Pennon Group continued to deliver revenue and profit growth in 2010/11

The year’s financial highlights

Pennon Group performed well with a good set of results from both operating companies, South West Water and Viridor.

It was a considerable achievement for South West Water to deliver stable profits during the first year of the new five-year cycle, which included the reduction of the rate of return allowed by Ofwat, the economic regulator, from 5.1% to 4.5% (post-tax, real). Viridor has delivered strong profit growth, driven by its recycling activities and the success of its PFI and Energy from Waste (EfW) joint ventures.

During the year we secured further funding to finance continuing growth. By the year-end we had around £825 million in cash and facilities in place to fund South West Water’s K5 (2010–2015) capital programme and future major growth in Viridor.

We have secured funding at a cost that is low in absolute terms. In addition South West Water’s average interest rate of 4.0% (pre-tax, nominal) is substantially lower than the 6.2% assumed by Ofwat for the 2010–2015 period. This is a significant advantage compared with a number of our competitors which will help drive value for the Group and our shareholders for years to come.

The principal key measures we use to assess the Group’s financial performance are profit before tax (PBT), earnings per share and the interest rate on average net debt.

Revenue

Group revenue increased by 8.4% to £1,159.2 million.

South West Water’s revenue rose by 1.0% to £448.8 million as a result of tariff increases, higher demand and new connections, partially offset by a further reduction in revenue from customers switching from unmeasured to metered charges.

Viridor’s revenue rose by 13.6% to £712.0 million, substantially driven by acquisitions and increased recycling activities.

Operating profit

Group operating profit fell by 2.0% to £260.9 million with South West Water down by 1.9% to £189.8 million and Viridor down by 1.6% to £71.6 million. Pages 10 and 16 give a detailed description of the financial performance of each company.

Finance costs

We continued our effective management of interest rates in 2010/11 with net interest payable on average net debt equating to 4.0% (2009/10 4.1%). During the year net finance costs (excluding pensions net interest, discount unwind on provisions and IFRIC 12 contract interest receivable) were £77.2 million, covered 3.4 times (2009/10 3.4 times) by Group operating profit.

Profit before tax

Profit before tax was £188.5 million, an increase of 1.5%.

Taxation

The Group’s UK corporation tax charge for the year was £38.6 million (2009/10 £43.0 million). Deferred tax for the year was a credit of £21.7 million (2009/10 charge £1.3 million), which included a credit of £25.1 million from the impact of the reduction in the rate of corporation tax from April 2011.

Earnings per share

Underlying earnings per share increased by 3.7% to 42.3p. The weighted average number of shares in issue during the year was 354.6 million (2009/10 350.0 million). Net assets per share at book value at 31 March 2011 were 218p.

Dividends and retained earnings

The statutory net profit of £171.6 million has been transferred to reserves.

The Directors recommend the payment of a final dividend of 17.15p per share for the year ended 31 March 2011. With the interim dividend of 7.5p per share paid on 1 April 2011, this gives a total dividend for the year of 24.65p, an increase of 9.3% over 2009/10 (reflecting 4% real growth plus RPI of 5.3% at March 2011).

Proposed dividends totalling £88.2 million are covered 1.7 times by net profit (excluding deferred tax) (2009/10 1.8 times). Dividends are charged against retained earnings in the year in which they are paid.

Dividend policy

In last year’s report we announced the Board’s intention to increase the dividend each year by 4% above inflation from 2010/11 until at least 2014/15. The Group is well positioned to meet future challenges and to continue delivering shareholder value. We remain committed to this increase, which is not matched by any of our peers.

Operating costs

Operating costs for the year totalled £898 million. The biggest areas of expenditure were:

¹ Excludes elements of transport costs

Raw materials and consumable costs have increased during the year primarily due to higher levels of waste recycling activities.

Asset value opinion

In the opinion of the Directors, the current market value of the Group’s land and buildings is not significantly different from the holding cost shown in the financial statements.

Group investment

During the year the Group’s capital expenditure on property, plant and equipment was £199.0 million (2009/10 £192.2 million). The major categories of expenditure for both main businesses are shown below.

Cash flow

In 2010/11 the Group once again had a strong operating cash flow. Net borrowings increased by £39 million primarily due to acquisitions and investments in joint ventures.

Liquidity and debt profile

At 31 March 2011 the Group held cash and deposits of £555 million (including £123 million of restricted funds) and had undrawn facilities of £270 million. These totals include £400 million in new or renewed debt facilities arranged during the year, being:

• replacement of £100 million Put Bond with £150 million 2040 5 7/8% Bond
• renewal of £75 million term loans
• £115 million of new term loans and Revolving Credit Facilities
• US$100 million longer-term facility.

The Group’s financing structure gives us the scope and flexibility we need to implement our strategic objectives and maximise value for our shareholders.

At 31 March 2011 the Group’s loans and finance lease obligations totalled £2,489 million. After the £555 million held in cash this gives a net debt figure of £1,934 million, up by £39 million during the year.

Debt incurred for the construction in progress of Viridor’s Runcorn Phase II EfW plant amounted to £46 million at 31 March 2011.

The major components of the Group’s debt finance at 31 March 2011 are illustrated below.

The Group’s debt has a maturity of up to 46 years, with an average maturity of 23 years.

The Group has successfully fixed or put swaps in place to fix the interest rate on at least 50% of South West Water’s debt for the entire K5 period up to 2015, at an average interest rate of 3.8%. A further 24% of South West Water’s debt is index-linked to 2041-2057, at an overall real rate of 1.66%. As a result of these initiatives, South West Water’s cost of finance is amongst the lowest in the industry.

