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Pennon upgraded by JP Morgan Cazenove, which sees potential in UK water

Published: 05:54 28 Aug 2013 EDT

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Pennon (LON:PNN) has been upgraded by broker heavyweight JP Morgan Cazenove, which says that despite an upcoming regulatory review there is still potential in the UK water sector.

Pennon is not a pure water play like Severn Trent (LON:SVT) and United Utilities (LON:UU) as it also has a waste business: Viridor.

This business offers both structural growth and cyclical upside potential and is less exposed to a review by Ofwat, which will publish, in 16 months time, the final prices that water companies will be able to charge customers over the next five years.

This review and its rulings pose uncertainty for the firms, reckons analyst Edmund Reid, but he added that investors should not rule out potential activity in the sector.

"...despite the likely reduction in returns, we would not rule out M&A in the sector with debt costs low and no immediate risk of the regulator moving to a company specific cost of capital," he said, referring to the fact the regulator has already pointed to there being an industry wide notional capital structure rather than company specific capital structures.

"LongRiver’s bid for Severn Trent shows that M&A in the sector remains possible despite the uncertainties surrounding the review," the analyst highlights.

Pennon moves to 'overweight' from 'neutral' with the price target lifted to 745p from 670p. The broker rates Severn Trent and United Utilities as 'neutral' with price targets lifted to 1,680p (1,520p) and 750p (720p) respectively.

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