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Pennon - rising costs restrict profit pipeline

Pennon's full-year underlying revenue rose 4.1% to ?825.0m.

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Pennon's full-year underlying revenue rose 4.1% to £825.0m, reflecting contract wins by Pennon Water Services and a full twelve-month contribution from Bristol Water.

Underlying operating profit fell 35.5% to £153.1m due to higher power and inflation-related costs.

Free cash flow fell from an inflow of £11.9m to an outflow of £205.6m largely because of the higher investment levels made in the year to help boost water supplies, as well as increased interest payments. Net debt rose from £2.7bn to £3.0bn.

Revenue is expected to increase while power costs remain broadly flat in the new year. Overall, Pennon is expecting to see improvements in near-term earnings.

A final dividend of 29.77p per share takes the full-year total to 42.73p, representing a 10.9% increase on the prior year.

The shares were broadly flat following the announcement.

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Our View

Pennon's full-year revenues were buoyed by a strong performance from its non-household arm, Pennon Water Services, which scored a handful of contract wins last year. But despite rising revenues, Pennon saw profits begin to evaporate as high power and inflation-related costs took their toll.

Pennon provides water and wastewater services to businesses and individuals. In return for providing a reliable and affordable service, Ofwat (the regulator) allows Pennon to earn an acceptable financial return.

In the short term, inflation looks to be pushing up costs and squeezing margins. However, longer term, high levels of inflation are set to be a net benefit for Pennon. That's because inflation increases the amount of revenue the group's allowed to earn on its assets, which are measured by Regulatory Capital Value (RCV).

The Bristol Water acquisition helped on this front, raising Pennon's RCV by around 16%. And further growth's being supercharged by investment, with RCV expected to grow by £0.5bn to £5.2bn by 2025.

These actions as well as dividend payments and share buybacks have all contributed to a substantial net debt position, which now sits at a lofty £3.0bn. Given the group's infrastructure investment plans, we wouldn't be surprised to see this creep up further. But compared to peers, a relatively low portion of this debt is linked to inflation. And the bulk of the related interest payments are non-cash and should be non-recurring, which hopefully removes a headwind moving forward.

The higher investment levels have their drawbacks though. Cashflows are getting squeezed as a result, which could put some pressure on the generous 5.9% 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 recently. 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. Pledges have been made to clean up its act, but progress won't be cheap.

And the group's water resilience is in question too, as the drought status in southwest England remains in place. Pennon's been scrambling to repurpose old quarries into mini reservoirs in a bid to shore up supplies. But as summertime nears, it's touch-and-go whether this will be enough to keep customers' supplies running at full flow. If not, Pennon could find itself back in the regulator's firing line.

The valuation's above its long-run average, which isn't surprising given some of its defensive characteristics. Should inflation come under control, there's likely to be some tailwinds too. But inflated costs and regulatory pressures have the potential to throw a spanner in the works in the near term.

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: 1st June 2023