Water shares face drought

The regulator is turning customers into winners in the long-term, writes Richard Shackleton
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CUSTOMERS are beginning to get a better deal from Britain's privatised utilities, especially the water companies. Once the most unpopular of all of the Thatch-erite sell-offs, water companies are, if not exactly the consumers' best friend, no longer their worst enemy.

This is largely due to a significant rebalancing of the interests of customers and shareholders. Since privatisation in December 1989, investors in water have done extremely well. Share prices have doubled while dividend payouts are up by around 50 per cent.

But the steady drip, drip, drip of adverse publicity surrounding issues such as executives' pay and the steep increase in bills has pushed the water companies on to the back foot. Now many are looking to buy off criticism by taking a more even-handed approach between customers and shareholders.

In March, North West Water struck back at its critics with a promise that efficiency gains would in future be split. Customers would get special rebates from their bills for at least the next five years, while shareholders would be paid enhanced dividends. The recent water companies reporting season has seen Anglian, Welsh and Yorkshire following suit - offering to refund up to pounds 10 per annum to their customers.

Does this mean the best days are now over for shareholders?

Once shareholders could have looked forward to the lion's share of any savings - now they must share them with customers. To judge by share prices, the stock market clearly agrees. Despite the usual run of impressive profits, dividend and cash-flow improvements in the recent reporting season, share price performance has been stubborn. The water sector is still 10 per cent below the peak it hit nearly 18 months ago. Over the same period equity values, as measured by the FT-SE All-Share index, are virtually unchanged.

Water stocks are in limbo. They yield on average 5.4 per cent, second only among utilities to British Gas on 5.9 per cent and well above the All-Share average of 3.95 per cent. But that compares with the yield on 10-year gilts of 8.1 per cent, with index-linked gilts returning an inflation- proofed 3.45 per cent.

Much of the underperformance stems from regulatory uncertainty. The electricity regul- ator, Professor Stephen Littlechild, said in March he would tear up an earlier power price regime that he considered to be too lenient and replace it with a much tougher one. Electricity share prices collapsed, dragging the water companies down in their wake.

A similar settlement imposed on the water industry by Ian Byatt, its regulator, is also widely considered to be too generous. Few believe he will take the Littlechild approach. However, he retires in just over a year, and many fear his replacement could be far tougher on the water companies.

If this was not enough, there is another regulatory time bomb just waiting to go off - the intended bid by Compagnie Lyonnaise des Eaux of France for Northumbrian Water.

Should Northumbrian follow the example of Northern Electric - it proposed a special dividend payment as part of its defence against the Trafalgar House bid - then Mr Byatt might decide on a pricing review himself. It was Northern Electric's dividend that prompted the electricity regulator to reconsider his pricing policy. The details of the bid and Northumbrian's response have yet to be published, but it has got water executives on the edge of their seats.

Then there is the political risk. The Labour Party has already described the recent rebate packages as "pathetic", adding to the concerns that the sector faces a big squeeze in the not-too-distant future. Precise details of Labour's policy towards the industry sector are not known, but remarks by senior figures would seem to indicate at the very least a windfall tax, which analysts estimate could be anywhere between pounds 2.5bn and pounds 5bn, and action on the controversial issue of directors' salaries and share options.

A worst-case scenario from one analyst shows the water sector having to cope with a Labour windfall tax of pounds 7.5bn with dividend growth virtually static. But that same forecast still has water yielding up to 8 per cent at the next election, due in 1997.

Nevertheless, even the more optimistic are convinced investors will have to navigate the sector with a great deal more care in future. To maintain dividends, the focus of investor attention will shift to the com- panies with the strongest balance sheets such as Northumbrian, Yorkshire and Severn Trent. Only they will have the flexibility to balance the political and regulatory risks while returning increasing value to shareholders.