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Finance & Investment Analysis Was Severn Trent too hasty? Nigel Hawkins speculates that Severn Trent investors may have cause to regret rejecting the £22 per share bid offer made in the summer by LongRiver. I n the UK utilities sector, the issue of greed normally applies to the pay of utility executives, which in some cases has been excessive since the utilities privatisation programme kicked off in the 1980s. More recently, however, Severn Trent's board has been accused of greed, not because of any salary excesses, but because of its decision to turn down repeated offers by a consortium of private equity investors offering what appeared to be a "full price". Following two previous offers, the LongRiver consortium, led by Borealis Infrastructure, the Kuwait Investment Office and the Universities Superannuation Scheme, submitted a final bid of £22 per share. The figure compares favourably with the latest trading range of between £16 and £18. In rejecting the bid, Severn Trent focused specifically on valuation issues and drew attention to the inflation-linked nature of water sector regulation, which appeals to specific institutional investors. Furthermore, over the past three financial years, Severn Trent claims to have delivered total shareholder returns of 72 per cent – an impressive record during a recessiondominated period. Severn Trent's chairman, Andrew Duff, set out the board's case: "We have consistently made clear to the consortium our belief that Severn Trent has a value to our shareholders above the level it indicated it was willing to pay." For analysts, it is the premium over Severn Trent's regulated asset value (Rav) that is paramount – £7.4 billion. Indeed, it is the valuation lynch-pin. Given that the final bid implied a premium over Rav of around 30 per cent, it is difficult to argue that LongRiver was trying to get Severn Trent on the cheap. By historical utility standards, such a premium would normally be a knockout blow, and would at least have led to lengthy negotiations with the bid target. Irrespective of these valuation parameters, there is an elephant in the room in the form of the 2014/15 periodic review, whose outcome will first be applied in April 2015. Unlike Pennon, whose Viridor waste 18 | 11Th - 17Th OcTObEr 2013 | UTILITY WEEK Severn Trent United Utilities Pennon 2009 2010 2011 2012 2013 Long-term share price comparison business partially dilutes the impact of the periodic review, Severn Trent's finances are almost entirely driven by the final determination numbers that will emerge at the tail-end of next year. Business plans are currently being submitted, but Ofwat's stance is far from clear. Public concerns about water charging levels and low tax payments – Thames Water was not liable for any corporation tax last year despite an operating profit of £549 million – are putting pressure on Ofwat to be more aggressive. Its recently appointed chairman, Johnson Cox, a former senior executive at both Yorkshire Water and Anglian Water, has already set out his views on some key issues. In the summer, he concluded that water company debt now had a cost of "no more than 1.25 per cent". At the last periodic review, Ofwat assumed a 3.6 per cent real cost of debt. Such comments will not be viewed as helpful by water companies as they strive to persuade Ofwat to assume as high a weighted average cost of capital (Wacc) as they possibly can. And, with interest rates expected to rise, the difficulty of setting a credible five-year Wacc is magnified. If, hypothetically, a sub 4 per cent Wacc were prescribed by Ofwat, the rejection of LongRiver's final £22 per share bid would not look smart. There are, of course, other key financial numbers beside the Wacc. Ofwat's capital expenditure projections and its operating cost assumptions – now grouped under the "totex" head – will be crucial for Severn Trent's long-term ability to grow its dividend and to boost its share price. Furthermore, there is an outside chance that Severn Trent could seek to become an Ofwat fast-tracker, whereby it presents a financial package for the next periodic review that Ofwat waves through. At its recent City briefing, Ofwat was keen to talk up its fast-track alternative, although the chances of it being applied to a large water company seem slim. Once Severn Trent's final determination is confirmed, it will become more apparent whether the Severn Trent directors have blundered in turning down the £22 offer. In doing so, Severn Trent will have spoken to its key institutional shareholders, most of whom clearly hold a bullish view of prospects for the water sector, irrespective of the risks inherent in the periodic review process. Many such investors continue to seek opportunities in low-risk sectors, with assured cashflows and the ability to pay robust dividends, increasing at least in line with inflation. The water sector fills these criteria admirably. Outside the utilities sector, there is a parallel with the difficult decision taken by the Severn Trent board. Back in 2004, top retailer Marks & Spencer had been struggling, with a September 2004 share price of around 350p. At that time, the City's favourite clothing retailer, the flamboyant and immensely successful Sir Philip Green, led the Revival Consortium which bid £4 per share. Not surprisingly, in a scenario that was replicated at Seven Trent, the Marks & Spencer board rejected the bid, on the grounds "that Revival's proposal continues to undervalue the group and its prospects signifi-