The Group’s average interest rate is impacted by the cost of carry of pre-funding with interest rates on cash deposits currently at very low levels. South West Water’s average rate for 2010/11 comprises debt interest of 3.5% and pre-funding costs of 0.5%. Pennon Group Plc incurred net interest costs of £3 million, reflecting funding raised to support future Viridor investment. South West Water’s and Pennon Group Plc’s interest rates on average net debt for the year to 31 March 2011 were both 4.0%.

More than half of the Group’s gross debt is finance leasing, giving us the benefits of a long maturity profile. The interest payable on the Group’s finance leases benefits from the fixed credit margins which were secured at the inception of the lease.

At 31 March 2011 the fair value of the Group’s borrowings was £261 million less than its book value (2009/10 £296 million) as detailed in note 27 to the financial statements.

Capital structure – overall position

At the end of the financial year the Group’s net debt of £1,934 million gave a ratio of net debt to (equity plus net debt) of 71.3% (2009/10 74.1%).

South West Water’s debt to Regulatory Capital Value (RCV) was 57.1% at 31 March 2011 (2009/10 60.6%) which is within Ofwat’s optimum range of 55% – 65%.

Viridor is funded by a combination of Pennon Group equity and debt (raised by Pennon Group) and direct borrowing by Viridor. At the year-end Viridor’s net debt was £487 million (2009/10 £420 million) equivalent to 4.2 times EBITDA (2009/10 3.7 times).

Treasury policies

The role of the Group’s treasury function is to ensure that we have the funding to meet foreseeable needs, to maintain reasonable headroom for future contingencies and to manage interest rate risk. It operates only within policies approved by the Board and undertakes no speculative trading activity.

The Board regularly monitors expected financing needs for at least the next 12 months which are expected to be met for the coming year from existing cash balances, loan facilities and operating cash flows.

The Group has considerable financial resources and a broad spread of business activities. The Directors therefore believe that it is well placed to manage its business risks despite the ongoing uncertainties of the current economic environment.

Internal borrowing

South West Water’s funding is treated for regulatory purposes as effectively ring-fenced. This means that funds raised by, or for, the company are used only in the provision of water and sewerage services and are not available as long-term funding for other areas of the Group.

Going concern

The Directors have a reasonable expectation that the Group has adequate resources to continue its operational existence for the foreseeable future. They therefore have continued to adopt the going concern basis in preparing the financial statements.

Taxation objectives and policies

Our tax strategy, as approved by the Board, is to enhance shareholder value by legally minimising the taxes we pay while having regard to our long-term relationship with the tax authorities. We will consider bona fide arrangements which are integral to our business and which qualify for tax exemption or relief.

The total tax charge for the year of £16.9 million was less than the charge which would have arisen from the accounting profit before tax of £188.5 million taxed at the statutory rate of 28%. A reconciliation is provided in note 9 to the financial statements.

The Group made a net payment of £43.2 million of UK corporation tax in the year (2009/10 £3.8 million). The previous year included refunds received from HM Revenue & Customs arising from the reassessment of payments in earlier years.

The Group’s total tax contribution extends significantly beyond the UK corporation tax charge.

Total taxes amounted to £327 million of which £63 million was collected on behalf of the authorities for net VAT and employee payroll taxes.

The most significant taxes involved together with their profit impact were:

• landfill tax of £158 million was accounted for by the Group on behalf of HM Revenue & Customs. Landfill tax is an operating cost which is chargeable to customers and is contained within revenue. In addition the Group incurred landfill tax of £26 million on the disposal of waste to third parties. This is an operating cost for the Group and reduces profit before tax
• Value Added Tax (VAT) of £20 million (net) was collected by the Group and paid to the taxation authorities; VAT has no material impact on profit before tax. The increase of £13 million compared with the previous year is due to the increase in the rate of VAT and Viridor’s increased revenue
• business rates of £23 million were paid to local authorities. This is a direct cost to the Group and reduces profit before tax

• employment taxes of £43 million include employees’ Pay As You Earn (PAYE) and total National Insurance Contributions (NICs). Employer NICs of £11 million were expensed approximately 94% to operating costs with 6% capitalised to property, plant and equipment
• Fuel Excise Duty of £12 million related to transport costs. This reduced profit before tax.

The corporation tax rate for 2010/11 used to calculate the current year’s tax is 28%. The forecast tax rate, as enacted into law on 29 March 2011, has been reduced to 26% for 2011/12 and is proposed to fall by a further 1% per annum until the financial year 2014/15 when the rate will be 23%.

In November 2010, as part of the PwC Building Public Trust Awards, Pennon Group Plc won the Tax Reporting in the FTSE 250 Award. The awards reward commitment of the largest listed companies in the UK to communicating their sustainable performance. The tax award recognises the most transparent disclosure of tax strategy, tax performance and the wider impact of tax.

Pensions

The Group operates defined pension schemes for certain existing employees of Pennon Group, South West Water and Viridor. The main schemes were closed to new entrants on or before 1 April 2008.

At 31 March 2011 the Group’s pension schemes showed a deficit (before deferred tax) of £86 million (2009/10 £108 million). Net liabilities of £64 million (after deferred tax) represented less than 3% of the Group’s total market capitalisation at 31 March 2011.

An actuarial valuation of the main scheme as at 31 March 2010 has now been completed. South West Water’s cash contributions to the scheme are within Ofwat’s Final Determination for the K5 period.

Insurance

Pennon Group manages its property and third party risks through insurance policies that mainly cover property, business interruption, public liability, environmental pollution and employer’s liability.

The Group uses three tiers of insurance to cover operating risks:

• self-insurance – Group companies pay a moderate deductible on most claims
• cover by the Group’s subsidiary (Peninsula Insurance Limited) of the layer of risk between the self-insurance and the cover provided by external insurers
• cover provided by the external insurance market, arranged by our brokers with insurance companies which have good credit ratings.