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Pennon - on track

Charles Huggins | 28 September 2015 | A A A
Pennon - on track

No recommendation

No news or research item is a personal recommendation to deal. All investments can fall as well as rise in value so you could get back less than you invest.

Pennon Group Ord 40.7p

Sell: 1,148.50 | Buy: 1,149.00 | Change 2.50 (0.22%)
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Today's pre-close trading update from Pennon confirms that the group is trading in line with expectations and is on track to grow the dividend by 4% plus RPI inflation. The shares were broadly flat in early morning trading.

South West Water has made a good start to the 2015-2020 regulatory period, although, as anticipated, revenues for 2015/16 will be impacted by the reduction in base returns allowed as part of the 2014 final determination.

Despite lower commodity prices, recycling EBITDA for the waste management business, Viridor, in the first half of 2015/16 has improved on H2 2014/15 due to on-going efficiency savings. The five new Energy Recovery Facilities (ERFs) brought on stream in 2014/15 are performing as expected, with another due to come on stream in the second half of this year, and two more by the second half of 2017/18. The ERF business is on track to contribute c. £100m to Viridor's Statutory EBITDA in 2016/17.

Viridor remains confident of the long-term regulatory drivers from the EU and UK Government underpinning demand for recycling and the business is well-placed to deliver sustainable returns. In the landfill business, volumes are gradually declining as expected and waste is being diverted to energy recovery.

Our view

Pennon offers the highest yield and has the most attractive dividend policy out of the three UK-listed water companies. United Utilities and Severn Trent yield 4.2% and 3.7%, respectively (both variable and not guaranteed) and aim to grow the dividend at least in line with RPI inflation until 2020. Pennon offers a prospective yield of 4.5% (variable, not guaranteed) and aims to grow the pay-out by 4% plus RPI over the same period.

Pennon's high yield is partly a reflection of concerns over its waste management business, Viridor. Viridor once was a predominantly landfill business, but has restructured itself to become a leading renewable energy and recycling provider. Viridor collects household waste and sorts it, then recycles as much as possible. The residual waste is burned in Energy Recovery Facilities (ERFs) and converted into energy. The problem is that lower oil prices are making recycled plastics and metals less competitive versus virgin materials, resulting in lower recyclate prices.

So far, Viridor is coping well with these pressures, and as more of these ERFs come on stream, the profitability of this business should improve. BY 2016/17 the ERF business should be contributing c. £100m to Viridor's EBITDA (earnings before interest, tax, depreciation and amortisation), which compares with market expectations of c. £474m in EBITDA for that year. This is significant, but unlikely to make or break the group, given that the water business will still be responsible for the bulk of profits.

With the shares down 18% year-to-date, concerns over Viridor's profitability are arguably already priced into the shares, given the higher yield and more generous dividend policy on offer compared to its pure-play water peers. Therein lies the opportunity although there are no guarantees.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research for more information.