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Pennon - Investment in plastic recycling, ERF profits heat up

Nicholas Hyett | 30 May 2019 | A A A
Pennon - Investment in plastic recycling, ERF profits heat up

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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: 1,152.50 | Buy: 1,153.00 | Change 7.00 (0.61%)
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Pennon reported revenues of £1.5bn and profit before tax of £280.2m in 2018/19, up 6.1% and 8.3% respectively. That was supported by particularly rapid growth in the waste management business following the completion of new ERFs (Energy Recovery Facilities).

The full year dividend rose 6.4% to 41.06p per share.

The shares were little moved following the announcement.

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Our view

As with most utilities, the potential for a reliable income is the main attraction for Pennon investors.

However, the group'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 this side of the business has seen profits grow.

The 'Blue Planet' effect is proving something of a tailwind at moment, with waste disposal higher up the political agenda than it has been for years. A new plastics recycling facility at Avonmouth is the group's first effort to capitalise on that opportunity.

However, recent history shows there are potential trip wires. Management have found recyclate pricing doesn't have the same regulation-induced predictability as water, although 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.

While the next regulatory cycle (2020-2025) is expected to be tougher, Pennon's plans have received approval from the regulator and the group's confident it can continue to outperform. It would be remiss not to mention the ongoing nationalisation debate though.

The Labour party has proposed nationalising the water sector for the first time in decades, and at a price that might not reflect the sector's current market value. Of course there are lots of ifs and buts, but it's something that should be kept in mind nonetheless.

Pennon deserves credit for its achievements, but in an increasingly political environment there are some headwinds that are out of its control. That's pushed the prospective yield up to 6% this year.

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Full Year Results

South West Water reported revenue growth of £581m in 2018/19, up 1.7% year-on-year, while profit before tax remained broadly flat at £180.6m. The group continues to deliver well against service targets, with a net outcome delivery incentive award (ODI) of £4.1m, Pennon's highest ever.

The division delivered a sector leading return on equity of 11.8% during the current regulatory period and remains on track to deliver £300m of cost savings by 2020. These are integrated into the group's 2020-2025 business plan, which have been awarded 'fast-track' and are expected to offer significant outperformance potential.

The Viridor waste management business reported revenue growth of 8.5%, to £852.7m, and profits before tax of £88.5m, up 25%. That was driven by the opening of three new ERFs during the year - at Glasgow, Beddington and Dunbar - with construction of the Avonmouth facility still on track.

Alongside results, Viridor announced investment in a new plastics recycling business to sit alongside the Avonmouth ERF. The facility will process 80,000 tonnes a year, equivalent to 8% of current market requirements.

Revenue from Pennon Water Services, a joint venture with South Staffordshire Plc, rose 4.7% to £173.7m, with pre-tax losses increasing 45.5% to £1.6m.

Pennon finished the period with net debt of £3.1bn, up 9.9% on the year before. That reflects capital investment of £395.9m, broadly flat year-on-year, as increased investment in Viridor offset lower water spending.

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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.