Watered-down returns(5)

Regulated UK water companies have traditionally represented one of the purest and most conservative infrastructure investment propositions around, providing rock-steady earnings year on year. Their monopolistic nature and the fact that, even in the darkest economic conditions the provision of clean drinking water and working sewerage is a necessity, have made them one of the most recession-resistant forms of infrastructure.

But recession-proof they are not.

As this year’s earnings season for UK water utilities demonstrates, these are not easy investments to make and much can go wrong after buyers ink the deal.

Earlier this week publicly listed water and sewerage company Northumbrian Water, whose main shareholder is the Ontario Teachers’ Pension Plan, posted its full-year results. Revenues were down 10 percent to £157.2 million. This is not necessarily disastrous news, however, as it is ahead of expectations.

Surely, you think, the households of Britain are not cutting back on the consumption of H2O amid a weakening economy. In fact, even though household consumption remains fairly stable through thick and thin, declines in heavy industry water usage during a slump can create a major dent in earnings. With heavy industry representing a  relatively large proportion of its customer base, Northumbrian was hit especially hard by this as North-Western UK factories continued to close.

The extent to which water utilities are regulated can also cause logistical headaches for those pondering a purchase. UK water regulators have proposed extending competition by vertically separating water companies’ activities with price controls and opening competition for non-domestic customers.

Moreover, owing to their monopolistic nature, buying regulated water assets can be pricey, meaning any potential acquisition may need substantial leverage. Needless to say, this is not ideal in the current market.

Think back to the acquisition of Kelda, parent of Yorkshire Water, agreed in November 2007 and completed in February the following year. The Saltaire Group, an investment consortium comprising Citi Infrastructure Investors, GIC Special Investments, Infracapital Partners and HSBC, paid just over £3 billion for the company, borrowing heavily to fund the takeover.

Ratings agency Moody’s immediately downgraded Kelda upon the completion of the transaction, estimating that Saltaire’s leverage would come close to Yorkshire Water’s entire Regulated Asset Base, or the regulator’s valuation of the underlying asset.

And make no mistake – regulated water companies are hungry for capital expenditure, as demonstrated by Macquarie’s 2006 purchase of Thames Water. The £8 billion deal came with significant commitments to fix-up and maintain Britain’s largest water utility. Thames plans to invest £5.5 billion over 2010 to 2015, with almost 60 percent to be spent on maintaining current service levels, according to its most recent business plan.

Success with water infrastructure requires not just deep pockets but a deep understanding of local regulatory risks and the impact that market changes will have on water consumption. Any buying group without this expertise is liable to spring a leak.