Don't waste time – buy Pennon

Pennon generates about two-fifths of turnover and four-fifths of profit from its South West Water and Bournemouth Water businesses, which serve about 2.2m people. At the start of the month, Ofwat set out its methodology for the upcoming AMP7 review, which includes tougher estimates on water companies’ cost of capital and new safeguards for consumers to protect them against the impact of cost overruns. However, importantly for Pennon, which in past reviews has emerged as a best-in-class operator, Ofwat is still keen to reward excellence. Indeed, its proposals allow for a 20-35 basis point uplift in return on regulated equity (RORE) for companies that submit business plans judged to be exceptional. 

Pennon’s water business was awarded enhanced status for its last business plan and so has the highest potential returns in the sector under AMP6. The deadline for AMP7 plans is September 2018. With Pennon outperforming its current regulatory targets and delivering against 33 of its 36 operational delivery incentives (ODIs), it’s in a strong position to thrive in a tightened regulatory environment.

A greater unknown is what a Labour government would with plans for renationalisation. But the ability to buy out high-yielding equity with low-yielding debt could make it possible for a policy ‘victory’ without causing serious financial pain to shareholders.

With all the furore over the water business, it’s easy to overlook Pennon’s prospects elsewhere. In the half-year to the end of September, Pennon’s waste business Viridor accounted for half of revenue but just a fifth of profits. Pennon is working on improving the performance of Viridor’s recycling operation and stands to benefit from a recent renegotiation of its private finance initiative (PFI) contract with the Greater Manchester Waste Disposal Authority. Viridor is also investing in its most promising activity, its energy recovery facilities (ERFs). The group’s eight ERFs grew earnings by a modest 2.4 per cent in the first half. There are four ERFs at various stages of development, which management expects to generate “significant growth in [cash profits]” in coming years.

Pennon also operates a non-household retail company, Pennon Water Services, alongside South Staffordshire. This operates in the recently deregulated market for non-household water supply. While it generated a tenth of first-half sales, the business did not turn a profit.