Water sector full-year results solid but PR19 looms

The three listed water companies have shown a solid performance in their financial results for the year ended March 2018 but their focus will remain on PR19, Nigel Hawkins says.

In successive days, the three remaining quoted water companies, Severn Trent, United Utilities and Pennon, reported their full-year results for 2017/18.

There were few surprises, with the market reacting most positively to the Pennon results – and to the 7.3 per cent dividend rise that was confirmed. Severn Trent’s and United Utilities’ dividend increases were 6.2 per cent and 2.2 per cent respectively.

Of course, there is an elephant in the room – and a very large one at that.

The forthcoming regulatory review, PR19, will impact the water companies’ returns from April 2020 onwards. Given Ofwat’s recent weighted average cost of capital (Wacc) projections – 2.4 per cent v 3.7 per cent currently – a sharp fall in earnings and, possibly, in dividends is certainly on the cards.

First up was Severn Trent’s announcement, described by chief executive, Liv Garfield, as “a strong set of financial results”.

Underlying profit before interest rose by some 4 per cent to £541 million, whilst underlying earnings per share rose at a slightly higher rate to reach 121p.

Significant progress was made at the operating level, with a major outcome delivery incentive (ODI) out-performance. Furthermore, the full integration of Dee Valley is expected later this summer, which should lead to further savings.

Severn Trent was able to announce a 6.2 per cent increase in its dividend, which – for the full year – will be 86.55p per share.

At the analysts’ meeting, emphasis was placed on its management of net debt, which now amounts to £5.36 billion – a very substantial figure but around half that of its arch-rival, the private equity-owned, Thames.

During 2017/18, Severn Trent claims to have out-performed Ofwat’s allowed cost of debt projections by £79 million – an astonishing figure which hardly reflects well on Ofwat’s forecasting abilities.

Looking forward, there must be some doubt whether Severn Trent’s dividend is sustainable from 2020/21 onwards.

For the current year, though, it is being underpinned by a property sale – of Teal Close in Nottingham – to leading house-builder, Persimmon. An £18.2 million profit is to be booked by Severn Trent from this one deal alone.

Elsewhere, United Utilities’ operating performance was sound. Underlying operating profit rose from £622.9 million to £645.1 million; there was a £7 million ODI penalty imposed by Ofwat.

More importantly, though, it was higher interest rate charges that saw underlying earnings per share fall from 46.0p in 2016/17 to 44.7p for 2017/18.

United Utilities confirmed that its comparatively high proportion of index-linked debt gave rise to a £40 million increase in underlying net financial expenses: the contrast with Severn Trent’s 2017/18 interest bill is quite marked.

United Utilities’ net debt rose over the period to almost £6.9 billion, a near £300 million increase over the year.

Compared with Severn Trent and Pennon, its 2.2 per cent dividend increase was decidedly modest, although not unexpected.

On the pensions’ front, United Utilities revealed a pension surplus of £344 million. Another privatised utility, British Telecom, will be casting envious eyes at this figure as it continues to be challenged by an £11.3 billion pension deficit.

In addressing concerns that its pension surplus could encourage Ofwat to cut its PR19 allowance for pension costs, United Utilities firmly repudiated the suggestion.

It does, though, raise questions as to how this surplus will be treated in the future, with lower ongoing pension contributions being the most likely scenario.

Pennon’s numbers met expectations, with pre-tax profits at £258.8 million being up slightly on 2016/17. However, the more relevant underlying earnings before tax, depreciation and amortisation (EBITDA) figure rose by 4.9 per cent.

The increase in adjusted earnings per share – up from 47.0p in 2016/17 to 50.9p in 2017/18 – was more pronounced at 8.3 per cent. Consequently, the 7.3 per cent dividend increase enabled dividend cover to rise slightly.

Not surprisingly, Pennon is proud of its dividend record, as its leads the sector over the decade between 2010/11 to 2019/20.

Its balance sheet, too, is comparatively strong – net debt at March 2018 stood at just over £2.8 billion.

Whilst Pennon’s returns from its core utility businesses were very solid – with significant out-performance of Ofwat’s numbers – the Viridor waste business also reported discernible progress.

Previously, Viridor has disappointed but its 2017/18 EBITDA exceeded £150 million, compared with £138.3 million in 2016/17.

The Energy Recovery Facilities (ERF) portfolio, which accounts for more than 75 per cent of Viridor’s EBITDA, is developing nicely – and making a meaningful contribution to Pennon’s overall returns.

Pennon will be hoping it keeps firing, especially in 2020/21, since its impressive progress may enable it to avoid a divided cut following PR19.

Whilst PR19 is pivotal for all water companies, there was little discussion of political issues – not even mentioned in Severn Trent’s presentation – despite their potential to hammer share price ratings.

For the moment, though, the three quoted water companies are fully focused on PR19.