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Pennon - over to you Ofwat

George Salmon | 24 September 2018 | A A A
Pennon - over to you Ofwat

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: 1,151.00 | Buy: 1,151.50 | Change 5.00 (0.44%)
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A brief trading statement ahead of Pennon's half year results on 27 November 2018 confirms performance remains in line with management expectations.

The shares were little moved on the news.

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Our view

As with most utilities, the potential for the stock to yield a reliable income is probably the main attraction for investors.

However, Pennon's waste management division, Viridor, means there's a bit more under the bonnet than your average water utility.

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. Pennon has proven adept at controlling cost, and the addition of new facilities means there's potential for this side of the business to grow its profits.

However, recent history shows there are potential trip wires. The Glasgow site is now in a position to ramp up activity, but construction was plagued by problems. Pennon's also found out the hard way pricing doesn't have the same regulation-induced predictability.

For all the moving parts at Viridor, it shouldn't be forgotten that 75% of operating profit is still generated in the regulated water business. That makes it central to the dividend plans - namely to increase the payout by RPI inflation plus 4 percentage points each year.

The group's built a good record in its core business. Rigid cost control has helped the group generate some of the best regulated returns in the sector, while service levels have been good enough to earn rewards from Ofwat.

However, regulatory conditions are expected to be tougher from 2020, and with a debate about nationalisation resurfacing for the first time in decades, the political climate is far from welcoming. In addition, UK interest rates look like they might rise quicker than had been expected.

Higher rates mean the interest on parts of Pennon's debt becomes more of a burden. They also increase the appeal of bonds, traditionally the preserve of income-seeking investors, relative to income-focused shares.

Predicting the nature and timing of political and economic changes is difficult considering the uncertainty around the Brexit negotiations. And with Ofwat not due to respond to Pennon's business plans until early next year, uncertainty could linger.

Pennon deserves credit for its achievements, but it's now facing a set of headwinds it can't control. That's pushed the prospective yield up to 5.7%.

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Trading details

South West Water continues to deliver strong operational and financial performance. Cost savings are helping the group deliver continued Total Expenditure (Totex) outperformance, while customer service scores remain high.

Energy Recovery Facilities in Glasgow, Dunbar and South London are all receiving waste, with activity expected to ramp up over the next 18 months.

After recent weakness, there's been some improvement in recyclate pricing, particularly in paper. However, performance for the half and full year remains in line with expectations.

Pennon has submitted its business plans for the 2020-25 regulatory period, with Ofwat's assessments expected by 31 January 2019.

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.