Shares in utility company Pennon have had a strong three-year run thanks to the growth promised by its recycling arm, Viridor, and the stability provided by its water utility, South West Water. Management is pressing ahead with the expansion of Viridor and has just signed a 25-year waste contract with Glasgow City Council, to handle between 175,000 and 200,000 tonnes of rubbish per year. Viridor is planning to divert 90 per cent of this from landfill and is investing £160m in a new recycling and energy-from-waste plant, which it hopes will generate 15 megawatts of power.
But Pennon's shares have underperformed the water utility sub-sector recently due to fears over Viridor. The economic downturn is affecting the amount of waste produced and the prices Viridor can demand for recycling it. A recent trading update revealed that Viridor's performance has been significantly worse than in the first half last year.
Still, Pennon remains confident that full-year results for the group will be in line with analyst expectations as South West Water continues to outperform. But with regulatory wrangling set to begin in 2014 this gives Pennon just over a year to see a recovery in the recycling market.
Liberum says...
Buy. Pennon is currently trading at a 7.3 per cent adjusted premium to regulatory capital value versus a 24 per cent premium to regulatory capital value for Severn Trent and United Utilities. We see Pennon EPS doubling by 2015-16 once the energy-from-waste assets are built, driven by a tripling of cash profits in Viridor. Share price weakness on concerns over the waste division should be seen as an opportunity for investors and, based on discounted cash flow calculations, we value the shares at 810p.
Credit Suisse says...
Underperform. Pennon's share price has performed exceptionally well and has proven resilient in the downturn, but we now believe Viridor Waste Management is under pressure from declining UK waste volumes and is seeing deteriorating returns on capital. The upside from Viridor's pipeline of energy-from-waste facilities is fully priced in and South West Water may face a challenging price control review, owing to its relatively high retail cost base, which we expect will result in the under-recovery of retail costs from 2015. We downgrade our recommendation to 'underperform' (from outperform) and cut our target price to 710p (from 800p).
