In times of turmoil consensus opinion is to pile into defensives such as utilities, almost regardless of price. As a result, this water company has been bid up to unsustainable levels and is vulnerable to a pull-back.
Pennon (PNN), rated as OUTPERFORM by CSFB
In contrast to Aviva, Pennon, the owner of South West Water and Viridor Waste, appears to be at the other end of the valuation spectrum. Its shares trade on stretching 2008 and 2009 p/e multiples of 20.0 and 17.3 respectively – on top of offering a frugal 3% dividend yield for a supposedly income-generating stock. Earnings per share is expected to rise just 8% this year, putting the firm on an expensive p/e to growth ratio of 2.5.
So why else are the shares overvalued? Next is the City’s infatuation with infrastructure-backed deals by large private-equity houses. In 2007, before the credit crunch struck, the industry was awash with cheap money, allowing both Thames and Anglia Water to be snapped up on very full, almost ludicrous, ratings. That saw the shares of many other publicly-quoted utilities rocket amid hopes of further over-the-top bids. But with many banks now looking to raise equity to shore up their capital ratios, I just can’t see there being a particularly strong appetite to fund highly-leveraged buy-outs on similarly generous terms.
Thirdly, and less widely understood, is that Ofwat regulates the UK water industry to protect consumers and improve service quality. Every five years it calculates a fair value (regulatory capital value, or RCV) for each business and specifies the price that each can charge, how much it should invest, and what level of return shareholders can get. So this RCV figure is a good indicator of underlying value. In fact, if actual returns are greater than specified, then it is likely that water bills will be cut by Ofwat at the next pricing review in 2010 to ensure consumers get value for money.
So how does this apply to Pennon? In relation to inherent value, Ofwat has set a March 2008 RCV of £2.4bn for the group. I also believe the Viridor unit is worth about £800m, which, after the deduction of £1.6bn in net debt, generates a sum-of-the-parts valuation of about 460p per share, or 25% less than today. It looks as though Pennon’s shares are being kept afloat by takeover fever and will sink if a bid does not materialise.
Lastly, there is another potential thunder cloud on the horizon. Ofwat has recently slapped hefty fines on some of its rivals for failing to patch leaky networks and for shoddy service. If Pennon were to be hit in a similar fashion then shareholder returns could be affected. Watch for full-year results on Thursday 5 June 2008.
Recommendation: TAKE PROFITS at 630.5p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments