Rumours about likely bids for UK listed water companies have become so endless as to almost reach the level of cliché. Even a looming price review of the water industry in 2014 (PR14) that was considered to be a significant, if temporary, obstacle for potential mergers and acquisitions (M&A) did little to dampen the embers.

With the revelation from Severn Trent on Tuesday about a potential bid putting a jolt into the utilities sector, electrifying the shares of other water suppliers, the whispers have not died down despite the company’s subsequent rejection of the advance. So, should investors expect further bids this year?

Although the market had its fingers crossed for some sort of bid, it came as something of a surprise to several analysts as UK water takeovers rarely occur this close to reviews from regulatory body Ofwat, due to the lack of visibility of cash-flows.

So if Severn is a potential target, two years after Northumbrian Water was sucked up for £4.7bn, could Severn be targeted again soon, or could United Utilities or South West Water-owner Pennon be next?

Water industry watchdog Ofwat is planning to impose a new five-year price regime from 2014 and these periodic reviews are normally considerable impediments to M&A. What’s more, Jonson Cox, Ofwat’s new Chairman, is considered to favour companies with a public listing, especially when compared to highly leveraged, less transparent, privately owned companies. Furthermore, in a recent pronouncement Ofwat spoke out against the returns being earned by shareholders, stating that customers should benefit more through price reductions.

This summer, the regulator publishes its pricing methodology for the water companies to then respond with their business plans by the end of this year, meaning the market’s focus may morph from speculation to pondering the downside risks associated with regulatory changes.

Final drafts of the new price limits will be published in the second quarter of 2014 before the new controls come into effect on April 1st 2015, and analyst Guy MacKenzie, at Credit Suisse, says he would not be surprised to see “a material de-rating” ahead of this.

But when a shark smells blood

However, others think the predators have the taste of blood now. Peter Atherton at Liberum Capital says that while a bid in the third year of the five year regulatory cycle is surprising, he thinks it likely the consortium will make a further offer before the June 11th deadline set by the Takeover Panel to make a firm bid or walk away. "We have seen many such bids in the past decade and no bidder has ever given up after just one offer," he adds.

Indeed, the financial sharks that have swarmed around Britain’s water companies are lured by the cash generated by these businesses. Utilities are always appreciated for their meaty dividends and Severn Trent is no exception.

Wessex Water was bought by Enron in 1998 and then by Malaysia's YTL in 2002, Thames Water was purchased by Australian bank Macquarie in 2006, and Bristol Water was bought by Spain’s Agbar and since by Canada’s Capstone Infrastructure, while most lately Northumbrian Water was acquired by Hong Kong’s Cheung Kong Infrastructure in 2011. The Office of Fair Trading estimates a third of the UK's water, telecoms, energy and transport networks are now owned by companies based overseas.

Severn, United or Pennon?

So, why might Severn Trent be next on this list - or indeed why not its peers? Well, Severn is more attractive than its closest rival United Utilities on several basic fundamental metrics: it has more customers, it has larger revenues, it has lower net debt and it is more cash-generative.

Severn has been very well run and its structure and strengths indicate the new regulatory regime may hit the company less hard than its listed peers. As Citi says: “With CEO Tony Wray due to leave in 2014 and, in our view, Severn Trent as the best positioned publicly listed water company post the PR14 regulatory review in 2014, we expect a formal bid to materialise and given the timing and the current rate environment, £23 per share and 35% premium to RCV seems possible, in our view.”

Although UU was more profitable last year, it has other issues. If under Ofwat’s new retail price limits it enforces an expected 100 basis point (bps) reduction in allowed returns, UU may have to cut its dividend 20% in 2015, according to analyst Guy MacKenzie at Credit Suisse. Also, if the regulator refuses to make many concessions under its new retail price limits, then UU’s returns could be under even more pressure than its rivals, reckons MacKenzie, as its retail costs are significantly above the industry average.

However, other analysts expect the first year of price controls in 2016 to only include a 25bps lower allowed return, 50bps at worst. For United Utilities and Severn Trent, a 50 bps cut in allowed return would be expected to hit earnings by 11%, more than Pennon.

Smallest but by no means the runt of the litter, Pennon Group, the owner of South West Water and waste business Viridor, is the cheapest of the three in terms of price/earnings and enterprise value (EV)/sales, but the most expensive on EV/earnings. Viridor might be cited as an unwanted sibling to the water business, but is expected to grow strongly from 2016 and a purchaser could sell that off to recoup some cash if it so wanted.

The potential price control effects of a 25bps cut in allowed returns would hit earnings the least of the three, while the effect would be masked by the strong growth coming from its energy-from-waste investment programme from 2016 onwards, with its dividend looking safe.

With the price review looming large, the M&A window was probably starting to swing shut, pressing Severn’s bidders into moving fast. Regulatory issues remain a considerable factor, especially around charging, and regulator Jonson Cox might yet step in due to his wariness about allowing more private ownership. The sector remains a decent one for income investors, but the bid speculation remains of most interest to business journalists and high frequency traders.

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