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Pennon - Interim dividend rises 7.9%

George Salmon | 29 November 2017 | A A A
Pennon - Interim dividend rises 7.9%

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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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The group has performed well in H1 2017/18, and is on track to deliver in line with management expectations for the full year. The shares moved slightly higher on the news.

The interim dividend per share has risen 7.9% to 11.97p.

Our view

Pennon comprises two main divisions; water and waste management.

The core water business has delivered impressive results. A rigid control of costs has allowed it to generate some of the best regulated returns in the sector, while also earning rewards from Ofwat for exceeding 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 electricity. Progress here hasn't been entirely smooth, with the facilities at Glasgow and Greater Manchester both encountering problems. Pricing also looks difficult, but Pennon is coping well with the pressures. Various cost saving initiatives are helping margins rise.

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 4.8%, 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.

Increasing regulation is a threat, but the main cloud on the horizon remains the prospects for UK interest rates. Rates have been raised for the first time in ten years, and while the Bank of England has guided investors to expect increases to be steady rather than spectacular, a more rapid upwards shift could hurt the stock.

Not only would higher rates mean the interest on parts of Pennon's debt becomes more of a burden, but the relative appeal of bonds, traditionally the preserve of income-seeking investors, would rise.

However, all this shouldn't impact the dividend paying potential of the stock, which remains the main attraction in our view.

Half year results

Group underlying net revenues rose 5.6% to £723.9m, boosted by the impact of the business taken on with the South Staffordshire joint venture. Group earnings before interest, tax, depreciation and amortisation (EBITDA) rose 3.3% to £253.5m.

In South West Water, marginally higher tariffs and customer usage helped revenues rise 2.6% to £292.2m. EBITDA rose by 2.9%, despite higher inflation leading operating costs up.

In the 18 months since acquiring Bournemouth Water, £12m of net synergies have been delivered and the group is on track to deliver £27m by 2020.

Underlying revenues at Viridor were £407m, with EBITDA up 5.2% to £66.6m. Operational performance from the group's energy recovery facilities (ERFs) has exceeded management's base expectations, although the group expects a tougher pricing environment in the second half.

The group has negotiated a reset of its Greater Manchester contract, with ownership of the Pennon/John Laing JV passing to the local authority. Pennon says it has reached a satisfactory financial outcome.

Viridor anticipates generating significant growth in EBITDA over the coming years, with a step up expected from 2018/19 as additional facilities come on stream.

Higher RPI inflation has increased the costs of the group's debt, with South West Water's effective interest rate now 3.5%. With 2016/17 and 2017/18 representing peak capital expenditure, net debt rose £126m to £2.8bn.

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.

George Salmon owns shares in Pennon.

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.