Pennon still the fount of quality income

Viridor's ERFs increased cash profits by 19 per cent during the year to £107m, some way ahead of the £100m target. Utilisation rates were good, with average availability for the portfolio meeting the 90 per cent goal. This strong performance from ERFs, along with a marked uptick in recycling profits, contributed to a 12.5 per cent rise in the waste business's cash profits, including joint ventures, to £199m. The division's large and relatively stable costs associated with interest, amortisation and depreciation, meant the cash profit increase translated into a near doubling in pre-tax profit from the division.

This adds some spice to the core investment case for Pennon, which lies with its excellent dividend record (see table below). The group has a generous progressive dividend policy of 4 per cent above RPI until 2020. While he strong performance of the waste business will help support the payout.

Pennon's dividend has risen steadily

The key to Pennon's dividend record is the sector-leading return on regulated equity (RORE) from its South West Water business. Regulator Ofwat has allowed the group a higher than usual base return of 6 per cent on the back of its 2015-20 business plan, which was granted 'enhanced status'. But Pennon has a great record of outperforming the base case. Indeed, last year performance against outcome delivery incentives (ODIs) pushed RORE up by 0.3 per cent, while cost savings and better than expected financing costs respectively accounted for an additional 3.2 per cent and 3.1 per cent. That brought the overall RORE to 12.6 per cent, up from 11.7 in 2016. The group expects to remain at the top of its sector until at least the end of the AMP cycle.

Much of the group's strategic focus has been on efficiency, looking to increase margins and reduce costs. It seeks to do this through measures such as contract renegotiation to share commodity risks and opportunities with customers and improving asset utilisation. It has generated cumulative savings of £129m since 2015.

The company also has significant spending commitments, and capital investment rose last year from £317m to £385m, split fairly evenly between the water and waste businesses. Combined with lower finance income, this increased net debt by 7.3 per cent to £2.66bn. These have been described as the "peak years" for capital expenditure, so balance sheet pressure should ease and the water business's debt to regulatory capital value ratio of 61.8 per cent remains in line with Ofwat's efficient gearing target of 62.5 per cent.

The risk to this great income stock is what happens should Labour win the general election next month. Despite the narrowing of the polls, we feel this currently looks unlikely, but the Labour manifesto promises to "replace our dysfunctional water system with a network of regional publicly-owned water companies". Anyone expecting another surprise outcome could always wait until 9 June before diving in.