PwC Valuation IndexUK Water: Delivering shareholder returns beyond expectations

December 2012

www.pwc.co.uk/valuations

2 PwC Valuation Index

Will the green shoots of recovery survive a winter frost?Despite a return to positive quarter-on quarter growth, the first since Q3 2011, this was likely to have been supported by a number of one-offs (e.g. Olympics and soft comparable data from the prior quarter caused by the Jubilee bank holiday).

The Eurozone remains a problem postponed rather than a problem solved, and the UK faces a ‘new normal’ of slow growth in the economy without the old tailwinds of cheap credit and strong consumer and business confidence. Any escalation of the Eurozone crisis could see a return to negative GDP growth.

However, despite this markets have returned to pre-crisis levels...The FTSE All-Share is now higher than it was before the Lehman crash (2,999 at the end of Q3 2012 compared to 2,653 on 15 September 2008), back when there was no Eurozone crisis and any downturn was expected to be relatively short-lived.

But the outlook for growth has not commensurately improvedIs this relative bullishness by the markets given the difficult circumstances justified? Our valuation index, which considers valuation fundamentals rather than being led by short term sentiment, suggests not.

Our index shows a disparity between PE ratios implied by fundamental long term growth prospects for the UK economy, and the PE ratios observed in the market today. Put simply, market prices today imply a level of expectation for growth that just isn’t backed up by the fundamentals of the economy.

Our index is at 121, which suggests that stock market growth expectations exceed those of the economy as a wholeWe advise caution when using market prices to benchmark deal pricing and observe that obtaining clarity over what is driving value in deals and investments (and where growth is going to come from to support the deal price) is as critical as ever.

Note on methodology used in the calculation of the IndexThe Index uses a dividend growth model (‘DGM’) to analyse equity markets. So that we can estimate what future dividends will be, we calculate an ‘equilibrium’ dividend yield based on the average of long-term independent economic forecasts of real GDP growth (made at the end of each time period). Once we have derived an equilibrium dividend yield, we convert this into a price-earnings ratio (‘PE ratio’) which we then compare to actual PE ratios.

Our Index is then calculated by dividing the actual PE ratio by the PE ratio implied by fundamentals. This shows in a single measure how much equity prices at a given point in time differ from the value implied by fundamentals.

The PwC Valuation Index stands at 121 for Q3 2012 121

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Source: Datastream and PwC analysis

3PwC Valuation Index

UK water Delivering shareholder returns beyond expectations for a stable infrastructure assetWhere are UK water company valuations heading?In the short term, we expect the market to value UK listed water companies at PE ratios in line with their fundamental PE ratios, even though it is the first time in the last five years that this is the case (figure 1). This is due to two key factors:

1. Ongoing demand from the ever evolving infrastructure investor pool, for stable, cash generating assets

2. Expectations that current regulatory changes that are proposed will not fundamentally change the risk-return profile for shareholders, due to Ofwat and UK Government’s desire to maintain private investment in the capital intensive UK water sector.

In view of the continuing demand for investments in UK water companies, we expect transaction multiples to stay within the range of 1.25 to 1.35x EV/RCV*. However, beware – if you pay this much for one of the low or underperforming water companies, you may need to lower your shareholder return expectations to justify an EV/RCV multiple of this magnitude.

Is fundamental value in the UK water sector at risk?Ofwat’s consultations regarding future regulatory price controls are underway. Whilst the market has responded negatively to Ofwat’s announcement on 26 October 2012 (with UK listed water companies’ average share prices decreasing 8% two weeks after the announcement) – we wonder if the market may have been over-reacting to these proposals. Long term investors should not ignore regulatory change, but at the moment, we believe fundamental value in the UK water sector is not at risk.

*EV = Enterprise Value, RCV = Regulatory Capital Value

Shareholder returns remain strong but not expected to revert to mid-decade highsPerhaps surprisingly, UK water companies have consistently delivered shareholder returns in excess of the FTSE over the last 15 years (figure 2). In our view, returns for listed UK water companies will stay in the range of 10% to 12% and will not revert to the 20% total shareholder returns achieved in the mid-2000s. This is because the market is currently trading in line with fundamental value - and overall reflects reasonable assumptions about capital expenditure growth, operational and financial outperformance, and inflation (including potential revisions to the way RPI is calculated by the ONS).

UK water deal activity to continue?There have been four transactions in the privately held UK water companies so far in 2012. In the next few months, we expect deal activity to continue, boosted by a growing number of sovereign wealth funds and pension funds making direct investments in infrastructure assets. However, in the run up to the next period of economic regulation, deals may go on ice as investors await the outcome of the next price determination.

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Source: Datastream and PwC analysis

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Figure 2: Five year CAGR of total shareholder returns

Source: Datastream and PwC analysis

This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

© 2012 PricewaterhouseCoopers LLP. All rights reserved. In this document, “PwC” refers to the UK member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

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PwC Valuation Index – contacts UK water valuations and regulation – contacts

Romil RadiaPartner, Valuations

+44 (0) 20 7804 7899 romil.radia@uk.pwc.com

Laura HillSenior Manager, Valuations

+44 (0) 20 7213 1895 laura.e.hill@uk.pwc.com

Nicola FomesConsultant, Strategy & Regulation

+44 (0) 20 7212 8047 nicola.j.fomes@uk.pwc.com

Nicholas Barlow Senior Manager, Valuations

+44 (0) 20 7804 6498 nicholas.j.barlow@uk.pwc.com

Thomas Romberg Director, Valuations

+44 (0) 20 7804 0860 thomas.romberg@uk.pwc.com

Richard ThompsonPartner, Valuations

+44 (0) 20 7213 1185 richard.c.thompson@uk.pwc.com

Ivan PoonSenior Associate, Valuations

+44 (0) 20 7804 7622 ivan.poon@uk.pwc.com

Robert White Senior Associate, Valuations

+44(0) 20 7212 5943 robert.g.white@uk.pwc.com