Standard & Poor’s ratings agency has said that Ofwat’s August Draft Determination will result in lower profitability and operating cash flows for water and wastewater companies in 2015-2020, despite continued high investment needs.

Standard & Poor’s (S&P)ratings agency has said that Ofwat’s Draft Determination, published in August 2014, which decreased the weighted-average cost of capital for the entire water sector will result in lower profitability and operating cash flows for water and wastewater companies in 2015-2020, despite continued high investment needs.

The comments on Ofwat’s decision to decrease the weighted-average cost of capital for the entire water sector come with today’s rerating of the outklook by the agency for United Utilities (UU). The outlook draws attention to United Utilities’  totex gap of about £1.0 billion highlighted by Ofwat in its Draft Determination in August - half the totex gap of the entire sector.

S & P has revised its outlook on United Utilities down from positive to stable – reflecting its opinion that Ofwat’s “relatively challenging regulatory review” for AMP6 means that the headroom that the company has built in its cash flow-based ratios will reduce.

The ratings agency said that the water regulator for England and Wales has published “a challenging set of Draft Determinations for the 2015-2020 regulatory period. S & P believes that United Utilities Ltd.'s headroom in its cash flow-based ratios will reduce and that as a result, the company will not achieve the threshold for S&P to raise its rating over a two-year rating horizon. The headroom had resulted in S & P assigning a positive outlook in December 2012.

At the same time, S & P has affirmed its 'BBB-' and 'BBB+' long-term corporate credit ratings on United Utilities and its regulated subsidiary United Utilities Water, respectively.

In particular, the agency believes that UU will not sustainably meet the threshold for raising its rating, of adjusted funds from operations (FFO) to debt of more than 11%, over the medium term. However, S & P is affirming its long- and short-term corporate credit ratings and assigning a stable outlook. The agency said this is despite “uncertainty associated with the sizable total expenditure (totex) gap.”

In S & P’s view UU’s adjusted FFO to debt will remain above 9%-10%, which it considers to be commensurate for UU's "significant" financial risk profile. In addition, other ratios such as adjusted FFO interest cover and adjusted debt to regulated capital value (RCV) remain relatively strong for the rating.

WACC decrease will result in lower profitability and operating cash flows in 2015-20 for the entire water sector

Commenting on the re-rating, S & P referred to Ofwat’s Draft Determination, published in August 2014, which decreased the weighted-average cost of capital for the entire water sector to 3.85% from 5.1% for the appointed business.  In S & P’s opinion, this will result in lower profitability and operating cash flows for water and wastewater companies in 2015-2020, despite continued high investment needs.

In its Draft Determination for UU, the regulator highlighted a large gap in assumptions on totex of about £1.0 billion - half the totex gap of the entire sector. The ratings agency said it understands  from United Utilities that it has, since August, agreed to reduce the gap to about £628 million, and has provided new evidence to support its claim for funding that will be determined in December 2014.

Standard & Poor’s said that in a best-case scenario--in which UU is granted funding for the full £628 million--it anticipated that adjusted FFO to debt would still fall short of 11% in 2015-2020. Conversely, if UU was to spend the full £628 million but not obtain the funding, the ratio could fall below the 9%-10% level needed to maintain the current rating. However, it considers this scenario to be unlikely, given that UU would be unlikely to invest without regulatory approval.

UU's "excellent" business risk profile primarily reflects the strong regulatory framework and the low risk associated with its regulated water and wastewater businesses, which contribute more than 99% of consolidated EBITDA.

“Regulatory framework for the water sector in England and Wales is credit supportive”

 However, S & P said it considers the regulatory framework for the water sector in England and Wales to be credit supportive, with revenues set prospectively for periods of five years, ensuring transparency and predictability of earnings and cash flows. UU has steadily improved its regulatory measures of operational performance in recent years, and we no longer consider these as below average relative to its peers.

From 2017, UU will be exposed to competition in the non-residential retail segment, which will be remunerated under a new regulatory framework based on a default tariff (set as the company cost-to-serve plus a retail margin). Standard & Poor's said it will monitor UU's consolidated credit quality for any margin compression or cash-flow volatility which might arise from increased competition in the retail segment.

The ratings agency views UU's financial risk profile as "significant" because of its relatively high financial leverage. However, S & P said the regulation of substantially all of its revenues mitigates this, allowing for higher leverage at a given rating level compared with a non-regulated corporate.

Standard & Poor’s said:

“We assess UU's financial policy as moderate, with high capital expenditure (capex) funded mostly by internal sources, but negative discounted cash flow (DCF) after sizable dividend payments. We apply the "low volatility" table to UU when assessing its ratios, because virtually all of its revenues are regulated.”

The agency’s base case for United Utilities assumes:

Mid-single-digit revenue growth.

Relatively high dividend payments and capex resulting in negative DCF, limiting the degree of deleveraging.

Solid profitability supporting interest coverage despite high leverage.

The stable outlook on UU reflects Standard & Poor's opinion that the company will maintain ratios consistent with the ratings over the medium term. The agency added:

“Although unlikely, we would consider lowering our rating if UU is unable to maintain an adjusted FFO-to-debt ratio of more than 9%-10%, assuming an unchanged business risk profile. This could foreseeably occur if, for example, UU was compelled to invest in projects during 2015-2020 for which it had not secured regulatory funding.”

S & P would consider raising the rating if it believes that UU can sustainably maintain a Standard & Poor's adjusted FFO-to-debt ratio of more than 11%.