Interactive Investor

Stockwatch: can you trust this 7% yield from a utility?

With a takeover in progress, trading as the City expects and paying an attractive dividend, this near-£2 billion company looks to have a lot going for it. Here’s what analyst Edmond Jackson thinks.

26th March 2024 11:47

Edmond Jackson from interactive investor

I am intrigued to assess the situation at Pennon Group (LSE:PNN), the mid-cap utility that owns South West Water and is currently taking over Sutton and East Surrey Water - SES Water – previously Japanese-owned.

Pennon has declared an “in-line” trading update, relative to consensus forecasts on its shares with individual analyst ratings ranging from “buy” to “hold”, with no sellers. If the expectation for a 45p dividend in respect of the March 2024 financial year, rising to 47p in 2025, is realistic, it implies a 7% yield.

The shares are trending somewhat against the market, so is this opportune or cautionary? From a 550p low last September, Pennon joined the “everything rally” to over 750p last November. Since then, however, the price has steadily declined and has eased 4% to 648p since yesterday’s update. It is nearly 12% down on a share offer at 730p priced only last January, which raised nearly £180 million to help buy SES. Directors and senior management put in £150,000.

In a long-term context, Pennon is back to its trading range from 2012 to 2018, followed by a roller coaster to near 1,300p in 2021. Investors have probably re-appraised water supply as representing investment value, given the charge the industry may not have invested sufficiently in past years to maintain the network responsibly.

Last May, for example, Ofwat announced an investigation into South West Water’s 2021-22 operational performance data relating to leakage and per capital consumption. Last October, that company declared a £2.8 billion investment plan to upgrade infrastructure. Funding looks quite a dilemma given last September’s balance sheet had £3,327 million of net debt.

The acquisition of SES faces a review by the Competition and Markets Authority, albeit this was anticipated.

Labour MPs tend to denigrate the current model of shareholder ownership of utilities. I very much doubt a Labour government would renationalise, but policy might favour accountability to customers, hence compromise on profit.

Even so, there is potentially a point where yield – if sustainable – prices in such concerns. At around 7%, might Pennon have reached it?   

Price rises ought to mean attractive cash flows

Despite regulation often cited as a dilemma, Ofwat appears to be waving through some significant increases for what are effectively local monopolies. Water supply is not like electricity or gas.

Coinciding with Pennon’s update, as a customer of SES Water I have just been reminded to pay an 8% price rise after a 19% hike in 2023. Yes, this was quite widespread in the industry, but has been allowed to happen irrespective of the cost of living.

That Pennon is “getting away with it” seems implicit in the board’s dividend policy – for annual growth of “consumer price inflation plus 2%”, hence an increase of over 8% in the interim 2024 dividend to 14.0p.

You could say it is quite like BT Group (LSE:BT.A) or Vodafone Group (LSE:VOD) – if one objects to paying annual increases, own the shares and get rebated via dividends. Personally, I am not doing so with Pennon.

But track record and debt levels hardly imply prudent payouts

The six-year table below shows an erratic and ill-established record of free cash flow, given high investment needs that seem now to be increasing:

Pennon Group - financial summary
Year end 31 Mar

 201820192020202120222023
Turnover (£ million)1,396633637624792797
Operating profit (£m)306254238190221109
Net profit (£m)2222232071,76215.40.1
Operating margin (%)21.940.237.330.527.913.7
Reported earnings/share (p)71.757.141.438.14.90.0
Normalised earnings/share (p)79.854.943.441.4-21.70.9
Operational cashflow/share (p)12610213074.780.458.1
Capital expenditure/share (p)14012711867.573.0126
Free cashflow/share (p)-14.0-25.012.07.27.4-67.9
Dividend per share (p)57.961.665.732.638.542.7
Covered by earnings (x)1.20.90.61.20.10.0
Return on total capital (%)5.54.33.63.14.52.3
Cash (£m)4033664392,669519144
Net debt (£m)2,9843,2833,2761872,6832,987
Net assets (£m)1,6381,6791,7122,9851,2751,125
Net assets per share (p)5855996101,061481430

Source: company accounts

The interim cash flow statement to 30 September 2023 showed £270 million spent on investment relative to just £40 million net cash generated from operations. This was financed by £325 million new borrowings, which took long-term debt to £3,292 million alongside £129 million short-term. September-end cash fell to £94 million from £165 million. Net gearing was 330%, giving rise to £77 million net finance costs that nearly wiped out £86 million of operating profit.

The full-year 2024 results are expected to be second-half weighted, but even so it does not look to me like Pennon should be adding to its extent of debt even if the company is quite immune from economic cycles. You decide if the extra borrowing funded necessary investment or the dividend.

I question why Pennon is paying dividends, certainly to the extent that it does. Payouts presumably meet institutional investors’ criteria to hold shares, nowadays, especially where capital growth prospects are lacking.

Debt reduction would be a better priority given higher interest rates have raised the share’s risk profile and contributed to their de-rating. Debt service costs are compromising margin recovery where the table shows a plunge from an attractive 30-40% range over 2019 to 2021 but has since plunged.

SES acquisition looks to have added further financial risk

It concerns me that this deal might effectively have been a means to “bulk up” revenues, thereby maintain a balancing act between debt interest and dividends. SES did offer a new element to the investment story, a sense of capital growth, but despite a successful share offer the market price has declined.

Management’s rationale was the expectation of being “earnings accretive in the first year of full ownership” and with the help of synergies, enhancing shareholder returns. The deal did, however, introduce more debt given an £89 million purchase price for the equity but an overall £380 million “enterprise value” including net debt of £291 million as of March 2023.

The 31 March 2023 annual accounts for Sutton and East Surrey Water (via Companies House online) do not inspire confidence. While the profit & loss account shows £4.3 million operating profit, it was obliterated by £29.8 million net finance charges, with a £6 million tax credit limiting the net loss to £19.5 million. Net gearing was virtually identical to SES at 331%, so in one respect they are well-suited.

Net cash from operations slipped 15% to £8.2 million but £22.5 million investment meant further debt.

SES is another example of how water companies’ relatively stable operational cash flows made them takeover targets post-privatisation. I recall my local water company being owned by a South African financier for a while. Directors got away with debt-loading during the era of ultra-low interest rates, but now the inflation genie is out the bottle I doubt rates can reduce that much again.

If you agree with current enthusiasm that interest rate cuts are coming, then potentially the likes of Pennon shares can rise given over-indebted companies may be targeted by traders for a bounce.

My mindset may be financially conservative, but I see Pennon’s 7% yield as more likely a reflection of intrinsic risk than a likelihood that the equity is underpriced and due a rise.

Net tangible assets of 281p per share will have altered somewhat since the SES deal but offer little support versus market price. Consensus is for net profit of £55 million in the March 2025 year, providing normalised earnings per share (EPS) of around 20p – hence a forward price/earnings (PE) multiple of around 32 times.

I do not grasp why shareholders supported a 730p offer last January. Essentials of the financial statements and the industry context imply unattractive risk/reward. I do, however, appreciate why two hedge funds are short of the shares, above the disclosure level of 0.5% of Pennon's issued capital. 

I am going to stick my neck out versus other analysts, and believe that if capital protection is a priority, Sell.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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