Which water companies should you invest in?

Water is running out. That's bad news for most of us, but it could be good for water companies. So which ones should you invest in?

A few days ago it poured with rain in London and, naturally, the Environment Agency warned of possible hosepipe bans, water rationing and compulsory metering in the coming months.

The problem is that England and Wales have had their driest January in nine years and the sixth driest since records began, say Matthew Hickley and Olinka Koster in the Daily Mail. Not only that, but in parts of the Home Counties hosepipe bans are "still in force" from last summer, and the weather forecasters see little chance of much rainfall any time soon. Hence the Environment Agency's strong, but perhaps not so timely, warnings.

As investors, be there clouds or clear skies, we are always looking for silver linings; and there is one. Scarce water could be good for water companies.

The water regulator Ofwat (to be replaced by the Water Services Regulation Authority from 1 April) is the body with overall responsibility for the 22 water companies in England and Wales, and every five years it sets a limit on the prices they can charge each year. Last April, the regulator allowed water companies to raise them by an average of 12%. This year, Ofwat has already signalled that prices will rise by more than the rate of inflation, so that companies can spend money on "ageing infrastructure", says Mark Milner in The Guardian.

This means that bills in England and Wales are set to rise again from this April by an average of 5.5%. South West Water customers will suffer increases of more than 9% and United Utilities and Wessex Water are also pushing through "above-average" price rises. Some of this will surely be spent on replacing ageing pipes, but it still represents a sizeable windfall for the water companies.

Price rises of this sort have led to a thriving water sector, as revenues benefit from these generous handouts, says Paul Newton in Utility Week. For example, Severn Trent's first-half profits rose from £176m in 2004/05 to £240m in 2005/6, after an increase in water charges of 11.8%.

Other performers within the water sector include Northumbrian Water, where profits rose 38%, and Pennon and AWG, whose annual profits were up 33% and 19% respectively. But Bristol Water, with a 2005/06 price increase of 13.8%, revenues "raced ahead". Its shares were up 70% in 2005, although bid speculation helped. Many also pay good dividends, so it is unsurprising that water utility shares have attracted interest over the past few years.

However, an element of regulatory risk has been introduced to the water sector. Ofwat recently published a consultation document on the provision of financial support through price rises, says analyst Verity Mitchell at broker HSBC. Higher customer bills and higher infrastructure spending have so far gone hand in hand, but Ofwat is currently looking at ways in which the water companies can manage their own spending and revenue raising, so that less help would be needed from the regulator in the future. They could issue more debt or equity securities, or even cut dividends, for instance.

The regulator might decide that the need for better infrastructure justifies handing over the public's money, but if they do not, a major incentive for buying the shares will be removed.

The best stocks in the sector

Lehman Brothers recently downgraded its ratings on the FTSE 100 water stocks, says Afx News. The broker said that the water sector in this country, up some 6% in the past few weeks, has performed strongly and is at current prices "fully valued".

In a sector note, it downgraded Severn Trent to equal weight' from overweight', and both Kelda Group and United Utilities were cut to underweight' from equal-weight'. Northumbrian Water Group is graded equal-weight' while Anglian Water Group and Pennon Group, are both overweight'.

HSBC is also positive about Pennon Group (PNN, 1,400p) the owner of South West Water, and recently upgraded its rating from neutral' to overweight'. Last April, Pennon raised prices by 12.5% and this year HSBC calculates that the company's post-tax allowed return is 5.9%. In December, it will return £200m of cash to shareholders and has made a commitment to increase its interim dividend for 2005/06 by 20% and to increase the dividends from 2006 to 2010 by 3% a year. This means that, on 2007 estimated earnings, the stock yields just under 4%. The shares have done well in the past couple of weeks, so they're on a p/e of 20 times 2007 earnings.

HSBC also rates Severn Trent (SVT, 1,158p) as outperform' and its 2007 p/e of 13 times and yield of 4.6% look more attractive than Pennon's.

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