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Pennon - first half on track, no surprises

Emilie Stevens, Equity Analyst | 25 September 2020 | A A A
Pennon - first half on track, no surprises

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Pennon Group Ord 40.7p

Sell: 1,001.00 | Buy: 1,002.50 | Change -7.00 (-0.70%)
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Pennon's first half has been in line with management expectations with lower business water use offsetting a rise in household usage. Covid-19 is still expected to reduce net revenue by £10m this year but the regulatory model will allow the lower revenue to be recovered in future years.

The sale of Viridor completed in July and Pennon received £3.7bn in cash. As planned some of this is being used to pay down debt and contribute to the pension.

The shares were relatively unmoved by the news.

View the latest Pennon share price and how to deal

Our view

Having sold Viridor Pennon's focus, for now, is on one thing and one thing only - water.

Pennon's taking its time to decide what's best to do with the £3.7bn in cash it received as part of the deal. How they spend it will set the group's course for the future. The group is looking at acquisitions, but isn't not saying what those might be. Some of the cash has been used to reduce debt and some will be returned to shareholders, although we'll have to wait until November to find out if that's a special dividend or share buyback.

With waste management out the door, 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 denting earnings.

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 25.7 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 3.2%.

Pennon key facts

  • 12m forward Price/Earnings Ratio: 25.7
  • 10 year average 12m forward Price/Earnings Ratio: 17.2
  • Prospective yield: 3.2%

Please remember yields are variable and not a reliable indicator of future income. Keep in mind key figures shouldn't be looked at on their own - it's important to understand the big picture.

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Half Year Trading Update

Pennon has continued to deliver essential services throughout the pandemic and has not made use of government support schemes or furloughed any employees.

Cash collection across the group is said to be "robust" and Pennon has introduced new initiatives in Pennon Water Services, the Business Water Supplier, to try and minimise bad debts.

South West Water is on track to deliver a higher return than the regulatory standard, thanks to lower financing costs and continued investment. The $1bn investment programme to 2025 is underway and the group has completed its expansion into Isles of Scilly, which will provide additional infrastructure investment opportunities.

Following the sale of Viridor, cash and committed facilities is expected to be well above £3bn by the end of September. Pennon said it continues to review the best method of returning value to shareholders, whether that be by returning capital directly or through acquisition opportunities. An update for shareholders on this review will be provided at Pennon's half year results announcement this November.

Find out more about Pennon shares including how to invest

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. 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.