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Pennon - inflation-linked debt eats into profits

First half underlying revenue increased 9.3% to £426m,...

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First half underlying revenue increased 9.3% to £426m, primarily due to growth in non-household demand and a full six-month contribution from recently acquired Bristol Water.

However, not much of this increased revenue made it to the bottom line as profit before tax came in at £20.9m, down from £79.9m the year before. This was mainly due to higher non-cash interest charges as inflation impacted the value of index-linked debt, up circa £37m on the year before.

Pennon's net debt increased 13% from the prior year, now standing at £2.9bn. There was also a free cash flow outflow of £41.1m for the half-year, compared to an outflow of £24.9m last year.

Over the second half, Pennon expect lower revenue coupled with higher operational costs due to inflation. The group also expects to lower its financing costs by reducing index-linked debt exposure.

The group announced an interim dividend of 12.96p, up 10.8% from last year.

The shares were down 3.41% following the announcement.

View the latest Pennon share price and how to deal

Our View

Pennon provides water and wastewater services to businesses and individuals. The group's business is regulated, and this oversight translates into stable and predictable revenues - one of its main attractions.

The group's benefitting from non-household demand returning to pre-covid levels as well as from the Bristol Water acquisition. The business has about 1.2m customers and raised Pennon's Regulatory Capital Value (RCV) by around 16%. Pennon paid a 44% premium to RCV for the business and the integration is still ongoing, but Bristol Water contributed £69.7m to total revenues in the first half.

However, that deal and a £1.5bn special dividend paid out in the last financial year, have contributed to a substantial net debt position. Pennon and its peers have index-linked debt, the costs of which increase in line with inflation. Pennon has a relatively low portion of its debt linked to inflation and is taking steps to get than lower still. It's also important to remember the bulk of these charges are non-cash and should be non-recurring. But it's still something to keep an eye on if inflation continues to rise.

In return for providing reliable and affordable service, 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. However, do remember that all dividends are variable and not guaranteed.

Ofwat reduced what it considers to be 'acceptable' this regulatory period and increased performance targets. Another review isn't on the cards until 2024, but it's worth considering that there could be another downward revision, particularly if the cost-of-living crisis is still hanging around. As with other businesses, lower earnings could result in less generous returns for shareholders.

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 additional rewards from Ofwat. Investors are paying for that strength, with a price to book ratio some way above its average. Given the challenging outlook for the rest of the year this valuation could come under further pressure.

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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Article history
Published: 30th November 2022