New Pennon banking on higher demand

Pennon (PNN) has to face some choppy currents this year. It has forecast a hit of £8mn in added financing costs for each percentage point in inflation, meaning current trading conditions make for tough reading for the water utility’s accounting department. Power costs are also hitting operating margins, and the company said it expected wholesale electricity costs to rise 50-75 per cent this year.

While Pennon – alongside sector mates Severn Trent (SVT) and United Utilities (UU.) – is protected in the long term from inflationary pressures as these can be passed on to customers, its 2023 bottom line will still feel the impact. 

But there are positives for this year: the company noted a “substantial population increase in the South West”, which will boost household demand; the vast majority of Pennon’s underlying cash profit comes from household water use. Non-household buyers account for a quarter of sales. The overall underlying cash profit was £384mn, a 15 per cent increase on the year before, although this figure fell when the contribution from new acquisition Bristol Water is stripped out. 

The competition regulator signed off on the the Bristol buyout in March. There should now be cost savings from the merger of £50mn out to 2025, Pennon said. The return on regulated equity, which is marked against a base set by Ofwat, was 9.2 per cent for South West Water and 6.3 per cent for Bristol Water – the former about par compared against peers elsewhere in the UK, while the latter showing room for improvement. 

Consensus estimates compiled by FactSet see Pennon (now in its first full year post-Viridor sale) losing some cash profit margin this year, but this was already outpacing its pre-Covid-19 level (48 per cent in 2022 compared with 37 per cent in 2019). This looks like solid enough progress to us to move it to a buy. 

Last IC View: Hold, 1,208p, 30 Nov 2021