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Pennon - still no acquisition news

Sophie Lund-Yates, Equity Analyst | 30 March 2021 | A A A
Pennon - still no acquisition news

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Pennon Group Ord 40.7p

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Pennon has confirmed it's on track to deliver results in line with prior expectations. Demand and revenue have increased in the second half of the financial year, as household demand rose to more than offset declines elsewhere. Operating costs have increased to reflect the higher demand. Cash collection has remained "robust" and bad debts are in line with initial expectations.

Pennon has used £1bn of the £3.7bn Viridor sale proceeds to pay down debt, and now has around £200m of gross debt on the balance sheet. The remaining proceeds will be used to fund an acquisition in the UK water sector or returned to shareholders. Management will provide an update at or ahead of June's full year results.

The shares fell 3.0% following the news.

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Our view

Now that Pennon has sold Viridor its focus is firmly on 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 saying what those might be. Some of the cash has already been used to reduce debt and some will likely be returned to shareholders.

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.

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.

Pennon is in an interesting position, and it's worth remembering that the excess cash on the balance sheet will be distorting the valuation somewhat. The core water business is in a good place and the business has plenty of cash on hand after selling Viridor. The dividend should therefore be secure for the immediate future, although nothing is guaranteed. However, it's difficult to take a strong view until we know what Pennon's doing with the sale proceeds. Smart investments could provide a growing dividend going forward, but they'll have to be judged when we know about them.

Pennon key facts

  • 12m forward Price/Earnings ratio: 30.5
  • Ten year average 12m forward Price/Earnings ratio: 15.8
  • Prospective yield: 2.4%

All ratios are sourced from Refinitiv. 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 Results

Pennon's underlying first half operating profit fell 13.0% to £114.8m, reflecting lower revenue due to COVID-19 and the new K7 regulatory period.

The sale of Viridor completed in July and Pennon received £3.7bn in cash. The group's statutory results include a £1.7bn profit on the disposal, bringing first half profits to £1.8bn. The group intends to use some of the proceeds to pay down debt, and either invest the remainder or return it to shareholders.

The board has declared an interim dividend of 6.77p, in line with the group's policy of annual growth equal to CPIH inflation +2%.

Pennon's underlying first half revenue fell 1.9% to £319.7m. COVID-19 reduced revenue by £10.7m as lower business demand was only partially offset by increased use by households. The new K7 regulatory regime also contributed a £10.5m reduction in revenue.

South West Water revenue fell 3.4% to £282.9m, mostly due to regulatory changes. COVID-19 has had limited impact because of the high share of household demand. Underlying operating profit for the division fell 11.2% to £116.8m.

Net revenue for Pennon Water Services rose 10.3% to £36.5m, despite the impact of COVID-19. The division made an operating loss of £0.1m, compared with a £0.6m profit last year.

Following the Viridor sale Pennon has £37.9m in net cash, compared with £3.3bn in net debt at the same point last year. Underlying operating cash flows fell from £178.7m to £154.6m.

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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 Refinitiv. 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.