Thames Water: Tapped out?

Press reports have confirmed that Thames Water’s CEO is stepping down while the company looks at options to deal with its reported £14bn debt.

The question investors are now asking is: what next?

Why Thames Water, and why now?

Thames Water had been warning for some time that the company was under pressure from inflation and the rising costs of energy, chemicals, labour and financing.¹

While the company reported a pre-tax profit of £493m in the six months to end of September 2022, by last September, net debt had reached £14.3 billion – up from zero when the industry was privatised in 1989.

At the same time, there have been growing consumer concerns over a lack of investment in infrastructure, with leakage, pollution and customer service being areas of focus.

All this comes at a time of high and rising investment needs for the company, while the cost of funding is also on the way up. Higher interest rates and investment costs can be passed through to water bills under current regulations, but political scrutiny could restrict tariff uplifts.

The resignation of Thames Water’s CEO appears to have brought these issues to a head.

Where next – and what are the investment implications?

A number of scenarios are possible, with many analysts speculating on the possible potential temporary re-nationalisation of the firm. However, this is not the only possibility.

In our view it is likely that the situation will continue to remain unstable until a solution for the financial position of the company is agreed. We foresee a possible a cash call on shareholders. There could be two potential  reasons for this: the operating company has significant liquidity on hand but is free cash flow negative, which could lead to a demand for a cash injection from shareholders over time.

Alternatively, the operating company’s dividend to the holding company could become restricted by regulations. This risks a default by the holding company, with shareholders losing control as a result. It’s possible that shareholders will contribute a relatively small amount of equity to forestall this possibility.

However, without shareholder intervention, Thames Water’s future becomes uncertain.

Insolvencies in the UK water sector are governed by a Special Administration Regime, which is designed to ensure continuity of service while operations are potentially transferred to a new company.

At present we don’t have much detail on the implications of such a process for Thames Water’s lenders, but we think it’s possible that its holding company’s bonds would experience significant losses in value.

We believe this process could lead to the transfer of the operating company’s senior debtholders to a new operating company, which in our view would be likely to be publicly owned (and likely to stay that way for an extended time).

This is all happening in the context of both soaring gilt yields and growing demand for increased infrastructure capex in the UK, whether that’s the completion of HS2 and nuclear energy project Sizewell C, or other schemes yet to come online.

There is potential that this could translate into an incentive to the authorities to act to protect senior bondholders, so as to retain credibility when fundraising for these other projects. Indeed, it is even possible that senior bondholders could benefit from any uprating of the debt that might result from a government takeover.

The situation remains fluid, and we will continue to monitor it.

1. See, for example, article from the Financial Times, Thames Water warns of threat from inflation and leaks, 5 December 2022, https://www.ft.com/content/c20ebf2a-b907-4d92-9741-9736bfca0288