Market is cautious over cross selling in utilities

The water sector has rebounded over recent months but sentiment for the utilities sector remains negative due to the impact of regulations.

The rise in water stocks is due to several factors, says David Bertocchi of Baring Asset Management's UK specialist team.

He says: "There is a general uncertainty in technology and growth which has led investors towards defensive stocks."

He adds the competition commission review on Mid Kent and East Surrey Holdings has had an effect: "These small companies challenged regulations. They were the only two that did and were largely successful, which indicated hope for the sector. The key regulation that was challenged was to change the cost of capital that businesses are allowed to earn, leading to improved capital costs and earnings.

"This does not change much in the short-term but will make the next review, in five years, look more hopeful."

There was also a bid by RWE for Thames Water, which stimulated investor interest. Bertocchi says: "It is probably a one-off, as excessive M&A activity will not be permitted due to competition issues."

Martin Cobb, senior portfolio manager of UK equities at Colonial First State, says there have been spikes in the water sector but nothing great in absolute terms.

He says: "They are defensive shares, so perform better when other sectors are weak. Water prices bottomed in April, but people are buying again as it had a good run in the second quarter. Since the 25 September takeover of Thames Water it has had a strong run, however, it is still 50% off its high."

Cobb does not believe it will reach previous highs due to regulatory restrictions. He adds: "The regulator made conditions tougher. Now there are cost cutting and profit-up requirements, which is difficult for the water companies." He does not believe that prices will rise much further, unless there is more consolidation.

The water sector is simply coming off some lows, says Bertocchi. "These events do not signal a long-term upswing in share prices, if technology collapsed then water would be a safe haven.

"Water is still trading at a discount, between now and the next five-year review this will close. However, each new regulation can change everything."

Cobb points out that utility companies are much less homogeneous than they were. He cites Centrica as an example, which now supplies gas to customers and has a financial arm.

Utilities are attempting to expand their customer base through cross selling of other services but Bertocchi is undecided as to whether cross selling adds value. He says: "Companies are trying to extract value from customers and are seeing the opportunity to sell additional products. These plans have potential, but we do not know whether they are workable."

Cobb holds Centrica and is looking to buy Innogy, a demerged company of National Power, which has recently changed its trading arrangements. He says: "Innogy has a new technology for efficient electrical storage, called Regenesys, developing a pilot battery which should be out in three to five years time."

Fiona Henderson

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