Broker snap: JP Morgan waters down Severn Trent rating

7th Jan 2014 12:51

After tough talk by the water regulator about the upcoming regulatory review period, JP Morgan has issued a cautionary note on the UK water companies, saying the chance of mergers and acquisitions is now less likely this year. "We believe that Ofwat's decision to alter the price review timetable and announce the key financial parameters on January 27th is likely to herald a lower allowed weighted average cost of capital (WACC) than the companies requested in their business plans," analysts wrote in a note.Ofwat changed its schedule to publish key financial parameters on January 27th, when it will make clear its views on key financial metrics such as the cost of capital and retail margins for the water companies, having pronounced just before Christmas that it thought "companies' views on risk and reward [...] are not in alignment with market evidence".They have now reduced their "vanilla" WACC assumptions for the next regulatory review period from 4.2% to 3.9% and said they "now see M&A this year as unlikely given the degree of regulatory risk" as Ofwat's final determinations are not due until December 2014. JP Morgan's target price for Severn Trent was cut by 8.6% to 1,535p and the recommendation downgraded to 'underweight'."We see M&A as unlikely until the regulatory review completes. In our view, given the uncertainty over allowed returns, M&A is unlikely until Ofwat publishes its final determination in December 2014. We have therefore excluded any M&A premia from our price targets for all three quoted water companies."The bank updated earnings estimates Pennon and United Utilities, taking account of lower UK inflation and the deferral of allowed price increases in 2014/15 for both companies. It retained an 'overweight' recommendation for Pennon and 'neutral' for UU, reducing price targets for both companies by 6% and 1.7% respectively to 700p and 735p.OH