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Pennon - new dividend lower but still above inflation

Emilie Stevens, Equity Analyst | 4 June 2020 | A A A
Pennon - new dividend lower but still above inflation

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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: 1,152.00 | Buy: 1,152.50 | Change 6.00 (0.52%)
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Revenue from Pennon's continuing water operations, finished the year marginally higher at £636.7m. Profit before tax fell 4.1%, to £193.1m, reflecting pressure on margins and an increase in exceptional costs, including provision for non-payment of bills in relation to coronavirus.

Viridor, the group's recycling business whose sale to private equity KKR is nearly complete, generated revenue of £757.8m and profit before tax of £104.6m.

Pennon announced a final dividend of 30.11p, bringing the total payment this year to 43.77p, 6.6% higher than last year. Pennon plans to distribute some Viridor sale proceeds to shareholders, but will confirm details at a later date.

The group's dividend policy for the 2020 - 2025 regulatory period is to increase the dividend by at least 2% ahead of inflation. That's a drop from the current policy of paying out 4% above.

The shares fell 3% on the news.

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Our view

With Viridor, the waste management business, on the way out, Pennon's focus is on one thing and one thing only - water.

The deal is expected to complete this summer and will see Pennon receive cash proceeds of around £3.7bn. It plans to return some to shareholders, reduce debt, and keep some for future investment. All eminently sensible in our opinion.

As with most utilities, the potential for a reliable income is Pennon's main attraction. That's particularly true in light of the current environment. While many sectors are seeing significant hits to revenue, life as a water utility means earnings are more predictable.

In return for providing an affordable water supply, Ofwat (the regulator) allows Pennon to earn an acceptable financial return. This return is reviewed every five years, which means earnings have tended to be stable and predictable, underpinning a generous dividend.

But Pennon and its water peers have just started a new and tougher regulatory period. Ofwat's reduced what it considers to be 'acceptable' for the coming period and increased performance targets. As with other businesses lower earnings have tended to result in less generous returns for shareholders.

Pennon now aims to grow the dividend by 2% above inflation each year, having been growing it by 4% above inflation over the last five. The group's not alone in this move, its listed peers have also reduced their pay-outs to rise with inflation. Which makes Pennon's new policy on the more generous side.

It's unlikely to rock the boat too much, but it's worth noting that while insulated, Pennon is not immune from the current pandemic. Like its peers the group's seeing a rise in customers failing to pay bills, business customers in particular, and that's already denting profits. The billions of pounds set to be received from the sale of Viridor means Pennon won't be as concerned as some.

To date Pennon's built a good record as a water business and while the next regulatory cycle is set to be tougher, we see no reason why this shouldn't continue. 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.

Against a backdrop of wider uncertainty, Pennon currently trades on 22.7 times future earnings, way above the long run average. Given the reliable nature of Pennon's business, that doesn't come as too much of a surprise. The prospective yield is 3.7%.

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Full Year Results (results are underlying unless otherwise stated)

South West Water revenue dropped 1.8% to £570.3m, as wet weather reduced customer demand. Despite improvements in operating costs this decline meant profits before tax fell 3.7% to £174.0m.

SWW earned £2m in operational outperformance payments this year, bringing the total for the five year regulatory period to £13.3m.

Pennon Water Services, which serves business customers, revenue rose to £67.1m. The group's loss before tax reduced to £0.4m up from a loss of £1.6m.

Both water businesses have seen bad debt rise in relation to coronavirus. However, it's affecting Pennon Water Services business customers more. This dented this year's reported profits as Pennon increased provisions for the non-payment of bills.

As expected Viridor's revenues were 11.1% lower than last year, reflecting the group's exit from recycling operations in Manchester. However, profit before tax was up 18.2%, boosted by full year performances from the three new ERF facilities in Glasgow, Beddington and Dunbar.

Despite a rise in cash generated by the group, capital investment of £339.2m, split roughly equally between SWW and Viridor, contributed to the marginal rise in net debt to £3.3bn. SWW accounts for £2.2bn of group net debt, Viridor £215m and Pennon as a company £822m.

At the end of March, Pennon had £1.6bn in available liquidity and expects to receive a further £3.7m in net cash from the sale of Viridor. Apart from shareholder returns, these proceeds will be used to reduce debt, pay down the pension deficit and to invest for the future.

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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.