The water utility Pennon (LSE: PNN) has streamlined its business over the past year. So, at first glance, a fall of 20% in the Pennon share price over the last 12 months may look bad. But it is important to realise that the company paid a £3.55 per share special dividend in the summer. That helps to explain the share price fall, as the company was returning funds to shareholders.
So, could this be a good time to buy Pennon for my portfolio?
A changing company
The special dividend was funded by the proceeds of Pennon’s sale of waste company Viridor. As well as helping fund the special dividend, the money the company raised from the sale has been put to use buying Bristol Water and buying back its own shares. I would rather the company had used cash to pay down some of its £2.4bn debt instead of buying back shares, but share buybacks can help boost a company’s earnings per share.
That means that Pennon is now a leaner group than it was before, with a clear strategic focus on water. I see pros and cons to that. It is good that the company can focus on a single area in which it already has deep expertise. I like the fact that customer demand for water is resilient. As it is often a form of regulated monopoly, it can be consistently profitable.
But the reduced diversification could hurt the company’s profitability, if for example a different regulatory regime comes into place for water prices. I also see substantial growth opportunities in waste and recycling due to growing green sentiment. So I do not think selling Viridor was necessarily the most value-creating move possible for shareholders in the long term.
Should I act on the Pennon share price?
It is a little hard to value Pennon right now due to the changes in the company’s business. In a year or two I think it will be easier to get a clear view on what the reshaped company’s revenues and profits will look like in future.
Pennon’s interim results in November showed a basic loss per share of 11.7p in a six-month period. Despite that, the company grew its interim dividend by 4.9%, to 11.7p. Once the reshaped business reports full-year results and its outlook, I think I will be in a better position to judge its future prospects.
My next move on Pennon
I like the fact that the company is focussed on serving shareholders. I feel it has shown that in the dividend increase, special dividend payment, and share buyback programme.
For now I am going to keep watching Pennon without adding it to my portfolio. I continue to like the characteristics of the water business. Through its consolidation strategy as shown in the Bristol purchase, Pennon could grow its role in the water business. That holds out the prospect of economies of scale, which could boost future profit margins.
There are risks, as well. When acquiring competitors, overpaying is always a risk. The Bristol Water acquisition led to cash outflows of £434m, which seems a bit expensive to me given the modest size of the business. Concern about energy inflation could lead to political pressure to cap price increases by a range of utilities. That could hurt future profits.
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Christopher Ruane has no position in any of the shares mentioned. The Motley Fool UK has recommended Pennon Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
