ii view: Pennon pumping £160 million into renewable energy

This water company is down by a similar amount to the FTSE 250 index year-to-date and now offers a dividend yield of around 5%. Buy, sell, or hold? 

First-half trading update to 30 September

ii round-up:

Water company Pennon Group (LSE:PNN) today detailed plans to invest £160 million into renewable energy generation as it highlighted first-half trading in line with management expectations. 

Energy usage for the owner of South West and Bristol Water is 95% hedged  for the year to the end of March, with power costs expected to rise to £106 million from last year’s £50 million. 

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Funds for its renewable energy investment are being diverted from a previously announced £400 million share buyback programme and will accelerate its existing plan to generate half of its own energy needs come 2030.

Pennon Group shares rose by around 3% in UK trading having come into this latest update down by around a third year-to-date. Fellow water companies United Utilities (LSE:UU.) and Severn Trent (LSE:SVT) are down by close to a fifth during 2022, while the FTSE 250 index has fallen by just over a quarter. 

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Along with rising energy costs, elevated inflation is raising the cost of financing Pennon’s own index-linked debt, with every 1% increase in inflation adding around £8 million in interest costs. Just under a third of its total £3.2 billion in debt is index-linked. 

Despite enduring record customer demand and the driest weather for over 100 years, operational delivery was summarised as resilient. Outcome Delivery Incentives (ODI), paid to water companies by the regulator for meeting or exceeding performance targets such as reducing leakages, remained on track for the year. 

Broker Morgan Stanley reiterated its 'overweight' stance on Pennon shares following the update, leaving its estimated fair value price target unchanged at 1,300p per share. First-half results are scheduled for 30 November. 

ii view:

Pennon Group came to the UK stock market in 1989 as South West Water. It later combined with Bournemouth Water becoming Pennon Group. In 2020, it agreed to sell its waste management business Viridor, later returning funds to shareholders. Most recently, it purchased Bristol Water, adding around 1.2 million new customers. 

For investors, rising costs such as chemicals used and increased interest payments on its index-linked debt warrant consideration. So do periodic negotiations with the industry regulator and the water industry’s accountability and impact on the environment. The previous sale of Viridor also removed an opportunity for growth outside of its regulated water business.

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On the upside, plans to invest in renewable energy should reduce its energy bill over time. Operational improvements are also being made, with South West Water on track to achieve a 9% reduction in leakages from 2020, while inflation remains something of a double-edged sword, with revenues also linked to it.

Water stocks have fallen out of favour in recent weeks, underperforming the wider market. But with Bristol Water still being integrated and the shares sat on an estimated future dividend yield of over 5%, income focused investors are likely to take interest at these prices.

Positives:

• Attractive dividend (not guaranteed)
• Targeting cost savings from Bristol Water acquisition

Negatives:

• Growth opportunities via waste management business now removed
• The weather can impact performance

The average rating of stock market analysts:

Strong hold