Pennon falls behind water stocks Severn Trent and United Utilities

Pennon Group, Severn Trent and United Utilities have managed to outperform the First Trust Water ETF year-to-date. However, with rising cost bases and a risk of penalties from the water services regulatory body Ofwat, can this outperformance continue?

UK water stocks Pennon Group [PNN.L], Severn Trent [SVT.L] and United Utilities [UU.L] have all managed to outperform the First Trust Water ETF [FIW] in recent months.

As of 30 June, the First Trust Water ETF, which invests in companies in the drinking water and wastewater industry, has sunk a disappointing 23.7% so far in 2022 and 15.3% over the past three months. The fund’s fall is mainly because of the wider market selloff amid inflationary and recession fears. It also reflects the large valuation of many of these water companies, which reached record highs post-pandemic.

Contrastingly, year-to-date (through 30 June), the United Utilities share price has dipped 3.6%, the Severn Trent share price has declined 5.7% and the Pennon share price has fallen by — a slightly larger — 17.4%, though all stocks still outperformed the First Trust Water ETF over the same period.

Pennon Group: rising costs and environmental breaches

From first glance, Pennon Group has severely underperformed both Severn Trent and United Utilities. In fact, over the past year, the Pennon share price has crashed 24.6%. However, this is mainly due to a special dividend of 355p paid out last year, after the company’s £4.2bn sale of Viridor to a US private equity giant. According to Pennon CEO Chris Loughlin, “on completion of the transaction, Pennon will continue to focus on its sector-leading water and wastewater businesses”.

However, things have not been entirely smooth sailing since the sale. For example, in the fiscal 2021 results, the firm saw its profit margins decrease and pre-tax profit fall 3.3% in the year. This was due to higher interest charges on debt, alongside supply chain inflation pressures. Most recently, the group is facing regulatory action over sewage spills, which could lead to penalties from UK water regulator Ofwat. This could partly explain why Pennon has underperformed both Severn Trent and United Utilities year-to-date.

Nonetheless, analysts remain confident about Pennon Group’s future. According to the Financial Times, the group has two ‘buy’ ratings, three ‘outperform’, five ‘hold’, one ‘underperform’ and one ‘sell’, with an average price target of 1,155p. This implies an upside potential of 21.2% from its 30 June closing price.

Severn Trent: resilient performance

In comparison with Pennon Group, Severn Trent has had a more robust performance over the past year. Indeed, in the company’s full-year results, it reported profit before interest and tax of £506.2m, up from £470.7m the previous year. Revenues were also able to increase 6.4% to reach £1.9bn. These strong results highlight why Severn Trent has been able to outperform Pennon Group year-to-date.

For income seekers, Severn Trent also offers a good option. In fact, this year, the company adopts an inflation-linked dividend policy, meaning that it increases in line with inflation. It also sports a dividend yield of 3.7%.

However, analysts are only moderately confident about Severn Trent’s prospects. According to 13 analysts polled by MarketScreener, Severn Trent has a consensus ‘hold’ rating and an average price target of 2,930.85p, implying an upside of 7.7% from its 30 June price. This signals that it may underperform other water stocks moving forwards.

United Utilities: a similarly robust performer

The United Utilities share price has performed in line with the Severn Trent share price, and there are several parallels between the performance of the two companies. For instance, United Utilities managed to increase underlying operating profits by 1.3% year-over-year to £610m. The dividend also climbed 0.6%, giving the company a yield of 4.2%, slightly higher than the other two water firms.

However, this robust performance has not led to glowing recommendations among analysts. According to the Financial Times, the group has one ‘buy’ rating, three ‘outperform’, eight ‘hold’ and two ‘underperform’ ratings. With a median target of 1,080p, this implies that the group only has an upside potential of 5.8% from its 30 June closing price. This highlights that United Utilities may not be able to outperform other water stocks in the next year.