Pennon expects to report full year results in-line with management's expectations. The group also highlighted the CMA has cleared the Bristol Water merger with South West Water, and Pennon has identified annual cost savings of £20m by 2024/25 from the deal.
The shares were unmoved following the announcement.
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Our View
Pennon provides water and wastewater services to businesses and individuals. The group's business is regulated, and this oversight translates into stable and predictable revenues - one of its main attractions.
The group's benefitting as easing covid restrictions improve non-household demand and the hybrid work-from-home model keeps household demand elevated. Together with the integration of Bristol Water, Pennon's in a stronger position.
The Bristol Water acquisition brought a lot to the table. The business has about 1.2m customers and raised Pennon's Regulatory Capital Value (RCV) by around 16%. Pennon paid a 44% premium to RCV for the business, but we think that's not unreasonable and it's already started to pay dividends - management said this part of the business is performing ahead of expectations.
However, the deal and recent shareholder returns mean the group's running a substantial net debt position. This is important now because inflationary pressure has become somewhat of a burden throughout the sector. Pennon and its peers have index-linked debt, which is becoming more expensive. We should note Pennon won't feel the sting as much as some of its peers since a lower proportion is structured this way, and we're not saying debt is at crisis levels, but it's still something to keep an eye on if inflation continues to rise.
Investing in reliable infrastructure is part and parcel with operating as a utility. In return for providing reliable and affordable service, Ofwat (the regulator) allows Pennon to earn an acceptable financial return. This return is reviewed every five years, which means earnings have tended to be stable and predictable, underpinning a generous dividend. However, do remember that all dividends are variable and not guaranteed.
But Pennon and its water peers have just started a new and tougher regulatory period. Ofwat's reduced what it considers to be 'acceptable' for the coming period and increased performance targets. As with other businesses, lower earnings have tended to result in less generous returns for shareholders.
To date Pennon's built a good record as a water business and while the next regulatory cycle is set to be tougher, we see no reason why this shouldn't continue. Rigid cost control has helped generate some of the best regulated returns in the sector, while service levels have been good enough to earn additional rewards from Ofwat. Long may that continue. We should mention that investors are paying for that strength, with a price to earnings ratio some way above the average.
Pennon key facts
All ratios are sourced from Refinitiv. Please remember yields are variable and not a reliable indicator of future income. Keep in mind key figures shouldn't be looked at on their own - it's important to understand the big picture.
Trading Statement
The Bristol and South West Water merger is expected to complete over the next two years, with Pennon retaining the "valuable" Bristol Water brand.
Pennon said its water resources remain in a "robust" position, with reservoir storage at about 93%. A new site for development has been procured.
For South West Water, Pennon expects a return on regulated equity outperformance double that of base return assumptions, which stand at around 3.1%. Outperformance Delivery Incentive (ODI) performance is expected to improve on last year, largely because of better leakage and pollutions performance. About 80% of ODIs are on or above target.
26% of Pennon's gross debt of £3.1bn is index-linked, meaning inflation is causing financing costs to increase. A 1% increase in inflation equals an extra £8m in costs. Wholesale power costs make up about 10% of operating costs, and the group is 40% exposed to rising wholesale prices, which have "increased significantly".
Pennon has completed around £200m of its ongoing £400m share buyback.
This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.
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