In a sector where M&A is often a highlight in investor discussions, we thought we would revisit the investment case for Pennon. In our view, whether there is M&A or not, Pennon offers the best investment value and balance among its publicly-listed UK water peers.
Pennon offers the most dynamic dividend policy. Pennon published its pre-close trading statement on 23 March, which headlined the continuation of its dividend policy of RPI+4 per cent till the end of FY20. This is superior to UU and SVT’s offerings that are “at least in line with RPI”. Pennon’s can afford this because of strong underlying financial fundamentals. These include its stable 3 per cent RAB CAGR in its water business South West Water (SWW), and growth in its waste management business Viridor. Viridor reconfirmed its guidance that FY15 EBITDA will exceed FY14, and that the Energy Recovery Facilities (ERF) will add around £100 million of EBITDA by FY17 (compared with FY12).
M&A expectations rises with the retirement of Ken Harvey. Harvey has announced that he will retire and be replaced as chairman by Sir John Parker, a utilities industry heavyweight. Importantly, Harvey’s retirement could reignite discussions about the future of Pennon. Harvey has been viewed as the chairman who has kept SWW and Viridor together over recent years. Indeed, Viridor has benefitted from being able to access low-cost funding at the backs of the stable SWW assets. However, as Viridor completes its build-out of the ERFs, we see little to justify keeping SWW and Viridor together. With Ofwat now appearing to be more open up on consolidation, we believe Harvey’s retirement is likely to raise M&A expectations.
Pennon’s underperformance YTD suggests good entry point. Pennon has underperformed YTD, with share prices (on a euro basis, as of 20 March) down two per cent, versus its closest peers UU and SVT at 11 per cent, and the broader European Utilities SX6P at 6 per cent. Most of this weakness is due to concerns surrounding its recycling business and what a low power price environment could mean for Viridor’s ERF achieved IRRs. We believe the reconfirmation of financial guidance in the pre-close trading update will help lay to rest some of these concerns.
Overall, whether there is M&A or not, we believe PNN looks attractive.
Maurice Choy, equity research analyst at RBC Capital Markets