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Pennon - ERFs drive profits higher

George Salmon | 27 November 2018 | A A A
Pennon - ERFs drive profits higher

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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: 1,149.00 | Buy: 1,149.50 | Change 3.00 (0.26%)
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Pennon's half year results show group revenue rising 3.1% to £746.7m. Pre-tax profits are up 8.7% to £142.5m, with continued progress in the core water business augmented by higher returns form Viridor, the waste management division.

In line with the stated target of raising the payout by at least 4 percentage points above RPI inflation, the interim dividend increases 7.3% to 12.84p per share.

The shares rose 1.3% on the news.

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Our view

As with most utilities, the potential for 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. Management have found pricing doesn't have the same regulation-induced predictability, but are hopeful conditions will improve as recycling becomes ever-more important.

While Viridor tends to get the headlines, the majority of profit is still generated in the regulated water business. And it's this that underpins the dividend policy - 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 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.

It doesn't help that UK interest rates look likely to rise again in 2019.

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, especially with 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 5.9% for 2020.

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Half year trading details

Higher customer demand from the summer's hot and dry weather and slight tariff increases helped South West Water rise 3.2% to £301.5m. While operating costs and depreciation charges both rose, pre-tax profits tax rose 4.3% to £100.3m.

Operational performance for the half-year resulted in a net Outcome Delivery Incentive reward of £1.2m, bringing the cumulative reward for the 2015-20 period to £9.3m.

Customer service levels have improved, as have instances of pollution and flooding. However, the 'freeze and thaw' in March saw leakage levels rise.

Revenue at Viridor rose 3.8% to £422.3m. Pre-tax profit increased 18.3% to £36.2m, boosted by new ERF facilities at Beddington and Dunbar, and higher contributions from recycling and landfill.

The group's Energy Recovery Facilities (ERFs) are performing well, and waste market dynamics are said to be becoming more favourable. Further expansion is planned.

Revenue from Pennon Water Services, a joint venture with South Staffordshire Plc, rose slightly to £84.1m, with pre-tax losses stable at £0.5m.

Net debt increased £240m to £3bn, as working capital changes limited operating cash flow to £151.7m, down from £211.2m last year.

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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.