Water worries may be overdone

Last Thursday's results from Wessex Water ended a water sector reporting season that has seen a bonanza for shareholders. The rash of extra dividend pay-outs and share buy-backs comes as the cream on top of five years of handsome gains in share prices since privatisation in 1990.

The largesse has left some chunky yields on water shares, ranging from 6.7 per cent at South West to 3.7 per cent at Northumbrian, compared with just under 4 per cent for the FT All-Share index. Yields such as these normally signal either abnormally low growth prospects or financial problems ahead. In the past, neither has proved a big risk in a water industry that has proved its ability to squeeze ever-higher profits from one of the safest businesses on the stock market. The question facing investors now is how much further that process can go.

The main perceived threat to the sector is the prospect that a future Labour government would impose a windfall tax on "excess" profits. The party's improving fortunes explain in part the recent pedestrian performance of shares in the sector, which as a group are down just over 2 per cent against the market since the turn of the year.

A new tax and a ferocious new regulatory regime always remain a possibility, but present indications are that such worries are overdone. The shadow trade and industry secretary, Jack Cunningham, recently suggested that utilities should be allowed a "market" rate of return, with companies being allowed to retain "a substantial proportion of profits" above that to reward efficiency and innovation. While such moves could curtail profits, they are unlikely to lead to the sort of draconian measures many had feared, suggesting that current yields are too high.

But even if that makes the sector look cheap, the recent hand-outs have widened the differences within it considerably. Some, like Thames and Southern, have decided to brazen it out and give away nothing extra. Although Southern may buy back some shares, balance sheet considerations may constrain future generosity at both companies. Gearing is currently 30 per cent at Thames and is forecast to rise to around 25 per cent at Southern.

By contrast, Yorkshire, currently yielding 5.8 per cent, Welsh on 6.2 per cent and North West offering 6.3 per cent offer greater potential for share price growth. All three have announced some of the more generous hand-outs to shareholders.

That none of the companies has been particularly successful at diversifying away from their regulated operations should also provide scope for recovery in potentially the fastest-growing part of the water industry. Northumbrian is another to watch, given the takeover interest by Lyonnaise des Eaux. Some analysts believe any bid would need to top pounds 10, compared with a current share price of 960p.