A top income stock to buy with inflation-beating dividend growth

Despite an ongoing Ofwat investigation, Andrew Mackie believes this income stock is a good buy for his portfolio.

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As the cost of living continues to rise, I’m scouring the FTSE 350 for defensive income stocks that aim to grow dividend payouts in line with the inflation rate, or even to outpace it.

Looking at the FTSE 100, two constituents currently offer an inflation-busting (above 9.1%) dividend yield — Persimmon and Rio Tinto. However, digging deeper, both have cut their dividends twice in the last 10 years. This isn’t surprising given their cyclical nature.

When hunting for income stocks, I therefore don’t just look at headline yields. I also look for consistent dividend growth. As the prospects of a recession rise, this quality is increasingly important to me as an investor.

A defensive play

Pennon (LSE: PNN) is one of only three FTSE-listed companies supplying water and wastewater services in the UK. It serves a population of approximately 3.5m across the South West of England. Its main brands are South West Water, Bristol Water and Bournemouth Water.

Pennon has a sector-leading dividend policy. Each year, it will grow by CPIH (consumer prices index including owner occupiers’ housing costs) plus 2%. For the year ending 31 March 2022, the yield increased 8.2% on the previous year. With a dividend per share of 38.53p, the yield comes out at 3.8%.

In 2021, the company sold Viridor, a waste management company to a private equity consortium. It used the proceeds of that sale to return excess capital to shareholders. Principally by way of a special dividend of £1.5bn. In addition, it also began a share buy-back programme of £400m. Finally, it bought Bristol Water for £425m.

Ofwat Investigation

Yesterday, regulator Ofwat announced a new investigation into Pennon’s South West Water unit. This links to the ongoing probe into multiple water companies regarding alleged illegal discharge of raw sewage into rivers. Unsurprisingly, the news sent Pennon’s share price tumbling and it closed down almost 6%.

Should it be found to be in breach of its legal permits, the consequences could be severe. Ofwat has the power to issues fines of up to 10% of annual turnover. If found guilty in criminal proceedings, the fine is unlimited.

Balancing risk and reward

The south west of England’s large coastal area, means that it’s at greater risk from climate change, in particular rising sea levels. In a worst-case scenario, up to 10 sewage works, and 150 sewage pumping stations could be at risk of sea level inundation. The consequences to the surrounding natural environment could be devastating.

Scenarios like this go a long way to explaining why the water industry requires significant upfront investment, often planned decades in advance. Funding this requires large amounts of borrowing. Pennon’s net debt currently stands at £2.6bn. Servicing this debt will undoubtedly cost more into the future as cost of capital rises.

However, on the other side of the coin, the company has highly visible income streams over the coming years. Indeed, as population migration to the south west accelerates due to the longer-term impact of the pandemic, water demand will continue to rise.

I feel the sell-off has presented an attractive entry point into a company with significant growth opportunities. A reliable (but not guaranteed) source of dividend income during these uncertain economic times provides me with an additional level of comfort. I will be buying.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be considered so you should consider taking independent financial advice.

Andrew Mackie has no position in any of the shares mentioned. The Motley Fool UK has recommended Pennon Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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