Thames Water - Slow Drip - Positioning
Dear all,
Please see our updated model and view on Thames Water here.
Thames Water continues to suffer from the perfect storm of a highly levered capital structure and a much-needed modernisation of its existing assets - all of which require fresh capital from existing shareholders (they have already injected £500 million) and rising water bills - all of this needs to be done under the glare of Ofwat, politicians and the public. As the first Kemble loans are coming due and shareholders are almost committed to another £2.5bn capital contribution, the structure continues to trade at significant discounts while the market is closing between only downside cases. However, we think we found our spot.
Investment Rationale
- We have taken a small starter position of 1% of NAV in the ’27 Class B Notes of the whole business securitisation structure of Thames Water at 75p/£ to realise a YTM in the low double digits as we will benefit from convexity as well as receive a cash coupon. We are looking to expand this position once we have further clarity on how shareholders are planing to deal with the maturities at Kemble, where a first £190m are maturing in April and could provide a negative event in the near term.
- On the downside, there are several scenarios that would have potentially detrimental effect on the B notes. More on that below:
- Special Administration Scenario: The Class A notes woudl be covered, but both the Class B and Kemble debt will be wiped out. We think this is a low probability event due to the due to the repetitional damage this would inflict on the government, the shareholders and the UK as a destination for international capital. Also, it would trigger the bonds inside the WBS, which would be the worst outcome for all parties involved.
- Restructuring Scenario (outside of Special Administration): The Class A notes would be covered, the Class B Notes would be wiped out and likely receive equity in Thames Water. However, this case (like all cases) would require fresh investment and the vast majority of the equity would go to the bearer of fresh cash. The Kemble debt will again see zero recovery. We think the probability of an out-of-court restructuring is slightly higher than the Special Administration Scenario but still low.
- Shareholder support (Status quo): The existing shareholders would continue to support the company and inject US$750 million for the AMP8 period. This will only happen if Ofwat and TW’s shareholders can agree on a feasible AMP8 plan. The company should gradually invest the cash in capex and build value for all stakeholders. Shareholders have invested a lot of capital, reputation and time in this asset and will probably not walk away. The key unknown here is at what entity would the injection come into - Kemble or Thames Water directly? We are concerned that shareholders would be looking to dilute the Kemble structure with a direct investment in Thames Water Limited and are therefore dismissing the idea of buying the Kemble bonds at this time.
H1 2024 Results
- Revenues improved 11% to £1.2 billion driven by higher tariffs. EBITDA improved by 22% to £627 million which was driven by increased revenue and cost efficiency initiatives.
- Operating cash flow was flat at £584 million in H1 2024 with higher EBITDA offset by an increase in working capital due to timing of billing schedules. However capex increased to £1.05 billion, keeping the company firmly in a negative free cash flow position.
- At the Thames Water level, liquidity remained strong at £3.5 billion with £1.7 billion of term maturities due by the end of AMP7 (March 31st 2025). However, at the Kemble level, the company has £510 million debt maturing in H2 2025 with a further £150 million in April 2026 and £400 million bond the following month.
- The company remained compliant with its existing financial covenants as it ramps up its AMP7 investment programme.
Will creditors remain supportive?
- The company is engaging with its existing lenders on a £190 million loan at the Kemble entity (which matures in April 2024). The outcome of the negotiations will be a key litmus test of creditor support. Creditors have some incentive to give the company time to turnaround the situation, as it is not in their best interest to push the company into a hard restructuring.
Housekeeping
- We will be looking for any evidence of outcome of the A&E with lenders of the existing £190 million Kemble loan.
- The reporting of the FY 2024 financial results (due late March) where we get to see further evidence of any operational turnaround.
- News around the negotiation of the business plan for the next AMP8 period (starting in 31st March 2025). We consider this the main driver of the credit and ultimately our par recovery.
Here to discuss with you,
Saahil
T: +44 203 192 0200
www.sarria.co.uk