Despite tough macro-economic conditions Pennon is expecting results for the half year to September 2022 to be in line with expectations.
There have been operational challenges, not least the driest weather in 100 years and significant population increases in the South West of England, where it provides water and wastewater services.
Pennon's South West Water was the second best performer amongst water providers in the last financial year in terms of the regulator's delivery incentives, and is on track for a positive performance this time round. This is being supported by measures including leak reduction goals and the WaterFit plans which are targeting coastal and river water quality improvement.
Despite significant forward buying, Pennon is expecting its energy costs to increase by roughly £50m this financial year against a total of £56m last year. It has ringfenced £160m for investment in renewable energy generation and aims to be self-sufficient for half of its requirements by 2030.
Pennon expects to save about £120m should the previously planned rise in corporation tax be scrapped. But high inflation is driving higher servicing costs of its index linked debt, about £8m for each percentage point rise in RPI inflation.
The shares had climbed 3.5% by mid morning.
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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 from improved non-household demand and the hybrid work-from-home model keeping household demand elevated. It is also seeing an influx of new residents to the Southwest of England. 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 - this part of the business is performing ahead of expectations.
However, that deal and a £1.5bn special dividend paid out in the last financial year, have contributed to 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.
Ofwat reduced what it considers to be 'acceptable' this regulatory period and increased performance targets. Another review isn't on the cards until 2024, but it's worth considering that there could be another downward revision, particularly if the cost-of-living crisis is still hanging around. As with other businesses, lower earnings could 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 expected earnings ratio some way above the average. That's partly due to analysts cutting their earnings estimates substantially over the last 12 months. Given that much of Pennon's demand is non-discretionary, and energy costs are largely fixed, there may be limited scope for further downgrades next year. The elephant in the room however, remains inflation, which can adversely affect both demand and the cost of financing for Pennon.
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.
HL COMMENT ON FULL YEAR RESULTS (31 MAY 2022)
A recovery in non-household demand meant underlying revenue rose 22.9% to £792.3m, which included a £104.4m contribution from Bristol Water.
Higher costs associated with servicing growing demand weighed on organic growth, but including the Bristol Water acquisition, underlying cash profit rose 14.7% to £383.9m. However, this was more than offset by the rising cost of interest-linked debt, meaning underlying profit before tax fell 8.6%.
The group announced a final dividend of 26.83p, bringing the total for the year to 38.5p, an 8.2% increase.
Inflation's expected to continue driving interest costs higher in the near-term.
Revenue at South West Water rose 3.6% to £583.4m, reflecting improving demand from non-household customers and continued elevated demand from household customers. Operating costs rose by £29.5m due primarily to inflationary pressure, which meant underlying cash profits fell 2.7% to £331.5..
Bristol Water was acquired on 3 June and contributed £104.4m in revenue and £55.3m in underlying cash profits. This part of the business saw relatively stable demand and benefitted from higher regulatory allowances. However, around half of Bristol Water's debt is index linked, so the division is more susceptible to rising inflation.
Pennon Water Services saw revenue rose 20% to £195.3m, reflecting improved demand among hospitality, tourism and manufacturing businesses. Underlying operating costs have grown roughly in line with revenue, so cash profits more than doubled to £3.4m.
The group spent £240.9m in capital investment, up 17.4%. The bulk of this went toward South West Water as the group replaces the first of two water treatment works in Bournemouth.
The group had a free cash outflow of £26.7m, up from last year's £20.4m outflow. Net debt rose from £64.3m to £2.7bn, reflecting the cost of the Bristol Water acquisition and increased shareholder returns.
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.
This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.