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Waste is potential at Pennon

As regulated profits from Pennon's water business look set to be squeezed, its waste-management division should underpin dividend growth
October 24, 2019

Enjoying predictable regulated returns, the UK's remaining listed water companies have long been a haven for income investors. But as the industry battles an increasingly tough regulatory outlook, accompanied by the resurgent threat of nationalisation, Pennon (PNN) offers a little more than the typical utility. While South West Water remains the group’s backbone, its waste management business, Viridor, has emerged as the engine of growth.

IC TIP: Buy at 904p
Tip style
Income
Risk rating
Medium
Timescale
Long Term
Bull points

Yield and dividend growth 

Water's sector-leading returns

Value of waste management arm

Bear points

Tougher regulatory regime from 2020

Vague threat of nationalisation

A burgeoning source of non-regulated profits, Viridor accounts for more than half of overall revenue and a third of underlying cash profits (Ebitda). Driven by its 'energy recovery facilities', underlying Ebitda from the waste-management business increased almost a fifth to £179m in 2018-19. With two site closures illustrating landfill challenges and China’s ban on importing waste depressing prices of recyclable material, Viridor is benefiting from £1.5bn invested in plants that turn waste into electricity and heat. Underlying Ebitda from such plants surged from £34m in 2014-15 to £155m in 2018-19, and should rise further as three plants ramp up and the Avonmouth facility comes on stream. Pennon's bosses plan three more plants because they anticipate an annual gap of 7m tonnes between combustible waste and waste-energy capacity until 2035; recently they entered a joint venture in West Sussex.

However, with its Glasgow plant £118m over budget, construction issues have pushed the ratio of debtors to turnover from 25 per cent in 2017 to 33 per cent in 2019. Having removed Interserve from the project in 2016, Pennon believes it is owed £72m for “rectifications and completion costs”, although a provision of just £29m against this receivable reflects Interserve’s uncertain future.  

Citing the “Blue Planet effect”, a £65m plastic-processing plant aims to capitalise on manufacturers' demand for recycled plastic pellets, especially as the UK government considers taxing plastic packaging. Expanding capacity by 80,000 tonnes, the majority of Pennon's plastic waste currently sold to third parties will be processed internally, with the reprocessed plastic estimated to be worth double the input material. With around 85 per cent of inputs and 75 per cent of offtake contracted, the facility will boost earnings from 2021.

While Viridor’s growth is impressive, the core water business should not be overlooked. Management claims a sector-leading double-digit return on regulated equity (RORE) during the latest five-year regulatory pricing cycle, which ends early next year. A combination of delivering £237m in efficiencies and better-than-expected financing costs meant the cumulative RORE in 2019 was 11.8 per cent.

The next five-year pricing period, commencing in 2020, will be tougher. With the regulator's final price determination due in December, allowed profits are expected to fall – the draft determination in April suggested a base return of 4.6 per cent on capital, down from 6 per cent in the current period. Even so, broker RBC Capital Markets expects Pennon to remain a top RORE performer. Pennon is confident it can continue to outperform and has been awarded ‘fast-track’ status for its plans, the only water company to achieve this for two successive price reviews.

The threat of nationalisation brings uncertainty as Labour says it may pay just £15bn to bring water companies back into public ownership, well short of their possible £44bn market value. True, the chances of this actually happening are long. Besides, Pennon claims to be addressing the issue of misaligned interests between customers and shareholders. Subject to shareholders' approval, its ‘New Deal’ proposes that up to £25m-worth of outperformance benefits from the current price period will be given to customers in new shares or money off their bills. 

Investing £208m in waste-to-energy plants in 2019 pushed the group's net debt to £3.1bn in March 2019, up 10 per cent on the year. In line with plans, investment in South West Water fell to £154m, dipping the ratio of the water business’s debt to its regulatory-capital value to 59 per cent – below Ofwat’s efficient gearing target of 62.5 per cent, but in line with the regulator's likely future target of 60 per cent figure. Having passed peak capital spending on energy-recovery plants, Pennon is forecast to produce positive free cash flow from next year.

Following a business review in September, there are suggestions Pennon could sell a stake of its energy-recovery portfolio or even split its water and waste businesses. Seeing both options as positive for shareholders, Deutsche Bank estimates that Viridor alone is worth £3.2bn, close to the market value of the groups' equity (see table).

PENNON (PNN)    
ORD PRICE:904pMARKET VALUE:£3.8bn 
TOUCH:903-904p12-MONTH HIGH:904pLOW:679p
FORWARD DIVIDEND YIELD:5.0%FORWARD PE RATIO:19 
NET ASSET VALUE:329pNET DEBT:183% 
Year to 31 MarTurnover (£bn)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
20171.3521139.836.0
20181.3926348.038.6
20191.4826051.141.1
2020*1.4327753.543.8
2021*1.4125348.345.4
% change-1-9-10+4
Normal market size:2,000    
Beta:0.76    
*RBC Capital Markets forecasts