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Pennon - on track for a good year

George Salmon | 9 February 2017 | A A A
Pennon - on track for a good year

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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

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In a brief trading statement, Chris Loughlin, Pennon CEO confirmed that the group is on course to deliver a good set of results for the full year 2016/17. South West Water is on course to remain at a sector-leading 11.7% return on regulated equity and Viridor is on track to contribute the targeted c.£100 million of EBITDA from its portfolio of Energy Recovery Facilities. The shares rose by 2.5% 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 useable power.

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 4.3% and 3.6% respectively, and both aim to grow the dividend at least in line with RPI inflation until 2020. Pennon offers a higher prospective yield (4.7%) and aims to grow the pay-out by RPI plus 4 percentage points over the same period.

In a time of economic uncertainty and low interest rates, the group's regulated revenues and generous dividend policy mean the shares are now trading almost 10% above their historic average price to earnings ratio.

Trading update details

As previously confirmed, the group has seen delays in the progress of the Glasgow Energy Recovery Facility. Viridor is assembling a new team to finish the work, with a new Engineering, Procurement and Construction contractor appointed. Glasgow City Council is supportive of this move, and Viridor will receive contractual remedies after terminating the contract with its previous partner, Interserve.

In Greater Manchester, while diversion of waste from landfill remains ahead of contractual commitments, the group recognises that prolonged austerity is creating challenges for it client, Greater Manchester Waste Disposal Authority. The group working with its partners on a response.

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 for more information.