Pennon weighs M&A against boosting shareholder returns

Water utility Pennon (PNN) saw its adjusted pre-tax profit fall by 15 per cent year on year in the six months to 30 September, to £87m, due to lower tariffs in the new five-year regulatory period and demand from commercial customers dropping by a fifth. The group was spared a more severe blow from pandemic disruption as revenue was weighted towards residential customers, who increased their water usage as they spend more time at home.    

On a statutory basis, pre-tax profit almost halved, pulled down by £25m of exceptional charges. This was largely down to Pennon’s ‘WaterShare+’ scheme, whereby £21m of outperformance payments from the past five years were returned to household customers in the form of credit on their bills or as shares.

Pennon is now solely focused on its water activities following the sale of its waste management business, Viridor, to private equity firm KKR in July. It netted £3.7bn in cash from the deal, of which £2.7bn is left over after debt repayments and pensions contributions. Shareholders have been waiting to hear what the group plans to do with these proceeds, however the final outcome remains unclear. Pennon thinks there is “significant value” to be found from M&A in the UK water sector, but says it is still narrowing down potential opportunities. If there are no suitable candidates, the capital will be returned to shareholders.

According to The Sunday Times, the group has been eyeing up private rivals Wessex Water, Bristol Water and Southern Water, with the latter believed to be the frontrunner for a takeover. Broker Jefferies estimates it would cost more than £6bn to buy Southern Water and views it as a “higher risk, higher reward option”. Southern suffered from performance issues in the last regulatory period and would require Pennon to turn things around.  

Thanks to the Viridor windfall, the group is sitting in a small net cash position of £38m, compared with £3.3bn of net debt at the April year-end. As previously announced, the dividend has been rebased to reflect the absence of Viridor, meaning the half-year payout has shrunk in cash terms. However, if you only take the portion of last year’s dividend that relates to the continuing group, the 6.77p payout has increased by 2.7 per cent. This is line with Pennon’s new policy to lift the dividend by 2 per cent above the rate of CPIH inflation.

That is a more generous stance than peer United Utilities (UU.), which is only aiming to increase its annual dividend in line with CPIH inflation between 2020 and 2025. The group is handing shareholders a 14.41p dividend for the six months to 30 September, although its net debt pile has ticked up by 3 per cent since the March year-end, to £7.6bn.

Mirroring Pennon, United Utilities has been similarly hit by Ofwat’s new price controls and lower water consumption by business customers. Underlying operating profits dipped by 19 per cent year on year to £392m, which also reflects the impact of higher investment in its network.

The group actually saw net water demand increase by 3 per cent as households used more water and during peak periods, jumping by more than a fifth versus a year earlier. Yet this was not reflected in earnings because more than 50 per cent of residential customers are not on a water meter. United Utilities is guiding that revenue from households will likely fall in the second half of the year in the absence of warm weather to boost consumption. It anticipates that full-year revenue will be £60m-£110m lower than the £1.9bn recorded last year, although regulatory mechanisms enable much of this to be recovered in two years’ time.  

Household bad debt remained stable during the first half of the financial year, equivalent to 2 per cent of revenue. While higher unemployment is expected to affect customers’ ability to pay their bills, United Utilities believes its existing £17m provision for additional bad debt should still suffice.

That contrasts Severn Trent (SVT) which has increased its bad debt charge by £8.2m in anticipation of a weak labour market. Together with the impact of lower water consumption by businesses, the group’s underlying operating profit declined by more than a fifth year-on-year in the six months to 30 September, to £226m.

It saw a £33m hit to revenue from lower commercial water demand during the first half and is guiding that the full year impact will be in the region of £50m-85m. Again, the regulatory model means that this shortfall can be made up for in future years.

Severn invested heavily in improving its network across the last regulatory period, spending £3bn in total. Having completed major programmes, capital expenditure is expected to fall this year. Cash capex came in at £284m in the first half – down almost a quarter versus a year earlier – which helped boost free cash flow from £27m to £129m. Net debt is largely unchanged from the March year-end position, however, at £6.2bn, equivalent to 66 per cent of the group’s regulatory capital value (RCV).

Just like United Utilities, Severn’s policy is to grow its annual dividend in line with CPIH. As such, the interim payout has been lifted to 40.63p per share and the group is pointing to full year dividend of 101.58p. That would be just about covered by consensus analyst forecasts for adjusted EPS of 106p.

Neither Severn nor United Utilities provided any specifics on their return on regulated equity (RoRE), so it’s a little more difficult to get a sense of their performance compared with their agreed plans with the regulator. Pennon, meanwhile, achieved a RoRE of 8 per cent, which stacks up well against Ofwat’s assumed 8.5 per cent of outperformance versus its total expenditure, financing and outcome delivery incentive targets.

Still, investors reacted positively to United Utilities’ half-year numbers, bidding the shares up by 4 per cent. We’d like to see Pennon provide greater clarity on its future plans, but in the meantime, all three water companies offer investors a defensive income haven in these turbulent times. Buy on all counts.

Last IC View: Pennon: Buy, 1,145p, 04 Jun 2020; Severn Trent: Hold, 2,452p, 21 May 2020; United Utilities: Hold, 865p, 22 May 2020