Thames Water - ‘Cause I don’t want my boat to be rockin’
All,
Please find our updated analysis here.
The proposition is simple: bet a large sum with little risk and an unlikely return, or a small sum at high risk and a likely return. No free lunch then. On this occasion we favour the large trade, a set-it-and-forget-it arbitrage that should not cost much – if anything – but is unlikely to pop. If it does, however, and it is a long-term play, then returns could all of a sudden be very attractive. Long-term narrow margin arbs require precise pricing however and we are not best placed to put it on ourselves.
Investment Considerations:
- The series 26 204 Class A bonds, below 60 p/£, trade at UK Bills + 200bps. Below recovery value and with a chance of a trigger by the government, that is the wrong price. The risk of being triggered here is remote, but positive and therefore should not command a premium, but - if anything - a discount.
- We explore a pair trade, short 2041 UK govies vs. long the 2040 Class As in the country's biggest water utility (underneath the capital). Both trade at similar £ values and the 200bps investors would pick up would fund the borrow etc. It's a set-it-and-forget-it trade that should carry little risk. But it will only pop in a very narrow scenario - possibly with a technical wobble first - and so the trade depends on narrow price differences today that we are ill-placed to identify.
- While the curve of Class A bonds are a bet on or against an unlikely trigger – i.e. Special Administration, the Class B and Kemble bonds are a bet on shareholder support or a new shareholder taking over. The difference between these scenarios, a UK scheme or plan, is unlikely.
Model:
- Due to contract structure, we expect TW's ability to raise water prices to be limited and in general lagging the development in its RPI-linked bonds that should grow more instantly. Our revenue assumption is cautious and admittedly still crude. Raising prices for water will be a politically sensitive issue that's unlikely to receive generous government support ahead of elections.
- Expenses have materially veered from the Ofwat forecast and with inflation creeping into cost, we expect that to continue. A more ambitious cost-cutting plan could arrest the growth.
- Our model assumes tax and WC as per Ofwat AMP7 plan. Tax could be better; WC could be worse. Both are minor.
- We are not forecasting further disposals.
- The model expects the £750m conditionally committed in July to be injected during H124. TW has significant borrowings coming due in H224, which it should then be able to address from its cash balance.
- When we plug in an incremental £2.5bn cash injection in 2025, the model confirms net leverage to fall below 60% of RCV.
- Any cash injected can be used to pay down the debt faster than scheduled - and therefore come in line with Ofwat leverage targets, or more likely, management and Ofwat agree that cheap debt is a blessing and that the cash should be invested in infrastructure instead. However, approaching the near 50% target level, an incremental pound invested in infrastructure only achieves half the deleveraging of a pound used to pay down debt.
Game Theory:
- Temporary nationalisation via a Special Administration is certainly possible, but it would amount to a major own goal for the government. The investors in TW are prolific infrastructure investors around the world and will take their capital elsewhere, leaving Britain with a disproportionate bill to pay. Bond investors could face haircuts of 50%, not what one expects of infrastructure investments - even if mostly due to rate changes.
- The existing debt is very cheap by today's standards and shareholders are incentivised to keep it in place. CoC clauses allow for "Acceptable" investors - who have more than £2bn in UK infrastructure assets. Thus - provided the front end is being paid down, it should be easy enough not to trigger the debt with about any transaction except a UK scheme or plan, which would require creditor consent - something their overwhelming long end should withhold.
- Although the equity is currently worthless, shareholders have an incentive to inject fresh cash. As much as the UK government doesn't want to rock the boat, the funds don't want their boats to be rockin' either. Good relations may not be worth the full £2.5bn but if the government can flex the AMP8 plan for one-third of the sum and investors inject one-third, then with the right shades of pink the solution is attainable.
Looking forward to discuss,
Wolfgang
E: wfelix@sarria.co.uk
T: +44 203 744 7003
www.sarria.co.uk