Income on tap at Pennon

The beauty of water utility stocks is the solid income they deliver. Pennon stands head and shoulders above its peers United Utilities (UU) and Severn Trent (SVT) in this regard. Following the approval of Pennon's business plan for the AMP6 regulatory period, which runs between 2015 and 2020, management said it would increase the group's dividend by 4 per cent above RPI inflation each year. This is more generous than the annual increases "at least in line with RPI inflation" promised by United Utilities and in sharp contrast to the 5 per cent dividend cut implemented by Severn Trent.

That Pennon is able to deliver a more substantial dividend than its rivals is testament to the quality of its South West Water business. The aim of a water company is to create more operational efficiencies than the regulator assumes in its final determination of the group's business plan. That way the savings can be shared between customers and shareholders. Pennon has a history of outperforming its regulatory targets by delivering extra cost savings. During the 2010-2015 regulatory period Pennon outperformed the total expenditure target set in Ofwat's 2009 determination by 6 per cent. In the group's 2014 determination Ofwat revealed the group has the highest potential return on regulated equity in the sector during the current regulatory period, with top-end expectations of 10.5 per cent. This means the group has the best chance of delivering outperformance. Pennon's AMP6 business plan was the only one submitted to the regulator to gain 'enhanced status', which has meant it had a head-start on its rivals and is well-advanced in its operational upgrades. Management said Pennon is on track to generate financial outperformance in the group's September trading statement for the first half.

Pennon is also turning around its waste management business Viridor. Taking advantage of European green energy policy, namely the EU Landfill Directive and Renewable Energy Directive. Viridor is focusing its resources on developing its energy recovery facilities (ERF). These facilities take waste that cannot be recycled, burn it at high temperatures to turn it into energy, and then feed it into the National Grid. Last year Viridor brought five new ERFs on line, adding to its Lakeside and Bolton sites. This drove Viridor revenue up 4 per cent to £836m, while underlying cash profits grew 8 per cent to £135m.

Viridor is in the process of constructing ERFs in Peterborough, Glasgow and Dunbar. Peterborough ERF is already in commissioning and is due to be brought on stream during the second half of this financial year. Glasgow will be brought on stream in the first half of 2016-17 and Dunbar in the second half of 2017-18. In its most recent trading update management said its ERF business is on track to contribute around £100m to Viridor's cash profit in 2016-17.

Admittedly, Viridor's landfill operations continue to drag on its earnings power. Last year the business was forced to book £11m in charges for underperforming landfill contracts. However, overall exceptional charges relating to Viridor fell. The group is also in the process of closing 15 sites to new waste inputs to focus landfill operations in three strategic sites. Commodity price weakness has also weighed on Viridor, with recycling volumes down by 8 per cent last year. This meant overall recyclate sales and gate fees were 8 per cent lower than they year before at £86 a tonne. However, management says prices have now stabilised to some extent. The group has also implemented an optimisation programme, aimed at increasing the efficiency of its recycling processes. This seems to be bearing fruit, with recycling cash profits improved on the second half of FY15, according to the group's most recent trading statement.