Questor share tip: Pennon waste concerns overdone

RELATED QUOTES

SymbolPriceChange
UTILITIES.SN4,116.69+23.32

This week it was announced that the Prince of Wales, J Sainsbury and financier Jacob Rothschild are investing in the production of energy from organic waste. Pennon already does this.

Pennon 697p -3p Questor says BUY

Anaerobic digestion involves using micro-organisms to convert organic waste into gases such as methane in the absence of oxygen. The gas can then be burnt to produce energy.

However, last week's trading update from Pennon was badly received by the market and the shares fell more than 3pc. The issue was with waste unit Viridor, which operates Pennon's energy from water (EfW) sites.

Pennon notes that Viridor had experienced a reduction in recyclate prices over the winter months. At the same time, a higher level of activity associated with its growing pipeline of long-term projects has led to an increase in bid costs. "Full-year profits are therefore expected to be a little below those of last year," it said.

Questor is relatively unconcerned. Recyclate prices may be falling now, but with landfill taxes on the rise, burying waste is not an option. Recyclate prices fell in the post-Lehman panic, but Viridor was still profitable. Analysts have pointed out that in 2009 recyclate margins only fell to 10pc.

So, Questor reckons that concerns about Viridor have been overdone and the EfW business is going to be a key driver of earnings growth over the next five years. Viridor is planning to build a further 4 plants.

The regulated South West Water side of Pennon's business performed well and the company is on track to meet full-year estimates.

Pennon remains unique among the major water companies because of Viridor and the real growth in earnings the operation is likely to bring.

Pennon also has a relatively generous dividend growth policy. The stated policy is to raise its dividend by the retail price index (RPI) plus four percentage points all the way to 2015. Most other water companies plan to increase the dividend by RPI plus two percentage points. Investors should note RPI is expected to weaken this year.

It should also be noted that the yield on Pennon shares is 3.8pc, which is lower than at other water companies. The current-year yield on United Utilities (Santiago: UTILITIES.SN - news) , for example, is 5.3pc. However, Viridor offers solid growth prospects.

The shares are trading on a March 2012 earnings multiple of 16.7 times, falling to 15.3. Last tipped at 639p in January, the shares are up 9pc. Buy.