(Debtwire) Thames Water benefits from defensive sector and liquidity but cash burn and leverage raise concerns - bond preview

11 November 2020 | 12:01 GMT

Thames Water operates in the usually low-risk, predictable utilities space while liquidity is comfortable. But the UK private water and wastewater company has a whopping GBP 13bn in debt and a hefty 12x leverage while it will continue to burn cash as stricter regulations curb revenues and require investments, leaving two buysiders and an independent special opportunities desk cautious. The buysiders agree, however, that at 4.75%-5% price-talk, the deal should fare well amid supportive market conditions.

The company is marketing the GBP 250m senior secured 2026 notes on its FY19-20 (ending March) results. Revenues had increased 3.5% to GBP 2.109bn and EBITDA was up 7.3% at GBP 1.102bn. At the HoldCo level, the Kemble Water group was 12x net levered (11x at the OpCo level), working off the GBP 13.190bn in net debt (GBP 12.124bn at the OpCo level). Total leverage for the HoldCo and OpCo stands at 13x and 12x, respectively.

Due to the nature of the business, one buysider uses gearing as an indebtedness indicator. The ratio between covenant net debt to regulatory capital value (RCV) stood at 82.3% at the OpCo level and 89.6% considering the parent’s financials. The group’s gearing covenant is 95% and even from that perspective, indebtedness is high despite the defensive nature of utilities companies, he noted.

“It is a decent sector but this is one of the most geared players in the space,” the buysider said.

Such high metrics reduce the room for error especially since Thames Water will be burning cash over the next few years, the second buysider noted. Although the regulatory framework provides predictable revenue streams, there are variable components to it that could impair cash flows, such as performance penalty fees, which Thames have recently incurred, he added.

On top of that, Thames Water is more capital intensive than its peers. Its GBP 1.1bn capex guided for next year is enough to consume all the EBITDA generated in the 12 months to March 2020. The company also faced EUR 337m in interest and fees in FY19-20 and, although it is likely to price this deal with a tighter coupon than the GBP 175m 5.875% 2022s it is redeeming, the reduction in interest expenses would be negligible, the second buysider said. That means that the cash burn would be significant even before the expected GBP 100m in working capital outflow, the first buysider added.

Management told investors the company should burn between GBP 300m and GBP 400m annually over the next few years but added that gearing should remain stable as net debt will increase at the same pace as the RCV, according to the first buysider. There is a higher chance, though, of leverage going up rather than down but the moves should be small, he added.

“They said they can incur GPB 400m of cash outflow for every GBP 300m of cash EBITDA increase but this is massively significant because they may lever up a business that is 12x levered already,” the second buysider added, noting that the constant outflows going forward mean that the company will need further financing, which could result in growing interest costs as investors are likely to require premiums to give it a vote of confidence.

CEO Sarah Bentley, who took office in April this year, has cost-cutting initiatives among the top priorities alongside a consumer-oriented approach. Thames Water has identified over GBP 100m in underlying run-rate savings to be realised by 2021/22 whilst it has not paid any dividends over the past three years.

Liquidity provides some comfort, the first buysider noted. Thames Water Utilities Holdings has a GBP 1.646bn revolving credit facility and another GBP 550m in liquidity facilities. At the HoldCo level, the group has a GBP 110m working capital facility, which is currently undrawn. In April 2019, the company received a GBP 250m cash injection funded by debt at the HoldCo.

Liquid business

Thames Water is a private provider of water and wastewater services within a monopolistic framework, being the largest player in the UK. It serves around a quarter of the population of England the Whales, supplying water to nine million customers and treating sewage for 15 million customers.

The water division accounted for 42% of FY19-20 revenues and EBITDA and 59% of capex, while its wastewater segment represented half of the topline, 58% of the bottom line and 41% of capex, with retail being responsible for the remaining 8% of sales.

Pension funds represent 53.6% of the company’s shareholders, with partially pension-backed funds accounting for 13.7% and sovereign wealth funds holding a 5.4% stake. Other investors represent 27.4% of the shareholder base.

