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Pennon - Dividend and profits up, with ERF expansion announced

George Salmon | 25 November 2016 | A A A
Pennon - Dividend and profits up, with ERF expansion announced

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Pennon Group Ord 40.7p

Sell: 1,008.50 | Buy: 1,009.50 | Change -21.50 (-2.09%)
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Dividend and profits up, with ERF expansion announced

Pennon's first half results are in line with management expectations, and the group remains on course to meet full year targets. The interim dividend has increased to 11.09p, up 6% on last year. The shares rose by just shy of 1% on the news.

Our View

Pennon has been doing a very good job with the core water business over recent years. A rigid control on costs has allowed it to generate some of the best returns on regulated business in the sector, while also earning rewards from Ofwat for exceeding the regulator's targets.

The group is also coping well with the pressures of lower recyclate prices in its waste management business. Viridor collects household waste, sorts it, then recycles as much as possible. The residual waste is burned in energy recovery facilities (ERFs) generating energy.

The group is successfully expanding its ERF estate such that higher profits can be expected from the division despite the lower recyclate prices. At the full year stage, the ERF business should be contributing c. £100m to Viridor's EBITDA, c.20% of the group total, on current analyst estimates.

If Viridor's profitability continues to improve, it will provide a nice fillip for the group, but it's the regulated water business that really matters, since this is what dividend expectations are based on. Pennon's double digit returns on regulated equity is impressive and supports the group's targets of above sector average dividend growth.

Pennon has the most attractive dividend policy out of the three UK-listed water companies. United Utilities and Severn Trent's prospective yields are 4.4% and 3.7% respectively, and both aim to grow the dividend at least in line with RPI inflation until 2020. Pennon offers a slightly higher prospective yield (4.5%) and aims to grow the pay-out by RPI plus 4% over the same period.

In a time of economic uncertainty and low interest rates, the group's regulated revenues and generous dividend policy have seen the shares rise in value. They are now trading over 10% above their historic average price to earnings ratio.

First half results in detail:

Group revenue was broadly in line with last half year at £686m, while lower operating costs helped adjusted earnings before interest, tax, depreciation and amortisation (EBITDA) up 6% to £277m.

South West Water continues to perform well in the new regulatory period. Total operating costs are down on last year while revenue rose by 3.1% as a result of higher demand and tariff increases. This helped EBITDA in the division rise by 5.4%.

The group expects to achieve further cost savings and synergies from the Bournemouth Water integration through the year. A non-residential joint venture with South Staffordshire Plc, with operations centred in Bournemouth has been agreed.

As expected, Viridor revenue dropped by 3%, as landfill volumes fall. However, reductions in the cost base and higher activity levels in the energy recovery facility (ERF) portfolio saw EBITDA rise 3.8%. The group remains on track to generate £100m of EBITDA from ERFs this year.

The group has announced that it is to invest £252m in a 12th ERF. This will be located at Avonmouth and will become operational in 2020/21. This will have capacity for 320,000 tonnes per annum and will deliver 33MW of electricity. 50% of fuel is already agreed or in the final stages of negotiation, including a long-term contract with Somerset Waste Partnership.

Net debt has increased to 3.3% £2.6bn, however the average interest rate fell to 3.3%.

Unless otherwise stated, all estimated figures, including prospective dividend yields, are taken from a consensus of analyst forecasts compiled by Thomson Reuters. These estimates should not be taken as a reliable indicator of future performance.

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 disclosure for more information.