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Pennon - positives balancing negatives

George Salmon | 26 March 2018 | A A A
Pennon - positives balancing negatives

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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

Sell: 1,138.00 | Buy: 1,139.00 | Change -9.00 (-0.79%)
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A brief trading update from Pennon confirmed trading is in-line with management expectations, ahead of full year results due on 25 May.

The shares were little moved on the news.

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Our View

Pennon consists of 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 construction of the facility at Glasgow encountering problems. Pricing also looks difficult, but cost savings are helping Pennon cope with the pressures.

However, the regulated water business remains the senior partner, and is therefore crucial to the group's dividend plans. As with most utilities, the potential for the stock to yield a reliable income is probably the main attraction.

The prospective yield is 6.6% and the plan is to increase the payout by RPI inflation plus 4 percentage points each year. Pennon's continued delivery of double digit return on regulated equity supports these goals. However, tougher regulatory conditions from 2020 mean we'll be reading the outlook statement in May's upcoming results with interest.

There's a couple of other clouds on the horizon too. The political climate is far from welcoming, with the nationalisation debate resurfacing for the first time in decades. In addition, UK interest rates now look like rising quicker than expected, which has also impacted the shares.

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.

It's reassuring that underneath these external factors, Pennon continues to deliver a solid operating performance. This should help support the dividend, at least in the short-term. However, wider conditions mean there's more uncertainty around the capital value of the shares than there has been for some time.

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Trading details

Pennon says South West Water continues to perform well. The division has delivered a sector-leading customer experience quality score, with Return on Regulated Equity expected to continue at a sector-leading 11.8%.

Looking ahead, the group acknowledges the regulatory environment looks tougher from 2020 onwards, but says given South West Water's strong operational and financial delivery in K6, it's 'well positioned deliver outstanding services to customers and achieve continued outperformance.'

Within the waste management division, Viridor, Pennon says its operational energy recovery facilities continue to perform above base case expectations. However, total expenditure on the Glasgow Energy Recovery facility is set to come in at around £250m, well above the £155m target. Viridor is contractually entitled to recover incremental costs from the original principal contractor in some circumstance. Discussions regarding a settlement are ongoing.

Pennon also says mitigating the impact of China's changes in recyclate import regulations will see recycling margins fall, but not to the extent there will be any material impact on overall financial performance.

Find out more about Pennon shares including how to invest

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.