Questor: Pennon is the best-in-class water firm and has what it takes to weather the storm

Questor share tip: newly-promoted to the FTSE 100 and with a £4.2bn deal for its recycling division signed, it’s time to dive in

James Ashton 26 April 2020 • 5:00am

Woman turning on water tap — The water company is the runaway leader in its field Credit: Edward Peter Atkinson /Getty Creative

With so much going on it is unsurprising that a recent notable corporate achievement passed with little comment. The promotion of water company Pennon into the FTSE 100 last month made it the sixth time the veteran industrialist Sir John Parker has chaired a member of the blue chip club.

This might normally be something to savour but right now bosses are too busy dealing with the uncertainty of coronavirus to reflect on accumulated glories.

When Questor recommended Pennon in October 2017 it wasn’t clear that Sir John was going to add further to his FTSE 100 tally with the owner of South West Water, which provides water and wastewater services to 1.7 million people in Cornwall, Devon and parts of Dorset and Somerset and water only to another 500,000 further afield.

Since then, the shares have gained 40pc and largely held firm despite recent swings.

There are several factors that explain why: a settled pricing regime agreed with the regulator, Ofwat, continuing low interest rates, the disappearance of Labour’s threat of industry nationalisation and a flight to defensives since the global economy went into tailspin.

And then there is one specific reason. Pennon could not have timed better its decision to sell its recycling and waste management division, Viridor, which serves 150 local authorities and major corporate clients.

Built up through acquisitions going back as far as 1993, there have been moments when shareholders would have preferred it to be spun off but in the past two years, as new energy-from-waste facilities have come on stream profits, have risen by almost 50pc.

Announced last month, the £4.2bn sale to funds managed by private equity group Kohlberg Kravis Roberts is at a price sharply higher than most analysts were expecting. The net cash proceeds of £3.7bn, plus a potential £200m follow-on, suggest that a return of at least £2bn to shareholders is on the way.

More details are expected alongside full-year results on June 4. Should KKR try to back out given the looming recession there is a £42m break fee.

Also to be spelt out is the group’s new dividend policy. Company followers at Deutsche Bank reckon it can grow the payout at between 2pc and 4pc above CPIH inflation through to 2025, when the current regulatory period runs out. That is not dissimilar to the previous five-year cycle.

Whether Pennon opts to pass on this year’s payment in view of political sensitivities remains to be seen. Customers cannot have too much to grumble about. By 2025 water bills will be lower than they are today and lower than they were 15 years earlier.

What is interesting is whether finally becoming a pure-play water provider puts Pennon in the mood for acquisitions. Industry deal activity tailed off after a slew of water firms were taken private by overseas investors that adopted arcane financial engineering to enable gushing dividends.

Pennon bought tiddler Bournemouth Water in 2015 but could accommodate something larger this time. The company is best-in-class, earning post-tax returns of 11.8pc from 2015 to 2020 and twice the rate of some industry laggards. It has done so by keeping debt costs low and grinding out operational efficiencies.

In fact, it is teacher’s pet, as the only water and wastewater company to achieve fast-track status for two consecutive pricing reviews that saved it further money. The next five years will be harder for the industry, with some operators struggling to make back their cost of capital as it stands.

In setting out its acquisition options, analysts at Credit Suisse suggest that only Southern Water, which covers some of Hampshire and West Sussex, or Affinity Water, which includes Luton and Woking in its supply network, would move the dial for Pennon.

For example, if it bought Southern and managed to close the performance gap it would be worth around 10p per share.

While it considers its options, the shares are trading at 20 times forecast earnings for the year to March 2021. Not cheap, but not likely to disappoint either. It also has £1.6bn of cash and committed facilities on hand to weather the storm. Dive in.

Questor says: buy

Ticker: PNN

Share price at close: £11.21

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