Pennon Group Plc (PNN) Earnings Call Transcript & Summary

Hello, and welcome to the Pennon Group Plc acquisition of Sutton and East Surrey Water. My name is Alex. I'll be coordinating the call today. [Operator Instructions] I now hand it over to your host, Susan Davy, CEO. Please go ahead.

Thank you very much, Alex, and good morning to everybody. Thank you for your time this morning. I'm pleased to announce the acquisition of Sutton and East Surrey Water, alongside the acquisition and equity raise, which we are undertaking this morning. And that equity raise is there to ensure that the gearing levels for the water group and may within our well-established 55% to 65% gearing range. In terms of Sutton and East Surrey, it is quality assets. It's a well-performing water-only company, serving around about 3/4 million customers. The impact of [Surrey] at West Essex and South London. The acquisition follows at Pennon's twin-track strategy of acquisitive and organic growth, and this will increase the proportion of water-only assets in the business. Sutton and East Surrey has a robust operation and is a top performer for water quality at leakage and supply interruptions and all the measures you would expect from a water company. In terms of scale of the acquisition, it represents around about 7% of the current water business measured by RCV, so useful incremental growth for the group. We obviously have a history of successful acquisitions by Pennon at Bournemouth Water in 2015 and Bristol Water in 2021. We obviously take a very measured diligent approach to assessment execution and delivery of those acquisitions and putting them into the Pennon Group. In terms of the pricing, the pricing that we transacted that reflects a premium to RCV at around about 6%. So an attractive premium relative to other M&A in the sector over the last decade. The acquisition will be subject to regulatory process with Ofwat and the CMA. Obviously, we haven't taken this processes previously with the same amount in Ofwat, and we will look forward to going through that process with our regulators in due course. We will obviously [indiscernible] deploy our proven integration blueprint and look to seek opportunities, actually maximize synergies between SES and the existing water group that we have. So in summary, this is a good acquisition. It will be earnings accretive from the first full year of ownership. And as I said earlier, along by the acquisition, we are launching an equity raise to ensure that we remain within the 55% to 65% gearing range to acquisition. And with that, I'll open for questions. I hand back to you, Alex.

[Operator Instructions] Our first question for today comes from Dominic Nash of Barclays.

Congratulations on this deal. I've got 2 questions, if I may, please. The first 1 is SES is operationally quite good, as you pointed out. But on the ROREs that is achieving, it's quite a weak performer on Totex and on ODIs. And so the first question really is what are you going to do to turn around both the ODIs and Totex or ROREs on that one? And the second question is that, clearly, in Sutton and East Surrey in the Southeast of England, there's a myriad of highly levered, small water-only companies in that part -- in that region of the country, a lot of them have got high levels of leverage and increasing investment needs. Do you think that there's going to be an increase in sort of theme of consolidation of the water only companies and in this part and will you be part of it?

Thanks for those questions. Dom, I want to introduce Steve Buck, who has joined us as CFO Pre-Christmas, Steve is with us this morning. And obviously, we've got Jen Cooke on the line as well in terms of being IR Manager. So in terms of those questions, perhaps if I start around RORE and then I'll hand over to Steve, and then I'll pick up the last question that you had around just where SES is positioned than other companies in the account. So in terms of SES, as I said in the opening comments, operationally, with the area of leakage, water quality, supply interruption performing well. But you're very right to point out Dom in terms of RORE, there are pressures there. So we have diligently worked through that and looked at what's driving it and what we think we will have as a pathway through to turning that from where it is now to a positive and an outperformance point. So perhaps if I hand over to Steve, he can walk through our plans, what we're focused on doing and walk through the 3 areas of RORE. So Totex and ODIs and financing.

