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UTILITY WEEK | 24TH - 30TH APRIL 2015 | 17 Finance & Investment Analysis T hought it was all over? PR14 may have reached its end (for all companies other than Bristol Water), but the real change in the UK water industry is just beginning. The acquisition of Bournemouth Water by Pennon Group, listed parent company of South West Water, blew the whistle on a long-anticipated period of M&A in the sec- tor as it gets to grips with its tough new price settlements and prepares for the opening of the market for non-household customers. Ofwat chairman Jonson Cox signalled the scale of the anticipated change this year when he set out a vision of a "much more dynamic and differentiated" water sector where "vertical integration no longer works". The Bournemouth acquisition may look fairly traditional on paper, but the reasons Pennon has given for the purchase show it has its eyes firmly fixed on the future. Under the £100.3 million deal, Pennon acquired Bournemouth Water from Singa- pore-based Sembcorp. It was funded by a new share issue to "allow flexibility rather than increase group leverage", says Susan Davy, the Pennon group's finance director. The deal includes a regulated water supply business, which supplies 440,000 people, and a developing non-regulated business that provides a platform for retail expansion, which "forms part of Pennon's broader strategy to re-organise South West Water's operations ahead of market liberali- sation and prepare for the statutory reform of the non-household retail market from 2017". One key customer that may have appealed to Pennon is the Fawley oil refinery. HSBC analyst Verity Mitchell tells Utility Week that Pennon's acquisition of Bournemouth Water, and its business customer base, will help the company build on its current, limited, non- household experience. "South West Water is pretty rural and the non-household customers it has are pretty small. To have a large industrial cus- tomer to service would increase their prod- uct expertise. They can learn about the Fawley contract. "Clearly they are serious about retail com- petition – non-household retail competition. And so they are diversifying their customer base in order to learn and compete better." Whitman Howard utilities analyst Ange- los Anastasiou calls the deal "a sensible, pro- active move", and Investec analyst Roshan Patel agrees the takeover "offers some strate- gic benefits" looking ahead to market open- ing, but "limited scope for cost efficiencies", at least in the next price control period. During the AMP6 period, staff at both Bournemouth Water and South West Water are unlikely to see any significant changes. The only real change so far has been two Pennon appointments to the Bournemouth Water board, replacing the departing Semb- corp members. The Competition and Markets Authority rubber-stamping of the deal could take up to six months, in which time the company's management teams will have to keep strictly apart. Aer that, a merger of the licenses is one possibility, and South West Water chief exec- utive Chris Loughlin hinted this may happen: "Longer term beyond 2020 you may have dif- ferent arrangements, but at the moment it's too early to say." In the meantime, each company remains committed to delivering on its own business plan Even if there is closer integration of the two companies for PR19, the separate brand- ing looks set to remain, at least in some form. This change will no doubt be the first of many, as the water sector evolves into a more dynamic and differentiated market. United Utilities and Severn Trent remain candidates for takeovers – or perhaps could acquire themselves – but smaller water-only companies, in particular Bristol, also repre- sent attractive propositions for investors. But, with Jonson Cox saying "bigger isn't always better" and that vertical integration is not necessarily the best solution, separation between wholesale and retail arms of the water companies is expected to be a feature of M&A activity in the coming years. Whitman Howard's Anastasiou says "individual bits of companies could be sold off " as market opening approaches, with some water companies deciding to focus purely on the wholesale side of things. Mitchell of HSBC adds that "not all the water companies want to retain their retail operations" so may sell them off to new or existing companies in the sector, and that "the merger regime will evolve as the market develops" allowing for more "flexible" takeo- vers of parts of companies. More M&A is expected, but who and what remains uncertain at the moment, especially as the non-household market continues to develop. The Pennon deal is only the start. Pennon blazes an M&A trail Futher mergers and acquisitions are expected in the water sector in the wake of Pennon's £100m purchase of Bournemouth Water. Mathew Beech studies the deal and asks who's next. Who's next? United Utilities As one of the three publicly listed companies, United Utilities remains a possible candidate for a takeover, while the Bournemouth Water deal has not increased the likelihood of a United Utilities takeover, but it remains one to watch. Severn Trent The other publicly listed company, and was a target for a failed £5 billion takeover bid in June 2013. It remains a possible candidate for another takeover bid. Bristol Water Was the subject of a £170 million takeover deal in 2006 by Spanish firm Agbar, and then Canadian firm Capstone Infrastructure took a 70 per cent stake with a £128 million deal in 2011. The water-only company is now in the midst of its second inquiry by the Competi- tion and Markets Authority (previously the Competition Commission) into its regulatory settlement. A less-than-favourable outcome could encourage its owners to sell up. Retail business Off the back of Ofwat chairman Jonson Cox's comments, the next M&A activity may not be for an entire company. In fact analysts are expecting a retail sell-off to happen as some water companies decide to stick to the wholesale side of the business and let others enter the retail sector.