Pennon Group Debt

Is Pennon Group debt too high to sustain?

Although Pennon Group reported higher sales of 6.1% and operating profit rising by 5.5%, along with interim dividend increasing to 12 pence per share, a rise of 7.9% it didn’t report changes to net borrowings.

Net Borrowing rose to £2.79bn from £2.66bn, whereas total borrowings rose to £3.36bn.

Also, the company didn’t mention trade payables increasing by 33% to £378.7m from £286.5m, despite the slower revenue growth.

Another important data point is the failure to highlight falling operating cash profit to £211m from £243m. Mainly due to rising receivable of £43m helping to contribute sales and profit.

 

For an in-depth look at Pennon Group, this post will cover the following:

1). Divisions;

2). Quality of shareholders’ equity;

3). The ability to continue sustaining dividend payment;

4). A brief look at their market valuation.

 

Brief Look at Pennon Group

Pennon Group provides water and wastewater to 1.7m in Cornwall, Devon and parts of Dorset and Somerset and water only services to c.0.5 million in parts of Dorset, Hampshire and Wiltshire.

It also has a waste management business under the name Viridor that does UK recycling energy recovery and waste management. It provides services to 150 local authorities and major corporate clients as well as over 32,000 customers across the UK.

 

 

Pennon Divisional Operation

Looking at the company’s divisions, we know that Pennon Group is made up of two main subsidiaries, Viridor and South West Water.

Viridor is labelled under Waste Management and South West Water is labelled under Water.

 

A quick analysis sees Viridor contribute the most revenue, but South West water makes the most profit. Details of both these divisions are shown below:

Pennon Group division analysis

South West Water earns a higher return as divisional margin reaches 30%, while their waste management division languishes around 6%, although it doubled.

Another interesting fact is Viridor employs 3,153 people vs. South West Water 1,589 people.

Some would make the case to sell off Viridor and reinvest the net proceeds to paying off debt to pursue profitable ventures with higher margins.

Any net proceeds raise wouldn’t make a big difference in the size of their debt. Total debt is over £3.3bn.

 

Quality of Pennon Shareholders’ Equity

Pennon Group quality equity is falling

Before 2008, Pennon Group was able to squeeze more Revenue out of each unit of asset, but it saw shareholders’ equity declined by £200m to around £600m This didn’t deter the share price from rising as it rose from £2 per share to £6.50, before the financial crisis sent the shares falling to £4.

Why did the share price rise when shareholders’ equity fell?

That’s because asset turnover rose from 0.18 to 0.27, an increase of 50%. It means Pennon can generate more sales and profits without having to spend too much on assets. From 2003-2008, the average capital spending was £206m per year, compared to £335m per year between 2013 and 2017 (a period when asset turnover fell).

So, why has the share price rise between 2013 and 2017, as asset turnover fell?

Partly because we are in a bull market and partly because investors believe in the company’s shareholders’ value. Both of these factors mean if Pennon Group was to get purchase today, the acquirer would pay a premium. In a recession, the acquirer would underpay for assets.

WE shouldn’t forget Turnover rose from £958m in 2009 to £1,353m by 2017, an increase of 38%, countering a fall in asset turnover.

Can this continue?

As long as turnover continues to rise to offset falls in asset turnover, then yes. Until you see sales stagnating, then Pennon continues to deliver profitable growth.

 

Can Pennon afford to pay Dividends to shareholders?

Although the company raises dividends by 7.9%, we shouldn’t dismiss the possibility of them cutting it the future. Before the financial crisis, they were paying shareholders up to 50 pence per share in dividend. Then came the dramatic to 10 pence, before the subsequent increase in dividends took hold.

Looking at Pennon Group cash dividend coverage, we can see it fell from 5 times to 2.8 times. If you include capex, then dividend coverage falls below one time.

Pennon Group dividend coverage

Although dividend coverage was much lower during the 2003-2006 (around 2-2.5 times), it had the confidence of paying a higher dividend per share due to earning higher profit margin (35%-40%). Today, the company saw an improvement in profit margin from 20% to 30%, as dividend per share rose to 36 pence, an unbroken rise since 2007.

 

But Pennon could stop increasing dividends because the business can’t support capital expenditure and dividends payout forever!

To put this into context.

Since 2003, the accumulation of dividend, capex and debt increase are as follows:

1). Debt saw an increase of £2.27bn to total £3.37bn;

2). Pennon returned £1.1bn in dividends during this period.

3). Capital expenditure spent totals £3.8bn.

 

So, half of the debt increase went to supporting dividends as the rest went to support capex.

Pennon can count on low interest rate to support their dividend policies. Annual interest paid is around £90m or 2.7% of total borrowings. Any future increase in interest rate could see this rise.

 

Pennon Group: Valuation

Pennon Group Valuation

Valuation at Pennon Group is close to record if you account for net debt (see EV/EBIT ratio). The PE Ratio is on 18 times multiple.

But Pennon profit is slowing as basic EPS grew by 7%. Take into account operating cash profit falling to £211m from £243m, then the quality of earnings get jeopardise.

Overall, Pennon’s Valuation is on the high side.

 

Final Thoughts: Pennon Group

Pennon Group has a good run for the past eight years. But, I fear that the increase in debt, coupled with slowing growth in earnings, as well as being on a high valuation multiple means the shares are on the high side.

If interest rates increase further, I feel the company will see higher borrowing costs, in turn, this affects their ability to continue paying a dividend.

 

My 12-month view is for the share price to drift lower towards £7 per share.

 

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DISCLAIMER

The above analysis is based on my opinion and nobody else. It does not constitute professional investment advice. Data is correct on at the time of availability.  I don’t hold the company’s shares unless stated.