Dealtalk - Taps on water infrastructure M&A may prove stiff

LONDON/AMSTERDAM Wed Jun 29, 2011 3:41pm BST

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LONDON/AMSTERDAM (Reuters) - Anyone hoping a possible bid for Britain's Northumbrian Water Group Plc NWR.L preludes a long-awaited spate of M&A across the sector could be set for a disappointment.

Monday's statement from Hong Kong billionaire Li Ka-Shing's Cheung Kong Infrastructure Holdings (CKI) (1038.HK) that it was considering a cash offer for Northumbrian was enough to spark gains in sector peers Severn Trent (SVT.L), Pennon Group (PNN.L) and United Utilities (UU.L).

But there are reasons to doubt a bid for Northumbrian would be followed by other acquisition attempts.

Most importantly, regulation has become less favourable since a previous M&A spree petered out in 2007, restricting companies' ability to raise prices -- by no more than inflation on average -- thus making them less appealing to bidders.

Between 2004, when CKI splashed out on its first UK water utility, Cambridge Water, and 2007, no less than 12 water infrastructure assets changed hands in Britain. Since then there has been no major buyout in the sector.

In the sector's previous M&A cycle, infrastructure funds, private equity firms and pension funds easily paid a 30 percent premium to the regulatory capital value (RCV) -- the valuation of assets set by the watchdog. The likes of Pennon, Severn Trent and United still trade at premiums to RCV due to residual bid hopes.

But industry sources caution that even if CKI launches a successful bid, this will not change the fundamentals of UK water companies, which have less scope to leverage up than before, while most of their capital growth is behind them.

"People are still cautious. If this was easy, Ontario Teachers' Pension Plan (Northumbrian's largest shareholder with a 27 percent stake) would have bought them already," said one infrastructure fund manager.

PRICE REVIEW

The total RCV of water and sewage companies in England and Wales grew from 12.2 billion pounds at the onset of their privatisation in 1990 (at 2009-2010 prices) to 50 billion by March 2010, according to regulator Ofwat, which in its latest price review sees it growing only to 53 billion pounds by 2015.

At the same time, total gearing in the industry as a percentage of RCV has increased from near zero at privatisation to 69 percent in March 2010, Ofwat says.

Northumbrian fared better than most utilities in Ofwat's latest price review, as it was allowed to raise prices by an average 1.7 percent above inflation between 2010 and 2015. Among all the water and sewerage companies which Ofwat regulates, only Pennon got higher rates.

Analysts suggest CKI would likely agree to shed ownership of Cambridge Water, which has an RCV of 57 million pounds, were regulators to make it a requirement for its acquisition of Northumbrian Water, which has a group RCV of 3.6 billion pounds.

"We see an 80 percent probability of a bid occurring, with a realistic bid price range being 450 to 500 pence. A 25 to 30 percent premium to Northumbrian's RCV would give a price range of 450 to 486 pence," Investec analyst Angelos Anastasiou said.

Such a premium was paid as recently as 2009, when Challenger Infrastructure Fund CIF.AX announced the 168 million pound sale of its 15.6 percent stake in Southern Water, representing a multiple of 1.26 times RCV.

Northumbrian shares hit a record high of 420 pence on Monday on news of CKI's interest and are currently hovering around 410p. Ontario Teachers' Pension Plan has not commented on its next move. But other water stock investors hoping for further takeover activity could be in for a long wait.

Bidders with the deep pockets of CKI and a track record of interest in UK water assets are thin on the ground. CKI has a reputation as an investor willing to pay hefty premiums over RCV.

"In CKI you have a hard to come by buyer, someone between an industrial player and an infrastructure fund, that has the balance sheet and a low cost of capital to make returns work by taking Northumbrian private," a sector investment banker said.

(Editing by David Holmes)

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