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Pennon - On track

George Salmon | 25 September 2017 | 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: 1,149.00 | Buy: 1,149.50 | Change 3.50 (0.31%)
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In a brief trading update prior to November's half year results, Pennon said it remains confident of meeting management expectations in both its water and waste businesses, and thus delivering a robust underlying financial performance for 2017/18. The shares rose slightly 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.

Viridor collects household waste, sorts it, then recycles as much as possible. The residual waste is burned in energy recovery facilities (ERFs) to generate energy. Pennon is coping well with the pressures of lower recyclate prices, with various cost saving initiatives helping margins rise.

Full year EBITDA (earnings before interest, tax, depreciation and amortisation) from the ERF business was £107m, ahead of the £100m target. This represented 22% of total profits.

However, the regulated water business remains the senior partner. Here, the group's impressive double digit return on regulated equity helps supports the aim of inflation-beating dividend growth.

Indeed, the group plans to increase the dividend by the rate of RPI inflation plus 4%. This, together with its prospective yield of 4.9%, lead us to believe that Pennon is the most attractive option of the three UK listed water utilities, in terms of income at least. Of course these are targets, so are not guaranteed to be met.

The dark cloud on the horizon remains the prospects for UK interest rates, especially since the Bank of England has guided investors to expect a first increase in 10 years at some point in the coming months.

Not only would higher rates mean the interest on Pennon's debt becomes more of a burden, but the relative appeal of bonds, also traditionally the preserve of income-seeking investors, would rise. There is no doubt then, that a sharp increase in rates has the potential to knock the shares.

However, macroeconomic uncertainty means caution is still very much the watchword for policymakers. With this in mind, we feel it's unlikely Carney & co will do more than nudge rates back up to 0.5%, with any increases from there on likely to be slow and steady.

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Full Year Results (24 May 2017)

South West Water continued to deliver a market leading return on regulated equity in the year, at 12.6% (2015/16: 11.7%). Profits before tax of £173.9m are up 4.9% on the previous year, with EBITDA (earnings before interest, tax, depreciation and amortisation) up 4.1% at £349.1m.

The division has delivered cumulative savings of £129m since the start of the current regulatory period (2015-2020) and will continue to focus on cost efficiencies going forward. The integration of Bournemouth Water has been effectively completed, and is on track to deliver £27m of synergies by 2020.

The group received net Outcome Delivery Incentive (ODI) payments of £3.6m in the year, taking the regulatory period total to £5.5m, with bathing water quality, interruptions to supply and leakage showing significant improvements on 2015/16. The group received penalties for pollution events and external flooding.

The Viridor recycling and waste management business saw profits before tax increase 96.7% to £60.4m, with EBITDA rising 18.7% to £138.3. The robust performance was driven by a strong showing from recycling and energy recovery facilities (ERFs), offsetting weakness in Landfill Gas.

The group remains in negotiations with the Greater Management Waste Disposal Authority regarding the exit from the Viridor Laing Recycling & Waste Management Private Finance Initiative.

Net debt of £2.7bn was 7.3% ahead of the previous year.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

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.