Thank you, Susan. And good morning, everybody. So yes, Dom you're correct. They've got to depress RORE at the moment. But the causes of it are threefold. So Totex is the first cause. As Susan indicated, we'll deploy our integration blueprint and confident that we will be able to address the underlying causes of those overspend because that's basically what sort of downside on Totex is an overspend. So I think we've got a plan that we can address that. The other factor that's dragging it down is the cost of financing. They're highly geared. They have some quite expensive debt. Now we are not allowed to touch the debt book until we've got regulatory clearance. We can provide solvency support to keep them going during the regulatory process. But once we've got that clearance, we see that there's about 1/3 of the debt book that we can remedy pretty much straight away. It is RCS and its overdraft and near-term settlements coming up. That will leave us with an index-linked debt, but it will -- will put us a position where we can start to address the financing cost. In terms of the ODIs as a Susan said, the fundamental ODIs are in good shape. The 1 where they had difficulty in the year that we're talking about is on asset health to do with water. Basically, the ratio of mains of burst mains to 1,000 kilometers of mains. That was -- there was to do with the hot weather in that particular year. When we've looked at their run rate before that, they actually have doubled the amount that they had before, double amount in that year versus their run rate. So I do think that's a spike that will their return. So we can see a write back to how we're going to resolve that or get it back to as it should be. But just to be clear, what we can do is, we can plan for it, but we can't actually execute it until we've got that regulatory clearance.

Great. Thanks, Steve. So in terms of the second part of the question, on around the where it's positioned geographically and other companies. But first thing to say around consolidation in the sector and I've said this for a while, I do think there are real benefits around consolidation in this sector. I think benefits accrue to customers. And we have proven that with the acquisitions we've made previously in sharing benefits with customers, reducing their bills and continuing with service whilst investing at rates that they wouldn't have had the standard in companies. So there are real benefits that come to customers from their fund there are benefits that accrue to shareholders who share in those efficiencies that are delivered and to share in the upside that Steve has just been talking about how we will get the RORE from where it is to a good performing company. And so very much believe in consolidation. The 1 thing I did at the beginning, which I will reiterate is we have a history in the successful acquisitions, but we do take a measured diligent approach to assessment of the execution and delivery. We have to very much understand where we think we can add value and where we think we can make a difference. So it's with that lens that we look at all opportunities, and we will continue to look at opportunities. And if we see those that would be accretive, then obviously, we will look to transact, which is what we've done here today.

Our next question comes from Mark Freshney of UBS.

Susan, just a question for Steve and a question for Susan. So Susan, I mean, you're effectively opening up another front here. Just as you've got over the hump in the Bristol acquisition, you've got storm overflows to deal within Southwest Water. And now you've got operating performance to deal with in Sutton and East Surrey. So can you talk about -- I know you've bolstered your management team, but can you talk about what gives you confidence that by opening up another front, you can manage both effectively? And secondly, a question for Steve. Just on the debt. I mean you mentioned the expense of debt and that there's about 1/3 that you can deal with. What is the fair value adjustment on the debt within Sutton and East Surrey? And what would the premium to RAB be that you mentioned, I think you mentioned 6% after adjustments. What would the premium be if you put the fair value through? And I guess further to that, can you talk about the adjustments between the headline RAB premium, which I think is 8% and the 6% that you mentioned in your release?

