Bristol deal ‘could bring WACC back into question’

The CMA’s decision on the cost of capital could be called into question by the premium Pennon Group has paid for Bristol Water, a sector analyst has suggested.

Bristol was one of four companies to appeal Ofwat’s final determination for 2020-25, which resulted in each being permitted a higher weighted average cost of capital (WACC) than the regulator had allowed.

Colm Gibson, managing director at Berkley Research Group, noted that the regulatory capital value (RCV) multiple is potentially over 1.4x, based on the enterprise value of £814 million, and that this may rekindle speculation as to whether the regulatory return allowed by the Competition & Markets Authority was unduly high.

“If the merger goes ahead, Pennon may be in the unique position of having two different regulatory determinations applying to the different areas, given Bristol Water’s successful appeal to the CMA,” Gibson said. “This would create an interesting opportunity from the regulatory accounting framework. To the extent that there are significant cost savings, the financial benefit will depend on their accounting allocation between the two entities. It remains to be seen how Ofwat will view these unintended incentives.”

Pennon was the last company in the sector to buy another when it added Bournemouth Water to its portfolio in 2015. Like Bournemouth, Bristol is geographically close to Pennon’s heartland and chief executive Susan Davy said the two businesses have much to learn from one another.

She told Utility Week the Bristol Water brand will remain in the long term and senior management teams are expected to stay on, including Mel Karam as head of Bristol. Davy said: “We’re really excited about the opportunities this brings to the Pennon Group. The experience we had when acquiring Bournemouth Water meant we had the best of the best and had opportunities to integrate. It is very important to us that the Bristol Water management team are very much a part of the Pennon family.”

The deal will be subject to approval by both Ofwat and the CMA, a process that could take several months. Davy said the proposition presented to the regulatory bodies will focus on what it means to customers.

“The proposal we’ll be putting forward is how customers from both companies will benefit from this acquisition and merger.

“There are real benefits such as the WaterShare+ Scheme, there are benefits to Bristol coming back into the listed space, operational benefits, and we can learn from Bristol as well. This will help services to customers and bring operational efficiency that will help with the lowering of customer bills in the future as well.”

She added that there would be an option for Pennon’s employee share scheme to be extended to Bristol staff.

Since assuming the role of chief executive last year when the Viridor deal completed, former chief financial officer Davy and her team have assessed opportunities for acquisition across the UK water sector. She said Pennon was attracted not only by location, but also the chance to work together across areas that each have greater expertise. Bristol Water has not been in a reward situation for outcome delivery incentives (ODIs) on supply interruptions, which is an area of strength for SouthWest Water. Meanwhile Bristol has been ahead of its new parent group on C-Mex scores. “It really is an opportunity for us as a group to come together and learn from each other.”

Investment programmes for 2020-25 are underway and will remain unchanged, however Davy said best practice will be shared between the companies.

Spending the war chest

Since the sale of Viridor last year, Pennon has had £2.7 billion burning a hole its pocket and the company made its intentions clear to find an opportunity within the regulated water sector.

Chief financial officer Paul Boote explained £1.3 billion from the sale would be used to position the sustainably by lowering debt and reducing pension deficit as well as targeting group level gearing of below 65 per cent by the end of the AMP cycle.

A further £100 million will be invested in the green recovery initiative.

The rest of the £1.9 billion from the proceeds of the Viridor sale will include £1.5 billion to be returned to shareholders via a special dividend of £3.55 per share. Boote added a buy back scheme has been discussed for post consolidation of up to £400 million to provide Pennon with ongoing financial flexibility, potentially for acquisitons.

“We can look at further opportunities if they come across our desk and we find them attractive so there is still ongoing flexibility,” Boote said and added Pennon has been an acquisitive group over the years that was unlikely to ever say it is done with further gains.

Pennon is understood to have run the rule over Northumbrian and Southern last year, however it had indicated it was interested in a full acquisition rather than a controlling stake in a company, which left mostly water-only companies that could be added.

After selling Viridor, Pennon was itself a smaller business and one commentator suggested it needed to “eat or be eaten”. Martin Young analyst at Investec, said after bedding in Bristol, Pennon is likely to remain attractive to buyers.

“It’s clearly a good interest in infrastructure assets that have a growth angle to them. Pennon is a well-run company, contrasted with some other companies in the sector it is not exposing itself to reputational angst. Why wouldn’t someone be interested in a growth opportunity in a well-run company?”

The benefits of managing water resources within a closer geographical area brought benefits not only to each company but to stakeholders. However, Young, told Utility Week, the selling points may have been downplayed by the organisation.

He said although Bristol was a logical acquisition and excellent business fit, expanding wholesale capabilities and RCV growth, more could have done to evangelise the “big picture” benefits for other stakeholders by merging the organisations.

“This could have been used to establish themselves as a leader in the greater southwest, it lacked the alignment with the big picture. It’s almost as if they’re downplaying what they believe they can deliver.”