Burning rubbish underpins Pennon’s dividend growth prospects

Both Severn Trent (SVT) and United Utilities (UU.) have had to cut their payouts over the past decade, but Pennon (PNN) has rewarded investors with sector-leading dividend growth that has outpaced the rate of inflation. It has done this by arguably being the best water company operator in the quoted sector. It has spent its money wisely, looking after its pipes, sewers and reservoirs, and has generally served its customers well. This has allowed it to bank extra profits for shareholders.

The other reason for Pennon’s dividend robustness is that it has managed to build a growing source of non-regulated profits that put it in a good place to keep on growing dividends into the future. United Utilities couldn’t do this, while Severn Trent decided to spin off its Biffa Waste business.

Pennon’s Viridor waste management business has gone through some tough times as it has become more difficult to make money from landfill sites and recycling. The good news for its investors is that it took the decision a few years ago to invest heavily in energy recovery facilities (ERFs). These ERFs take household rubbish that can’t be recycled or put into landfill and turns it into electricity and heat.

Viridor has invested around £1.5bn in 11 ERFs. Seven of them have been up and running for a few years, three are in ramp-up phase as they have only just entered service, while one facility at Avonmouth near Bristol will enter service in 2021. Once all 11 are running at capacity and assuming availability 90 per cent of the time, they will be capable of handling nearly 3m tonnes of waste per year and have an electricity generating capacity of 240 megawatts.

The ERFs make money from various sources:

• Collecting waste.
• Burning it and turning it into electricity and heat, which is sold to businesses or the National Grid.
• Selling ash by-products to the construction trade.

ERFs are also a comparatively clean source of energy. The gases given off in the rubbish burning process are cleaned up before they – along with some water vapour – are released into the atmosphere. They are very different from old-fashioned waste incinerators.

Viridor first entered this business in 2010 with a joint venture. Since 2014 the profits it has generated from its own ERFs has grown significantly.

Viridor ERFs financial performance

Source: Pennon

In 2014, Ebitda (not the best measure of profits but it’s the only one the company has given us) was just about positive. Last year it was £154.8m. With newly commissioned facilities at Glasgow, Beddington and Dunbar ramping up and new capacity set to come on stream at Avonmouth by 2021, the strong growth in profits is set to continue. Viridor has also proved itself to be good at eking out capacity improvements from its existing facilities as well.

As you can see, the ERF has been eating up cash flow so far (I’ve used Ebitda less capex as a proxy for pre interest, pre-tax free cash flow) as investment has gone into building the ERFs while profits and trading cash flows have built up. Capex is at, or is close to, its peak, which means that the ERF portfolio should become a decent source of free cash flow in the near future.

An important point to bear in mind is that these ERFs do not last forever. They typically have working lives of around 25 years. The good news is that they are backed by long-term contracts with customers, which gives them reasonably predictable cash flows. Pennon is pleased with how they are performing – better than they initially expected – and reckons that the existing portfolio is on track to produce an internal rate of return (taking into account all the cash spent building them and the cash flows generated by them) over their working lives of nearly 9 per cent after tax and inflation (a real return) is taken into account.

If this plays out then this will have been money well spent and will have created a reasonable chunk of value for Pennon shareholders.

There could be more growth to come as there is forecast to be a significant capacity shortage for ERF over the next 15 years (around 7m tonnes of waste worth) which means that Viridor is weighing up the economics of three further ERFs.

Elsewhere in the Viridor business, there are positive potential developments that could see higher profits. The company is looking into the idea of having energy parks near its ERFs and other facilities. These will offer direct connections for electricity and heat to businesses and will bypass the need to use the national grid and allow Viridor to offer cheaper electricity.

Smarter use of remaining landfill sites and landfill gas should produce a more reliable source of profits. The company is also looking at investing significant sums of money in plastics recycling if it can get the long-term contracts to make it worthwhile.

Pennon forecasts

Source: SharePad

The outlook for the water business looks reasonable, but allowable profits are likely to be squeezed by the upcoming regulatory review of water bills. That said, Pennon seems confident that it is well placed to outperform any likely performance targets it is set. Throw in continuing growth in profits from Viridor and the company should be able to keep on increasing its dividend when new water prices come into force from April 2020.

Despite this reasonably positive backdrop, Pennon shares seem relatively unloved and offer a forecast dividend yield of 5.9 per cent at a share price of 746p. If analysts’ dividend forecasts are on the money for 2022 then the dividend yield on cost at the current share price rises to 6.5 per cent.

It seems that the high yield indicates some fear that Jeremy Corbyn and John McDonnell might come along and steal Pennon off its shareholders for less than its true worth. I’ll leave you to take a view on that happening, but in my opinion it is unlikely. 

If my modest optimism in this regard is well founded then Pennon today looks like the pick of the UK utility shares for current income and future income growth.