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(Sharecast News) - UK water companies were on the rise on Tuesday as Citi and JPMorgan Cazenove struck a positive note on the outlook ahead of Ofwat's Final Determinations next month.
Citi said it expects a "constructive" set of FD proposals from Ofwat on 19 December, with improving returns, outcome delivery incentives risk reward balance and higher totex.
"Yet we struggle to turn more bullish beyond the FD catalyst despite unchallenging valuations," it said.
"While FD should provide much needed financial clarity for listed companies, pending government review of the wider water sector, balance sheet repairs and operational challenges will continue to drive share price volatility."
Citi upgraded United Utilities to 'buy', saying it was the best way to gain exposure ahead of the regulatory review.
The bank said it needs to see an operational turnaround in Pennon - which it kept at 'neutral' - and recapitalisation of its balance sheet before it can look to turn more constructive.
"We continue to flag Severn Trent (upgrade to 'neutral') premium rating versus the sector but see limited downside," it said.
Citi opened 90- day "positive catalyst watches" on United Utilities and Pennon into the Final Determinations.
JPMorgan Cazenove said it expects "significant" improvements in regulatory allowances on 19 December to drive a re-rating of the UK water sector, and it is turning more positive following its upgrade in June.
"We expect the Final Determinations (FDs) to de-risk the sector, justifying higher regulatory capital value premia compared to current valuations," it said.
JPM said it was refreshing its views for the next regulatory period, updating assumptions for future outperformance and growth.
"We see upside in our base case assumptions, which conservatively assume 50-70% less return on regulatory equity (RoRE) outperformance versus recent years, and 60% lower asset growth estimates than industry forecasts post-2030," it said.
"Incorporating estimates of RoRE outperformance more in line with recent history, and higher medium-term growth underpinned by statutory requirements, suggests a bull case for the sector implying 50-70% upside."
The bank placed all three water companies on "positive catalyst watch" into the FD.
JPM upgraded Severn Trent to 'overweight' from 'neutral', saying the premium to the sector is justified given its expectations of RCV growth and future outperformance, underpinned by the "best-in-class track record".
It also upgraded Pennon to 'overweight' from 'neutral' as it argued the market already discounts balance sheet and environmental performance headwinds the company faces.
"We acknowledge that a discount to peers is likely to persist until the market has clarity on the company's funding of capex to 2030," it said.
JPM maintained its 'overweight' rating on United Utilities, where it sees upside on conservative assumptions for outperformance in the next regulatory period, with upside risk to growth at FD.
RBC Capital Markets cut its price target on shares of Close Brothers to 425p from 435p and added a "speculative risk" qualifier to its rating as it assessed the impact of premium finance.
The bank said that if the Supreme Court upholds the Hopcraft judgement applying a broad interpretation, motor finance litigation could spread to other products like premium finance.
"There is an outstanding question following last month's Court of Appeal judgement: does the ruling have wider implications outside motor finance? One possible interpretation is that the decision is broad enough to encompass any broker commission in any finance arrangement in which the borrower did not provide informed consent to the commission being paid," RBC said.
"Our focus until now has been on motor; today we broaden our attention to premium finance."
It noted that Close Brothers is the only bank in its coverage that has material exposure here - around 10% of the loan book, 50% retail, and 80:20 motor:home, respectively.
RBC said that its initial estimate of the potential liability for CBG - in the event of a bad outcome in respect of premium finance - is around £250m, of which £100m has been included in its model.
The bank said total commission provisions now in its model are £420m, £320m of which are for motor and £100m for premium finance.
"Whilst CBG's CET1 can absorb this (CET1 trough 11.6%), assuming that the bank unwinds its motor/premium loan books and doesn't pay a dividend in FY25-26, our downside scenarios of circa £640m (motor £390m; premium £250m) suggest there could be a bleaker path," it said.
RBC reiterated its 'outperform' rating on the shares but now includes a "speculative risk" qualifier to account for increased earnings unpredictability.
Melrose Industries shot higher as Citi said it remains "high conviction" in its 'buy' case, given the trough multiple and the strong mid-term cash outlook.
The bank said mid-term cash generation is a central question for investors.
"The growth in receivables, driven by 'pull forward' revenue recognition from the RRSP portfolio, is key to understanding the relationship between profit and cash," it said.
"In this report, we utilise some of the information from the RRSP explainer to drive our receivables estimates."
Citi said that from its analysis, it concludes the company could be generating about £450m to £550m free cash flow in the 2027/2028 timeframe, versus VA consensus of £320m to £420m.
"On peer free cash flow yields, this gives a valuation of £6-8, i.e. 30% upside at the low end," it said.
Shares in Melrose surged last Monday after it released a document explaining the accounting around its 19 Risk and Revenue Sharing Partnerships (RRSPs) and said the portfolio was "well positioned" to generate significant returns for investors in the coming decades.
