Join our community of smart investors

Recycling a pain for Pennon

Pennon faces falling profits in its Viridor recycling business - that will be enough to keep its share price under water for a while yet.
November 29, 2012

Investors searching for safe income were drawn to Pennon's (PNN) mix of a steady regulated water utility combined with a fast-growing waste management business, and this brought its share price to a record high of almost £8 in July. But the price has dropped almost 25 per cent, as the waste management arm, Viridor, faces a sharp reversal in fortunes and the regulatory cycle slowly turns against water services suppliers. We warned investors of the challenges facing Pennon in early August and, adding political pressures on utility bills into the mix, we can see the share price sinking still further.

IC TIP: Sell at 606p
Tip style
Sell
Risk rating
High
Timescale
Long Term
Bull points
  • Water business sound
  • Growth potential in waste to energy
Bear points
  • Profits falling at Viridor recycling business
  • Viridor key to group's success
  • Regulatory cycle turning for water
  • Cost of major investment programme

The speed and severity of the downturn in recycling has surprised City analysts. The problems are twofold: first, the downturn in UK construction has reduced the volume of material sent for recycling; second, as competitors fight for business, prices of recycled materials are falling. In the first half of 2011-12, prices hit £125 a tonne, but analysts now estimate that may have fallen as low as £85 a tonne.

The concern is that in the current climate prices may drop further. Shanks' solid-waste business was loss-making in its first half and privately owned Biffa continues to struggle. Analysts at Deutsche Bank slashed their forecast for Viridor's 2012-13 earnings before interest and tax plus associated companies' income (Pennon's preferred profit metric) from £65m to £47m; it made £76m last year. The analysts are also cautious about recovery - forecasting £51m for 2013-14. And that's a problem because, as Pennon's bosses said earlier this year, "recycling is now the company's largest profit generator and will be key to profits in the next year or so".

This faltering performance also comes at a sensitive time for Viridor as it embarks on a major programme of investment in technology to generate electricity from waste. It is building a 750,000-tonne site at Runcorn in north-west England, which is expected to generate 120 megawatts (MW) of power, with the first phase due for completion next March. Viridor currently has 136MW of capacity available and this is set to rise to 300MW in four years' time. Management hopes these new plants will double Viridor's cash profits in the next five years.

PENNON (PNN)

ORD PRICE:606pMARKET VALUE:£2.21bn
TOUCH:606-607p12M HIGH:797pLOW: 589p
DIVIDEND YIELD:5.0%PE RATIO:15
NET ASSET VALUE:228pNET DEBT:256%

Year to 31 Mar Turnover (£bn)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
20101.0718640.422.6
20111.1618948.424.7
20121.2320148.126.5
2013*1.3419440.428.3
2014*1.4319941.530.2
% change+7+3+3+7

Normal market price: 3,000

Matched bargain trading

Beta: 0.7

*Deutsche Bank estimates

On the other hand, Pennon's water utility, South West Water, is performing strongly. Its prices are allowed to rise with inflation and costs are predictable as spending plans are midway through a calmer regulatory period. Pre-tax profits were up 10 per cent in 2011-12 to £142m. Analysts at investment bank JPMorgan Cazenove forecast another 10 per cent rise in operating profits this year. There are no surprises expected here in the first-half results, which were due out on 29 November.

But regulatory cycles, albeit slowly, do eventually turn and this will put pressure on the water business as the next five-year pricing review comes due in 2014. Analysts at Deutsche Bank believe that, at current share prices, South West Water is implicitly valued at 18 per cent more than the value of its regulatory asset base. That's in line with Severn Trent and United Utilities, but that premium will be under pressure from next year.