Jefferies cuts United Utilities and Severn Trent to 'hold'

Jefferies has downgraded both United Utilities and Severn Trent from 'buy' to 'hold' ahead of this month's Ofwat final regulatory proposals, saying that the risk-reward looks more balanced at current valuations.
The broker reiterated a 'buy' rating on sector peer Pennon following the stock's recent underperformance - having underperformed United Utilities and Severn Trent by 20% so far this year.

"We expect the December update to improve Pennon's outlook, but the key question is whether the regulatory improvement will be enough for PNN to avoid a potential equity raise. Under our base case for regulation, we see a 20% equity raise with a 20% dividend rebasing as likely to support Baa1 credit rating of the regulated water subsidiary (South West Water)," Jefferies said.

Ahead of Ofwat's Final Determination for water companies due on 19 December, the broker said all eyes will be on allowed returns: "Ofwat's July Draft Determination assumed a 3.7% allowed real return on capital and 4.8% allowed cost of equity. We expect some increase in both these metrics with our assumptions of 4.1% WACC, including 5.2% of allowed cost of equity."

The broker also said it expects "favourable updates" on other aspects of regulation, such as the risk-reward balance on output delivery incentives and a higher allowance for costs.

"We reiterate our 'buy' rating on PNN, where the balance sheet issues appear priced in. In our view, the risk-reward looks more balanced on UU and SVT at their current valuations. Therefore, we downgrade both to 'hold'."

UU and SVT were trading 1.8% and 2.4% lower on Friday morning, respectively, while PNN was down 0.8%.