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Pennon - both waste and water on track

Nicholas Hyett | 27 September 2019 | A A A
Pennon - both waste and water on track

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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: 975.00 | Buy: 975.60 | Change 11.40 (1.18%)
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Pennon's on track to meet full year expectations, according to a brief trading update ahead of full year results. The group continues to invest in the Viridor waste management business, with South West Water performing well.

The shares were little moved on the news.

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Our view

As with most utilities, the potential for a reliable income is Pennon's main attraction. However, 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 5.7% this year.

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First Half Trading Update

South West Water reported a fall in revenue for the first half, as the bumper results from last year's summer heatwave were not repeated. Cost savings are ongoing and the group remains on track to deliver around £300m of savings over the current regulatory period (2015 - 2020). The division remains on track to achieve a sector leading 11.8% Return on Regulated Equity.

Viridor's portfolio of ten Energy Recovery Facilities are performing well. Activity has stepped up at the newer facilities in Glasgow, Dunbar and South London. The Avonmouth facility and associated plastic recycling plant, currently under construction, looks set to contribute to earnings in the next financial year.

Pennon is looking to expand Viridor's portfolio and is currently scoping out locations for up to three new facilities. West Sussex looks likely to be one and the group have entered into a joint venture with Grundon Waste Management.

Pennon is about to begin a strategic review of growth opportunities and capital allocation policy.

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 disclosure for more information.