Thames Water - New IM - Of value and Process
All,
Please find our updated Investment Memo and Model of Thames Water here.
How does it feel to be ahead of your time, you ask? Well, not all that good to be honest. Originally alerted by one of you, we analysed Thames Water some three years ago, but the bid for long-dated paper was so overwhelming, that a short - however cheap - did not make sense then. Since 2019, much water has flown under the Thames and we now find ourselves behind the time.
Investment Considerations:
- We yet have to do more work on the RPI language of the bonds and the attractiveness of some of the long-term issues. But we see the Class A as value covered and Class B too, except that it’s pretty close to the equity if a third party were to bid for the going concern in a Special Administration auction.
- In the latter case, we’d have concerns that there may not be enough demand for so much GBP debt at these coupons. Credit bidding has been tested in a Special Administration only recently.
- In a solution where the current structure remains intact, we even see some recovery to the Kemble bonds - but only in that scenario.
- On balance then, we think the value breaks in the relatively narrow Class B and we think it most likely that TW avoids a re-nationalisation and that the balance sheet can be restructured to leave Class B with full recovery.
Gross Margin:
- Bigger than the problem of RPI-linked debt that now provides the trigger, is the melting gross margin of the company. It’s gone from 55% to 45% in the last years and that is the primary driver of trouble. Revenues have increased with CPIH, as per regulator allowance, but OpEx has grown relatively faster, leaving EBITDA more or less flat over the years.
- CapEx has also been flat if not slightly growing in the last two years and so a company that struggled to pay dividends in the first place is now significantly overindebted.
RPI-linked Debt:
- Much of the debt inside the Whole Business Securitisation (WBS) is linked to RPI. While Free Cash Flow has been flat at best, therefore, the debt burden has grown significantly in the last twelve months and now stacks higher than where we have EV.
Special Administration:
- Rumours have been leaked - and moderated - that the government of Rishi Sunak is toying with the idea of reversing party history and re-nationalising the company after Margret Thatcher drove its privatisation in the first place. If the coffin of his premiership needed another nail, the re-nationalisation of failed utilities would do nicely.
- Depending on bid scenario, a Special Administration, which would result in an auction of the business, could benefit those Class A bonds that are trading at the deepest discounts, if they were to be repaid as a result.
- Because of the sheer size of debt that would be required to bid successfully for TW, we are concerned that Class B would struggle to fit into an all-new capital structure, except for senior equity.
- Under all circumstances, future debt at the regulated entity would not exceed 55% notional leverage (of RCV), which would cut deep inside Class A territory. Any other debt would have to sit behind that.
Restructuring:
- A restructuring should allow for better recoveries on the regulated debt. We see approx. 80% of Class A debt as reinstateable and see sufficient room above the WBS to reinstate the remainder.
- If shareholders or a new party (mind CoCs) were to come with the £1.1bn cheque the government is hoping for, then that would also put the Class B creditors back in the money (behind the Class A creditors and outside the WBS).
- If this were the size of the cheque, even Kemble creditors would see some recovery, but we doubt (and can see) that investors are not immediately willing to inject fresh equity at that valuation.
Valuation:
- We think TW should be valued at a discount to Ofwat’s notional RCV and at a discount of United Utilities and Severn Trent in terms of EBITDAx.
- Relative to its revenue, Thames Water faces nearly double the CapEx burden in maintaining and updating the Victorian pipe system underneath the capital.
- To account for that difference, we have very roughly placed EV around £15bn. We concede that a lot more work could be done on this number. However, depending on process going forward, we think a Special Administration auction would underachieve even this value.
Wolfgang
E: wfelix@sarria.co.uk
T: +44 203 744 7003
www.sarria.co.uk