The regulatory environment is known for its predictability but has become more challenging recently. The Water Services Regulation Authority uses an asset management plan (AMP) every five years to assess key performance indicators such as water quality and customer service. The framework is used to set allowable price increases for the privately-owned water companies in the English and Welsh water industry but can also result in fines if targets are not met.

Water utilities are highly regulated entities and under the recently-agreed budget, the company has good visibility of its future earnings and must manage expenses accordingly, special opportunities desk Sarria noted.

"Generally, capex budgets have been front-loaded somewhat, which is one reason the company is burning cash, but Thames Water is also building a super sewer, which goes beyond mere maintenance capex," adding that, overall, budget visibility is good and management know their revenues and commitments for several years to come.

The new AMP 7 cycle is particularly restrictive, reducing the company’s ability to generate revenues and resulting in further stretched credit metrics, the first buysider added. “They will be facing some prohibitively costly performance targets and if they don’t meet these, they pay penalties.”

Potential fines may arise if the company does not meet leakage targets, for instance. Such a problem is not uncommon since a significant part of its underground infrastructure is over 100 years old and works on pressure rather than gravity, meaning that pipes bursting are a recurring problem, the second buysider noted.

“That is certainly an additional cost. Not only to catch up with standards but to improve them, as the regulator has required,” he said.

Operating in London means the company has to maintain an old and often victorian network of pipes, which in a highly-populated area is disproportionately expensive when compared to peer expenditures. However, the regulator has accounted for this and the budget is set accordingly, according to Sarria.

In the AMP 6 cycle ended March 2020, Thames Water was fined some GBP 120m for missing leakage targets and faced a GBP 110m Service Incentive Mechanism (SIM) penalty, according to management. Reducing customer complaints by 20% was the only self-set target the company missed in FY19-20.

The cancellation of the Counters Creek relief sewer original project also resulted in an underperformance payment of GBP 130m in 2012-2013 prices in the form of opening RCV adjustments for the AMP 7. It means that the company will adjust future tariffs to reflect the amount of revenues it is entitled to earn over the five-year cycle ending March 2025.

Regulatory changes regarding COVID-19 have also had a GPB 100m negative impact on the company’s free cash flow and introduce uncertainty regarding the cash generation outlook. The company notes, however, that the regulatory scheme compensates for under-recovery of revenues in following years.

Among Thames’s priorities for 2020/21 are reducing client complaints, supply interruptions, leakage, blockages and pollution, and implementing a new approach to managing its water network, the executives noted.

Which Water?

Leads have set price talk at 4.75%-5% versus IPTs in the low 5% area for the B1/B+ rated GBP 250m senior secured 2026 non-call life notes. The pricing is considered fair by the two buysiders, although they are not comfortable with the business.

Anglian Water (OSPRAQ) is a direct comp, with similar securitisation but higher rating, the first buysider noted. The UK-based provider of drinking water and wastewater services’ B1/BB- rated sterling-denominated 4% senior secured 2026 are currently indicated at 99-mid, yielding 4.22%, according to Markit.

“You could probably have fair value for Thames Water around 50bps-75pbs back of Anglian Water, which would put Thames at 4.75%-5%,” he said.

The deal enjoys supportive market conditions, though, especially since the news about a COVID-19 vaccine breakthrough announced on Monday (9 November) and the reduced uncertainty regarding the outcomes of the US election.

This is not a great company. It is smoking money but, in the scheme of things, IPTs in the low 5% area appear reasonably fair. I am surprised they have to come quite as wide as this.” Sarria noted.

The second buysider is cautious despite Thames Water operating in the utility sector and consequently having safe earnings. The regulatory changes impacting revenues, the GBP 12bn pile of secured debt and the increasing leverage make it an uncomfortable situation to be in.

“It puts a lot of weight on the long-term viability of the business model. I don't think they will have trouble pricing it, but we won't be involved,” he said.

The roadshow ended yesterday (10 November) and books close at noon today (11 November). BNP Paribas, HSBC (B&D), Morgan Stanley and RBC are joint physical bookrunners, while NatWest Markets and Santander are acting as passive bookrunners.

by Mario Braga