We are tweaking our fair value estimate for United Utilities (UU.) from £7.30 to £7 after deciding the company no longer has a sustainable competitive advantage over its peers. Our moat rating downgrade is driven by the sharp cut in allowed returns in the next regulatory period starting in 2020. Shares currently look fairly valued.
We downgrade our moat rating from narrow to none because of the significant cut in allowed returns from 3.6% to 2.3% as of 2020. Factoring in this cut, we calculate that United Utilities will not earn its cost of capital as of 2021.
This reduction in regulated returns resonates with increasing political noise about alleged too-high profits and dividends in the UK water industry at the expense of customers. UK environment secretary Michael Gove has instructed the head of regulator Ofwat to strengthen governance in the water industry, which could include interventions on dividends.
We forecast net income to decline annually by 3.9% on average through 2022. Key to that is the 18% drop that we expect in 2021 due to the cut in allowed returns. Despite this cut and barring any political intervention, we expect the group to generate enough free cash flow to increase its dividend by 2% annually through 2022.
Investment Thesis
Much of Britain's water infrastructure is more than 200 years old and could require major upgrades during the next decade. We project that United Utilities, which is one of 11 UK water utilities, will invest roughly £560 million annually during the next five years in its water and wastewater system to address these needs.
Regulators in Britain approve capital budgets and utility rates once every five years based on utility budget forecasts. Utilities then must stay within that budget to achieve sufficient earned rates of return.
Recently, the UK water regulator cut United Utilities' allowed real cost of capital from 3.6% to 2.3% for the next regulatory regime beginning in 2020, way too low to justify a narrow moat rating despite the efficient scale provided by the natural monopoly.
We caution investors to beware of execution risk in Britain's five-year price reviews, as the company must meet performance targets, along with the threat of continued conservation. Given the recent events in the UK, investors must now also worry about an uncertain political future in the country.