Okay. Thanks for those questions, Mark. In terms of your first question around distraction, this is not a distraction. This is a benefit to the group and the benefit to the organization. And I don't say that lightly. As I said, we take a diligent approach today, take a measured approach about what we're doing about how we're growing the group. And we look at opportunities where we can see benefits that will play across the rest of the water group as well as for the acquisitions that we are making. First thing to say is, Sutton and East Surrey do have a strong management team in place, and they are obviously staying in place. And as we said earlier, in the key metrics for SES, they are performing very well. So this isn't a disruptor. We're actually gaining by getting another good management team into the group. So that's the first thing to say. And all the things that you mentioned around our plans for the wastewater side of Southwest Water, with our WaterFit programme, [indiscernible]. That's not affected by this. That's still being deployed, that's still obviously going to be delivered. So it's not a case of it being a distractor at all. We see it as an opportunity. And indeed, for Sutton and East Surrey based on some digitization on the 3,500 kilometers of network, which is really interesting to us, which might be something that we deploy further across the rest of the group, which then gives the group of the benefits in terms of deploying operationally. So always see these as benefits, but we're very measured in terms of making those assessments and looking at the targets to see which ones will give us those opportunities, and this is 1 of those. And then I think you had a quick question around fair value of debt and what that does to premium. I mean the 1 thing to say before I hand over to Steve if -- Steve ultimately went through the fact that there is a debt portfolio. Obviously, we are looking at what we can do with [1/3] of the debt portfolio, which we can obviously affect in due course and see some value from doing that, that has no kind of make-whole costs or any impact in that sense. The 2/3 of the debt, which is the securitized wrap index-linked loan. We've unwraped these before. You're right, there are fair value assets, but we're not retiring that debt. And so in terms of looking at a premium to RCV, that's not something that we would take into account because we're not changing that debt and it rolls up naturally in 2031. If we were to, though, in terms of that fair value adjustment, we're looking at very low in terms of premium adjustments, I think the fair value quantum is around about low -- well, just -- I think it's a high single-digit adjustment, but we can double check that, but I think it has a percentage point on the valuation if you're going to look at it in that way. But like I said, we're not retiring debt, so we wouldn't -- but Steve, do you want to talk a little bit more about the debt, please?

Yes. I mean, Susan, I think you've covered most of it here, which is that, I mean, our approach to this debt book is that we will basically settle debt when it becomes due or whether it makes economic sense to do so early. So we're not in a position where we need to retire it. And even on that 2031 bond, that the RPI bond there will be accretion payments starting in 2027. If there is some flexibility where it makes good economic sense to start making those payments early. We'd like to do so. But if not, then we'll wait until they become due. And in terms of the -- obviously the sure guarantee I've got an interest in that particular bond. We have an experience of working with them. They know us well and we know them well. We're already engaged with them, and we'll be having a conversation about how we can sort of unwrap that debt. But fundamentally, we're looking at the cash flows and value.

Our next question comes from James Brand of Deutsche Bank.

Congratulations on getting the deal done. I have 2 questions. One was circling back to incentives. So I can see from just looking at the 2022-'23 Ofwat financial resilience document that SES was underperforming on kind of Totex, ODIs and retail. And I was just wondering whether you could just kind of fill us in, is that something that's been kind of sustained over the last few years? You mentioned on ODIs that there was 1 area that things have gone maybe particularly wrong recently. So if we look back to prior years, would we see a slightly better ODI performance that we see when we look at the 2022-'23 report? That's the first question. And then secondly, on timing, what's the rough timing for the approval process from Ofwat? And do you think the investigations will slow that down at all?

Steve, you have to say something.

So you're right. What you can see in the Ofwat report is there's a downside to do with retail, and there's a downside to do with Totex. I mean, basically, they're both overspend. So when you aggregate it, you just you get a net overspend. And so as part of the due diligence process that we do have one or two questions whether they've got the allocation right between retail and Totex. But actually, when you add them together, it doesn't matter because it's either in 1 or in the other. So what we're seeing is that there has been, for the last 3 years, a consistent overspend on retail, that the overspend on Totex has been a little bit a bit more recent. And ODIs if we strip out that mains repair issue they got, they've been pretty close to being neutral as a run rate.

And I think the second question was around the timing of approval process. I mean, obviously, the timing to a certain extent, is out of our hands in the sense that it's an Ofwat CMA process. We have walked through processes before. Obviously, we will share all the information and give all the required assessments through to Ofwat and CMA. We have had the opportunity to have some conversations ahead of transacting. And as I said, I anticipate it to be a similar process to the 1 we walked through for Bristol. That's what have concluded from the conversations that we have had. And in terms of timing, if we think about what happened with Bournemouth and Bristol, anywhere between kind of 6 to 12 months.

Our next question comes from Martin Young of Investec.