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Questor: worried about inflation? This company’s dividend growth plan is the answer

water pipes
water pipes

The Bank of England’s latest inflation forecasts make for grim reading. They predict that inflation will remain above 4pc throughout the winter before peaking at around 5pc in April.

Of course, those forecasts may already be out of date. Inflation reached 4.2pc in October against the Bank’s prediction of “just under 4pc”. With a “false start” on expected interest rate rises at this month’s meeting of the Monetary Policy Committee, the outlook for investors who seek to maintain, or even grow, their spending power could become increasingly challenging in the coming months.

As a result, Pennon, the FTSE 250 water services company, could become increasingly attractive. It aims to increase dividends by an annual rate 2 percentage points higher than inflation on the “CPIH” measure over the next four years.

This task is made easier by the fact that regulatory revenue controls link its revenue to the CPIH. The CPIH has been the Office for National Statistics’ main inflation index since 2017 and includes council tax as well as owner occupiers’ housing costs. It currently stands at 3.8pc.

Meanwhile, Pennon began the second phase of a £400m share buyback programme last month following the sale of its waste management business, Viridor, in July 2020. It used part of the proceeds from the sale to pay a special dividend and also acquired Bristol Water in a £425m deal, which is subject to regulatory clearance.

Perhaps more importantly, it reduced total debt by £1.1bn so that it had a net cash position at the end of the 2021 financial year.

Of its remaining debt, more than 60pc is repayable at a fixed interest rate while 26pc is index-linked. The latter figure is among the lowest in the water services industry and could put the firm in a relatively strong position in an era in which higher inflation prevails. More details on its financial performance will be included in its half-year results due on Tuesday.

Alongside a generous dividend growth plan and relatively modest debt levels, Pennon offers defensive appeal at an uncertain time for the economy and stock market.

Indeed, the apparently imminent end of the era of record low interest rates may check the progress of today’s bull market. This could prompt investors who were previously growth-oriented to switch towards relatively robust companies as they give priority to the return of their capital.

Similarly, demand for water and wastewater services is likely to remain relatively resilient even if the economic outlook deteriorates in response to squeezed disposable incomes and supply chain challenges.

Clearly, such difficulties could lead to rising bad debt provisions across the water services sector if consumers struggle to afford rising household bills. Furthermore, Pennon’s medium-term earnings growth potential could be inhibited by a recently introduced regulatory settlement that includes a tougher pricing regime than before.

In addition, some investors may argue that the company’s 3pc forecast dividend yield is insufficient to appeal to income investors at a time when some FTSE 350 stocks offer prospective yields of more than 4pc.

However, Pennon’s inflation-beating dividend growth plan could become an increasingly useful ally for income investors over the coming months. It appears to be affordable thanks to the link between the company’s revenue and inflation. Moreover, dividends are expected to be covered 1.3 times by earnings this year.

The company’s solid financial position and defensive characteristics could be deemed more valuable by investors should the Bank of England’s widely expected hawkish shift cause the stock market’s rampant rise to come to an end.

Ultimately, the path that inflation and interest rates will take is a “known unknown”. However, Pennon could provide a viable means for investors to increase their spending power should the Bank’s grim inflation forecasts prove accurate.

Questor says: buy

Ticker: PNN

Share price at close: £12.37

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