UK water companies may need to cut dividends - Goldman Sachs

But while Goldman initiated coverage of Severn Trent at 'sell' and a 1,881p share price target, with United Utilities and Pennon at ‘neutral’ and targets of 778p and 749p, other areas of the UK utility landscape were seen a more attractive, with National Grid upgraded to ‘neutral’ in a separate note.

Water regulator Ofwat last November released its final methodology for the AMP 7 review, the asset management plan to cover the period from 2020-2025.

"While there is insufficient information to gauge the dividend outlook post FY2020, the information given on allowed returns was negative," analysts at Goldman said in a note to clients.

"In our view, maintaining current dividend policies into the next regulatory review will be a challenge and the poor outlook for return-regulated equity is clear. The drive of the regulator to deliver affordable bills for consumers is key to the outlook and is likely to be a headwind well into 2H18."

While the analysts take no view on the likelihood of Labour winning the next UK election, with the party's poll ratings on
the rise and a manifesto pledge at the last election of taking the UK water sector into public control, "we would see significant risk for UK water sector share prices in the event that a UK Labour party victory was increasingly discounted by the market".

Marking down sum-of-the-parts valuations to regulatory capital value (RCV) would leave 8-20% downside to current share prices, which "creates a deterrent to future M&A, which has long supported the sector". For Pennon, the risk of more waste management contracts being renegotiated at its Viridor business adds to uncertainty over its growth outlook.

Key upside risks for the water trio include a more benign outlook for UK interest rates, favourable political and regulatory changes and a return of M&A within the sector.