Pennon Group has few acquisition options in which to deploy substantial cash reserves garnered from the sale of its waste subsidiary Viridor, two sources familiar with the company, a sector lawyer and a sector investor said.
On 18 March, despite intense market disruption due to the beginning of UK-wide lockdown measures, Pennon sold the waste business to KKR for net cash proceeds of GBP 3.7bn, with the vendor set to use the capital to lower its borrowings, make a return to shareholders, and to retain some funds for future opportunities.
The UK utility company, which has a GBP 4.7bn-market capitalisation, will, as stated, return some of this capital to shareholders through dividends, the sources, lawyer and investor said, but its M&A options are limited.
Any major water acquisition or merger is automatically referred to the Competition and Markets Authority (CMA), but it would also need water regulator Ofwat approval as changes to the licence holder require its sign off, the investor and lawyer said.
Most synergies that could be accrued via an acquisition would likely be retracted by Ofwat, which may insist that savings are passed on to the consumer, the lawyer and investor said.
Therefore, the only real synergies that water companies can achieve through merging are on the operational level, the sector investor said, which means that Pennon would need to look at adjacent water companies.
The most obvious target for Pennon would therefore be Wessex Water, which is owned by Malaysia’s YTL Corporation [KLSE:YTL], which shares county borders with Pennon’s South West Water, the investor said.
Pennon’s only other strategic acquisition rationale could be a similar geographically overlapping utility business, the sector investor said, perhaps even outside the water space, such as a Devon and Cornwall electricity distributor.
The time is ripe for water sector consolidation and M&A, given that Ofwat has just completed its five-year pricing framework, which determines the regulated returns of these companies over that period, the sources, lawyer and investor said. This means that there is the window of long return visibility that usually allows deals in the sector, the lawyer and investor said.
Many of the large private companies – such as Kelda, Thames Water, and Anglian Water – are, however, appealing against Ofwat’s pricing framework, which they view as unfairly reducing water bills at the expense of investment, according to reports.
Investors in these private companies may seek to exit in the near-term due to this shift in support from Ofwat and the expected drop in returns, the sources and lawyer said.
The shareholders in Kelda, which owns Yorkshire Water, for example, recently sought to exit, while others like Anglian Water and Thames Water may logically see stakes sold this year, the first source said.
It has traditionally been difficult for public companies to pursue private market water assets, given deals in the space, based on the regulated asset base (RAB) of the target, are in excess of public water company valuations, the sources said.
Public and private water companies have very different debt structures, with the latter’s high leverage model a source of contention with Ofwat, the second source and the lawyer said. This difference in capital structure makes it difficult for a public company like Pennon to acquire a private water company, the lawyer and investor said.
However, strategic investor YTL is also seen as likely to exit the UK water market, the sector investor said, and an acquisition by Pennon of Wessex may have the strategic and operational credentials to garner discreet preannouncement approval by regulators that see a tie-up as beneficial to consumers.
Take private – the blank cheque
Pennon’s low leverage and cash-rich balance sheet make it a prime target for a take-private offer, the first source, lawyer and investor said, especially given the aforementioned window of returns visibility.
by Patrick Harris in London