It would be a shame to sell a company that is performing well, but we rather think there is better value elsewhere. Hold.

Media Square

Our view: Hold

Share price: 14p (-2p)

Media Square, which runs companies ranging from advertising and public relations to research, has endured a chequered few years. It is now looking to return to growth after picking up the pieces from bad management decisions and plain bad luck.

The group was forced into a three-year restructuring plan after what it described as "a number of years of reckless, acquisition-led growth, which had led to high debts, weak management controls and low operating margins".

It put out its interims yesterday for the six months to the end of August. Revenues fell 25 per cent year on year to £24.3m, as expected, and swung from a £2m operating profit to a £1.5m loss as clients stopped spending.

Revenues are expected to remain under pressure, although following the turnaround plan, which saw the group bring its agencies from 40 two years ago to 11, annual costs should fall from £6m to £2m. Hold.

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