Proactive Investors - Water companies such as Pennon Group PLC (LON:PNN) and United Utilities Group PLC could be viewed as "cheap" but returns are "unattractive" compared to electricity networks, said JPMorgan (NYSE:JPM) after the government published its strategy for the sector.
The risk/reward for the sector is "looking more balanced", the bank said, after the Department for the Environment, Food and Rural Affairs (Defra) unveiled its Water Plan, including measures such as bigger penalties for those that break the law and more inspections and new targets for regulators.
But JPMorgan analyst Pavan Mahbubani said he and his team "remain cautious on the UK water sector due to low regulatory visibility at this point in the regulatory cycle, unattractive proposed returns compared to electricity networks, and the dividend yield spread to 10-year UK gilts remaining at a 10-year low".
On the flip side, he noted that shares are cheap on a regulatory capital value (RCV) multiple basis, with 4-11% premia to 2025 RCV, compared to a long-term average of 10-15%.
"Furthermore, we have seen in recent weeks the government and regulator emphasizing that more investment is needed in the water sector for environmental performance to improve.
"This should mean higher allowed investment for the sector, driving asset & earnings growth."
But in the analyst's view, "the missing link is an improvement on proposed allowed returns - we do not expect an update on this front until summer 2024".
It was suggested that investors optimistic about such a regulatory outcome in 2024 should play this through United Utilities or Pennon, though the bank has a 'neutral' rating on both, but there is "less is priced in" than at Severn Trent PLC (LSE:LON:SVT), where the rating is 'underweight'.
On Severn Trent, the analyst noted that it is the only UK utility company covered "where we see no valuation upside", with top picks being those with UK power generation exposure: SSE PLC (LON:SSE), Centrica PLC (LON:CNA), Drax Group (LON:DRX) and UK electricity networks, SSE and National Grid PLC (LON:NG).