Actually... this is not the first time I have heard this rumor... and also, yes, a scaled down version of Diagon Alley is what I had heard (along with DA going on the Lower Lot being the other location). Remember, our Hogsmeade will already feature a shop or two from Diagon Alley... The whole "too close to Hogsmeade" isn't exactly a good enough excuse to use when it comes to a park like USH that is short on expansion space.
In regards to show refurbishments, it doesn't matter when it comes to the big grand plan of what they want to do with the park. If we have anything to learn from Orlando, nothing is safe, and they have unused expansion areas not used yet (well.. KONG 360 2.0 used one of the expansion plots) and insist on replacing existing rides/attractions instead. As for shows though, (while a totally different kind of show, it still applies) Beetlejuice got a new (budget cut) show last year which included tech & lighting upgrades (along with new songs & choreography), yet they're closing that in January for "Supercharged 2.0".
Plans for DA here do exist... and they're looking at BOTH the Lower Lot & Waterworld area. If I remember correctly, it all depends on the outcome of WWOHP.... I'll see if anything has changed, but right now, its all an "I'll believe it when I see it" rumor.
Besides... as I said before, the only thing that should replace Waterworld is WB's other IP..... Mad Max!