Pennon Group (PNN) ORD GBP0.6105

No recommendation - No news or research item is a personal recommendation to deal. All investments can fall as well as rise in value so you could get back less than you invest.

In June, Pennon received CMA clearance for its acquisition of Sutton and East Surrey Water (SES). Integration is underway and around 10% of the planned cost savings have already been captured.

On a like-for-like basis, first-half revenue has been impacted by lower customer demand. Operating costs have remained broadly flat as elevated power costs have been offset by efficiency savings.

Around £300mn of infrastructure investment is planned for the first half.

For the full year, lower revenue from falling customer demand is expected to be offset by higher tariffs and increased customer numbers. Operating costs are expected to be lower in the second half as more of the planned cost savings from the SES acquisition are captured.

The shares fell 1.3% following the announcement.

Our view

There are a few moving parts to monitor, but Pennon’s performance as a whole looks to be moving along well. The regulator gave the Sutton and East Surrey Water (SES Water) acquisition the final green light in June, helping expand the group’s footprint across Southern England by bringing more than 750,000 paying customers into the fold.

Pennon’s making good progress on streamlining operations after bringing SES on board. 10% of the planned cost savings have already been captured, which is helping to offset elevated power costs. With more fat left to trim, operating costs in the second half look set to fall and provide some relief to profitability.

In return for providing reliable water and wastewater services, the regulator allows Pennon to earn an acceptable financial return.

Lower consumer demand is likely to hold back half-year revenue growth as customers feel the pinch of higher costs of living. Inflation-linked tariff increases from the regulator, as well as increased customer numbers, should help soften the blow, so we’re not expecting too much of a drop-off on a like-for-like basis.

It's important to remember that a utility company's revenue and earnings power are linked to both inflation and its asset base, measured by Regulatory Capital Value (RCV). That provides Pennon with incentives to invest in its assets (which helps to deliver a good service to customers), as well as operate efficiently (which helps increase company earnings).

That said, Pennon invested much more money in improving and expanding its infrastructure last year. While this has put some strain on cash flows in the near term, we’re impressed with the big-picture focus and expect it to be a net benefit in the long run. The acquisition of SES Water also helped boost RCV growth, which should provide a further lift to revenue in the years to come.

Another thing to bear in mind is the regulatory pressure that's been mounting against water utility companies. South West Water, which is owned by Pennon, has been on the receiving end of fines for discharging untreated sewage into rivers and lakes. Until these issues are firmly in the past, investor sentiment around water companies is likely to be muted, putting downward pressure on valuations.

Despite the challenges, we think Pennon looks well-placed to benefit if it can execute its long-term strategy. Regulatory pressure and some high-profile slip-ups mean it currently trades at a discount to its peer group, which we see as an opportunity. But it can take time for investor attitudes to change, and nothing is guaranteed.

Environmental, social and governance (ESG) risk

The utilities industry is high-risk in terms of ESG. Management of these risks tends to be strong, with European firms outperforming their overseas counterparts. Environmental risks like carbon emissions, resource use and non-carbon emissions and spills tend to be the most significant risks for this industry. Employee health and safety and community relations are also key risks to monitor.

According to Sustainalytics, Pennon’s management of ESG risk is strong.

It has a very strong health and safety programme, with zero fatalities among its employees and contractors over the last three years. However, Pennon has been fined for numerous unpermitted wastewater releases in recent years and has been heavily criticised by the regulator.

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.

Previous Pennon Group updates