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Pennon - full-year performance to be weighted to the second half

Pennon's underlying revenue grew 5.4% in the first half, up to £448.6mn.

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Pennon's underlying revenue grew 5.4% in the first half, up to £448.6mn. This increase was largely driven by inflation-linked tariff increases, with new contract wins providing a smaller contribution.

Operating profit was down 11.6% to £85.9mn, but this was ahead of market expectations. This decline comes as revenue growth was more than offset by increased operating costs, as well as higher depreciation charges on the group's larger asset base.

Free cash outflow increased from £92.6mn to £210.1mn as a result of lower operational cash generation and increased levels of investment. Net debt increased from £2.9bn to £3.3bn.

Pennon expects full-year profits to be weighed towards the second half due to seasonal demand and lower operating costs. The market expects operating profit to grow around 15% to £176mn.

An interim dividend of 14.04p per share has been announced, up 8.3%.

The shares were down 1.1% following the announcement.

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Our view

In return for providing reliable water and wastewater services, the regulator allows Pennon to earn an acceptable financial return. First-half revenue was buoyed by an inflation-linked increase from the regulator, as well as some new contract wins from its non-household arm, Pennon Water Services.

But despite rising revenue, profits came under pressure as high power and investment costs took their toll. Operating costs are expected to fall in the second half due to lower prices and usage, which should bring some welcome breathing room.

It's important to remember that a utility company's revenue and earnings power are linked to both inflation and its asset base, measured by Regulatory Capital Value (RCV). That provides Pennon with incentives to invest in its assets (which helps to deliver a good service to customers), as well as operate efficiently (which helps increase company earnings).

With that said, Pennon increased its investment guidance by £100mn, now expecting to pump over £850mn into upgrading its assets by the end of the next financial year. Coupled with the acquisition of Bristol Water, Pennon's RCV is expected to grow around £0.5bn to £5.4bn by 2025, which should provide a further boost to revenue.

There's also a large amount of infrastructure spending expected over the second half of the decade. But despite this, debt levels are expected to remain within the group's target range. That means future investment should be covered without the need to issue new equity - which may not be the case for some peers.

The higher investment levels have their drawbacks though. Cashflows could get squeezed in the meantime, which has the potential to put some pressure on the generous 6.3% prospective dividend. As always, remember that all dividends are variable and not guaranteed.

Another thing to bear in mind is the regulatory pressure that's been mounting against water utility companies. South West Water, which is owned by Pennon, has already been on the receiving end of fines for discharging untreated sewage into rivers and lakes. We expect more fines are on the way due to past offences, with the market forecasting the bill to land around the £50mn mark, due next financial year .

All in, Pennon has a history of sector-leading performance and looks well-placed to benefit if it can execute its long-term strategy. But regulatory challenges and some high-profile slip-ups mean it currently trades at a discount to its peer group. We see that as an opportunity, but nothing is guaranteed.

Pennon key facts

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.

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. 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 disclosure for more information.

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Written by
Aarin Chiekrie
Aarin Chiekrie
Equity Analyst

Aarin is a member of the Equity Research team. Alongside our other analysts, he provides regular research and analysis on individual companies and wider sectors. Having a keen interest in global economics, he knows how macro-events can impact individual companies.

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Article history
Published: 29th November 2023