Pennon opens the taps with £1.5bn special dividend

Investors had been patiently waiting to see what Pennon (PNN) would do with the £3.7bn of cash proceeds from the sale of its waste management business Viridor. The water utility has now announced the acquisition of Bristol Water Group for £425m, a £1.5bn special dividend and a £400m share buyback programme.

The remainder of the proceeds have been put towards repaying £1.1bn debt, contributing to the company’s pension scheme and investing in green projects. As a result, Pennon is now in a net cash position of £64m, versus £3.3bn of net debt at the end of March last year.

Splashing out

Bristol Water will increase the scale of Pennon’s water supply activities, boosting the customer base by almost 50 per cent to 3.5m and adding 16 per cent to the group’s regulatory capital value (RCV). The acquisition is subject to approval from the Competition and Markets Authority (CMA), but if it is completed, Pennon will have paid a 44 per cent premium to Bristol Water’s RCV.

RBC Capital Markets analyst Alexander Wheeler said that this was “quite a high price”, and that Pennon would need to demonstrate “how it can gain additional value from Bristol Water, a company which has struggled to produce a meaningful RoRE [return on regulated equity] over AMP6.” (AMP6 refers to the previous five-year regulatory period which concluded at the end of March last year.)

Pennon believes it can eke out efficiencies as it did with its 2015 acquisition of Bournemouth Water, pointing to opportunities for operational improvements, and savings from centralised control functions, shared support services and economies of scale.

The group’s M&A hunt may not be over yet. While it has proposed repurchasing £400m-worth of shares by the end of September 2022, these funds may be redirected if further acquisitions arise. Potential targets could include neighbouring rival Wessex Water, which is currently owned by Malaysian utility YTL Power International (MY:YTLPOWR).

More certain shareholder returns come in the form of a 355p per share special dividend, which is being combined with a share consolidation that will see investors receive 2 new shares with a nominal value of 61.05p for every three existing shares they own. Subject to shareholder approval, Pennon says this consolidation will “reduce the number of ordinary shares in issue by approximately the same percentage of market capitalisation returned via the special dividend.” The intention is for Pennon’s share price to be undisturbed by the payment of the special dividend.

The bumper payout will add to the 21.74p per share dividend declared for the 12 months to 31 March, which has halved versus a year earlier. Yet if you strip out the portion of the 2020 dividend that relates to Viridor, the annual payout has increased by 3 per cent.

Bristol Water is expected to add 3p to this year’s dividend post-share consolidation, and Pennon is still aiming to grow the annual payout 2 per cent ahead of CPIH inflation through to 2025.   

Pandemic adds to regulatory challenges

The FY2021 dividend hike comes as Pennon’s underlying revenue increased by just over 1 per cent to £645m. The group was hit by lower allowed tariffs during the new regulatory period, AMP7, and reduced water consumption by commercial customers due to the pandemic. However, this was more than offset by higher-than-expected water demand from households as people spent more time at home, as well as new contract wins.  

Underlying operating profit fell by 12 per cent to £215m on the back of pay increases, higher power costs and Covid-19-related expenses. On a statutory basis, operating profit was further weighed down by £25m of exceptional charges, which largely relate to £21m of outperformance payments being returned to households via the group’s ‘Watershare+’ scheme.

Pennon’s earnings were similar to those of peers Severn Trent (SVT) and United Utilities (UU.), which reported their results last month.

United Utilities’ revenue dipped by 3 per cent in the year to 31 March, to £1.8bn, reflecting an £80m hit from the lower pricing regime agreed with Ofwat for AMP7. The pandemic proved less significant than the regulatory changes – while non-household water consumption dropped, the impact was cancelled out by the increase in household water demand.

Lower revenue and higher investment in its network saw underlying operating profit decline by 18 per cent to £602m, and this figure also included a £5m increase in bad debt charges to account for the financial strain that Covid-19 has placed on its customers.

Still, despite the earnings squeeze, United Utilities increased its full year dividend by 2 per cent to 43.24p per share. This is consistent with its policy to raise the annual payout in line with CPIH inflation in AMP7, which is less generous than Pennon.

Severn Trent’s approach lies somewhere in between the two, promising to grow the annual dividend by at least CPIH inflation. This resulted in its 2021 dividend rising by 2 per cent to 101.58p per share.

The group’s revenue dropped by 1 per cent in the year to 31 March, to £1.8bn, as it was more impacted by the pandemic than the lowering of tariffs. It suffered a net £50m blow from lower water consumption during lockdown, although the regulatory model allows for this shortfall to be recovered in later years. Together with higher labour, power and chemicals costs, this pushed Severn Trent’s adjusted operating profit down by 17 per cent to £473m.

Ramping up investment

Pennon increased capital expenditure on its water and wastewater operations by 5 per cent last year to £168m, and it will invest a further £100m as part of Ofwat’s ‘Green Recovery’ initiative. The regulator has approved more than £850m-worth of environmentally-friendly projects across the country’s water networks to contribute to a green economic recovery from Covid-19.

Severn Trent has been the biggest winner of this green push, securing the nod for £565m of investment. Planned projects include the decarbonisation of water supplies and installing over 150,000 smart meters.

In order to help fund these plans, the group recently raised £250m via a placing, retail offer and subscription for new shares by management, in a move that Wheeler called “somewhat surprising.”

Reliable income

The listed water companies have proven to be relatively resilient to the twin threats of Covid-19 and lower allowed returns for AMP7. Yet that has not been reflected in their share prices, which have, at best, advanced only slightly since the beginning of last year. Amid the vaccine rollout, the utilities have been caught out by investors’ shift from defensive stocks into cyclical and recovery plays.

While Pennon, Severn Trent and United Utilities may not make for the most exciting investments, we think the dependable income on offer should not be overlooked. The pandemic pressures should hopefully soon abate, and even with a tougher regulatory period ahead, the companies’ dividends are expected to keep rising. With that in mind, we are sticking to a buy on all three counts.  

Last IC Views: Pennon: Buy, 972p, 25 Nov 2020; Severn Trent: Buy, 2,466p, 25 Nov 2020; United Utilities: Buy, 930p, 25 Nov 2020