Join our community of smart investors

Tap into income and value at Pennon

The water sector looks worth dipping into again and Pennon is the best way to play it.
July 10, 2014

The UK water sector now has a clearer regulatory outlook and a realistic chance of bid action. So after a period as a bit of an investment backwater, the waters are sexy again. Pennon (PNN), with the greatest regulatory clarity and valuation upside, is the pick of the bunch.

IC TIP: Buy at 803p
Tip style
Income
Risk rating
Medium
Timescale
Long Term
Bull points
  • ● Low regulatory risk
  • ● Good visibility on water business
  • ● Turnaround at Viridor
  • ● Reliable dividend income
  • ● Potential M&A beneficiary
Bear points
  • ● Tough conditions in landfill
  • ● Dividend policy under review

Pennon's South West Water is the only combined water and sewerage company to have been given "enhanced" status for its 2015-20 business plan by water regulator Ofwat. Pennon has already received its draft determination from Ofwat, while the other water companies will have to wait until late August for theirs.

That means Pennon can concentrate on finding the cost savings that Ofwat wants, while its peers continue to wrangle with the regulator. What's more, there are financial incentives for enhanced status such as an £11m initial financial award and more preferable sharing rate for excess profits.

The ultimate aim for a water company is to generate more efficiencies than the regulator has assumed. The company can then share those extra profits with shareholders and customers. Pennon has an excellent track record of outperforming regulatory targets by generating extra cost savings.

In its current 2010-15 regulatory period, South West Water has found 14 per cent more operating cost savings than Ofwat was looking for. With early implementation of its 2015-20 business plan, there is every reason to expect that Pennon will continue that strong track record.

The visible, regulated nature of the water business is one of the major attractions for potential bidders and the UK water sector has long been prime M&A territory. Last summer, Severn Trent (SVT) rebuffed an approach from the LongRiver consortium of international infrastructure investors. Now, with the current regulatory review process drawing to a close, bid chatter has returned to the sector.

A recent softening in Ofwat's stance towards water company mergers is adding fuel to the flames. Obviously, a direct approach for Pennon would bring the most share price upside, but an approach for a peer would also lift Pennon, as it would drive ratings higher across the sector.

Pennon is perhaps a more complex takeover prospect than peers due to it also having a non-regulated waste business, Viridor. While Pennon's water business has being going swimmingly, Viridor has been battling against a declining landfill market characterised by tough price competition and dwindling volumes.

At the recent full-year results, Pennon warned that Viridor's cash profits would slump in the first half as the landfill downturn continues to bite. But Viridor should turn a corner in the second half as its strategic shift towards the more attractive energy-from-waste (EfW) market begins to bear fruit.

Pennon believes EfW is central to the UK's waste and energy strategy as a low-cost alternative to landfill and the group aims to have a 15 per cent share of the market by 2020. Viridor has five EfW plants due to come on stream this year, which Pennon says will start making a meaningful contribution in the second half and mean that Viridor's full-year result is up on the year.

The turnaround at Viridor and attractive prospects for the water business both have the potential to act as re-rating catalysts. And, in typical utility stock fashion, there is a decent dividend yield as back-up, too. Pennon offers just over 4 per cent dividend yield and a current dividend policy of increasing the dividend by a best-in-class 4 per cent above inflation.

Pennon, in common with the other listed water companies, has said it will not update its dividend policy until early 2015 when it has fully evaluated the impact of the 2015-20 price controls. But unlike the other water companies, City analysts see no risk of Pennon having to cut its dividend as a result of the new price controls. Indeed, Macquarie's forecasts assume a 7 per cent increase in the dividend in the 2015-16 financial year, which will be the first year of the new regulatory period.

PENNON (PNN)
ORD PRICE:803pMARKET VALUE:£3.1bn
TOUCH:802-803p12M HIGH:805pLOW: 629p
FORWARD DIVIDEND YIELD:4.3%FORWARD PE RATIO:17
NET ASSET VALUE:233p*NET DEBT:183%

Year to 31 MarchTurnover (£bn)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
20121.2320148.126.52
20131.20145.728.46
20141.3215938.830.31
2015**1.3318133.032.4
2016**1.4525846.434.6
% change+9+43+41+7

Normal market size: 3,000

Matched bargain trading

Beta:

*Includes intangible assets of £370m, or 96p a share

**Macquarie forecasts