Questor share tip: Pennon a hold on recycling pain

Pennon
760p-23.5
Questor says HOLD

Pennon [LON:PNN] is not your average utility company; it combines South West Water, a profitable and stable water utility, and Viridor, a loss-making and hugely capital-intensive landfill and recycling group. Quite the odd couple.

Though the company is increasing its profits — and stuck to its inflation-busting dividend policy by increasing the final dividend by 6.5pc to 30.31p — the recycling business is proving to be a real drag on the group as a whole.

Viridor is being hit by significant upheaval in the British waste industry. An EU directive to reduce the amount sent to rubbish dumps, agreed during Gordon Brown’s time as prime minister, has resulted in taxes on rubbish going to landfill almost doubling within the past two years and they will continue to rise. Owners of landfill sites have slashed the fees they charge to dispose of waste in an attempt to win as much work as they can before the taxes put them out of business. Viridor reported a loss before tax of £21.1m for the year just ended.

Viridor’s landfill business reported average gate fees down 9pc to £23.06 per tonne in the year ended March, and costs jumped 19pc to £21.90 per tonne. With costs rising at more than twice the increase in revenue, the profits from landfill fell sharply. As a result, Viridor had to write off about £43m in the asset value connected to landfill sites during the year. This comes in the wake of £78m in write-downs a year earlier.

Ensuring a rubbish tip is safe after it is closed is also costly. Viridor increased its provisions for the restoration of land by £5.7m in the year ended March — and that’s after setting aside a whopping £90m a year earlier.

Viridor is also suffering from a downturn in recycling, the speed and severity of which has surprised everyone. A construction downturn greatly reduced the amount of waste sent for recycling. One of the world’s largest buyers of recycled material, China, also bought less as the economy slowed and its government introduced “green fence” legislation to stop the import of low-grade material.

The price of recyclates has collapsed from £125 per tonne in 2012, to £93 per tonne today. Viridor’s average cost to recycle has been reduced from £93 per tonne to £83 per tonne within the past year, but clearly the profit margin has been crushed. Ian McAulay, chief executive of Viridor, said he remains cautious about the outlook for recyclate prices but expects them to hold at £93 per tonne in the year ahead.

Although the recycling and landfill business is proving painful, Pennon is also embarking on a major construction project to build rubbish incinerators to create power from waste. Nearly three-quarters of the spending on construction is complete. Sites at Runcorn, near Manchester, are already burning waste; another site in Runcorn and one in Cardiff are expected later this year. Pennon expects that once these new plants are completed it will more than double cash profits at Viridor within the next three years, to more than £100m.

South West Water, by comparison, is an oasis of tranquillity. It reported pre-tax profit up 10.8pc to £162.5m. The utility division has also had its application fast-tracked for the next five-year regulatory period that starts in 2015. This effectively removes any regulatory risks.

Pennon ultimately has huge potential. Questor thinks that if it can use the cash cow of South West Water to complete its construction programme of recycling plants and waste incinerators it could become highly profitable. It has also signed long-term agreements for the supply of power and waste disposal which would make it difficult, if not impossible, for competitors to move into the market.

Questor is not blind to the risks though. Nobody predicted the dramatic reversal in prices within the recycling industry, and energy from waste, though promising, could prove very low profit. Analysts’ predictions of a sharp recovery in profits looks overly optimistic. The shares, rated on 20 times earnings, also look too high for a utility. Hold.