City fears for water shares

Big enforced price cuts to slash dividends

THE CITY is bracing itself for a stormy ride for water stocks on Thursday when the regulator orders what are expected to be sweeping cuts in the price of water paid by the consumer.

Analysts are expecting Ofwat, the industry regulator, to order average price cuts of up to 10 per cent, with some companies being told to slash their prices by as much as 20 per cent.

While the move is excellent news for the consumer, it is likely to rattle investors, who fear that the consequent reduction in prices could cause water firms to slash dividends.

Environment Secretary Michael Meacher announced in September that he expected water firms to invest some pounds 8.5bn on environmental clean-up programmes while making "substantial" cuts in water bills. But the final decision rests with Ian Byatt, director-general of Ofwat, who will announce investment and price-cut levels on Thursday.

"I am expecting something fairly ferocious next Thursday that will cause the market to run a mile," said Kevin Lapwood, water companies analyst with Charterhouse Tilney Securities. "I think the regulators will err on the side of the customer big time."

Charterhouse Tilney is forecasting that Mr Byatt will order an average 7 per cent cut across the industry. Other brokers are expecting the price cuts ordered to be even higher. Credit Lyonnais, which is an adviser to Ofwat, is expecting to see an average cut of 9.7 per cent.

Water companies - the biggest of which are Thames, Severn Trent and United Utilities - are expected to resist the enforced price cuts, which they say could cause them financial difficulties if accompanied by heavy investment requirements. One option would be to make a complaint to the Monopolies and Mergers Commission.

Mr Byatt will offer the water companies some flexibility by ordering the cuts to be within a range. The wider the range, the worse it will be for the share price of the companies concerned. That is because, while the market has to some extent already factored in price cuts, it will react unfavourably to any uncertainty. Credit Lyonnais analyst Bruce Bromley said he expected the range to be wide.

Even with the most conservative price-cut estimates - like Charterhouse Tilney's 7 per cent average cut, followed by a mandate that prices are only increased for the subsequent four years in line with inflation - will lead to a fall in industry pre-tax profits of 11 per cent in 2001.

"What is not certain is whether companies will react by cutting the dividend in order to allow four years of above-market growth, or whether they will settle for five years of minimal or zero real dividend growth," said Charterhouse Tilney in a report.

According to Credit Lyonnais, Wessex will be ordered by Mr Byatt to cut prices the most, with the range either side of 20.8 per cent. United Utilities is expected by the bank to come off most lightly, with a cut of around 4.4 per cent.

Credit Lyonnais brokers say that although they advise Ofwat, they do not have an inside track into what Mr Byatt will do on Thursday. His recommendations will still only be framework prices, with the final numbers not expected to be settled until next July.

Mr Meacher said the environmental investment, which would be for a five- year period beginning in April 2000, will be aimed at ending the dumping of sewage in the sea, improving sewage treatment and boosting drinking water standards to meet European Union requirements.

Shares in water companies already fell sharply last month after Mr Meacher warned them of the pounds 8.5bn investment expectation.