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Why Pennon Group plc Is A Better Buy Than Centrica plc And Severn Trent plc

Pennon Group‘s (LSE: PNN) latest trading update shows that the water and waste management company is on track to meet its targets for the 2015/16 financial year. Following last year’s regulatory review, South West Water will see weaker revenues, as base allowed returns have been cut. But this should be more than offset by improving profitability from its waste management business, Viridor.

In recent years, Viridor has invested heavily in recycling and energy recovery facilities (ERFs), to move away from land-filling rubbish. These investments will soon pay off, and the rewards are beginning to show up in its financial results. Over the past year, Viridor has brought online five new ERFs, and it has plans to commission another four over the next three years. Its ERF business is already beginning to make a significant contribution to the group’s revenues and earnings, and by 2016/7, the expected contribution to statutory EBITDA is expected to be in the region of £100 million annually.

Shares in Pennon Group have fallen 18% since the start of the year, following a combination of cyclical and regulatory changes. Firstly, weaker commodity prices are expected to hurt margins for recycling and ERF. Secondly, the government’s removal of the climate change levy exemption for renewables should reduce the profitability of its ERF business.

Although these changes are negative to the group’s earnings, the impact should not have a very significant impact on longer term fundamentals. Viridor remains confident of the long-term regulatory drivers from the EU and UK Government underpinning demand for recycling, and the impact of climate change levy has a smaller impact on ERFs than other forms of electricity generation.

As is typical of shares in the sector, Pennon Group has a relatively low dividend yield of 4.2%. But, although the dividend yield is low, it is higher than its peers in the sector. In addition, Pennon Group has an attractive dividend growth policy, which promises to increase its dividend by at least 4% above RPI inflation until 2020.

By contrast, Severn Trent (LSE: SVT) has only promised to grow its dividends by at least in line with RPI inflation. Severn Trent had promised to increase dividends by RPI +3%, but following similar regulatory cuts to its base allowed returns, it could no longer afford to grow its dividends at the same rate. Although, this puts its dividend policy on par with United Utilities (LSE: UU), Severn Trent only yields 4.0%, compared to United Utilities’ dividend yield of 4.1%.

Centrica‘s (LSE: CNA) prospective dividend yield of 5.4% may seem more appealing than the yields coming from water utility companies, but it is also much more risky. The company has already cut its dividend by 30%, and both of its businesses, downstream and upstream, have been performing poorly as a result of structural and cyclical changes in the energy sector.

With its downstream operations, profit margins have been squeezed as consumers have increasingly become more price conscious. More and more of its customers have been switching to its competitors in search of more attractive deals. To combat this, Centrica has lowered its household gas prices. But, unless it retains enough customers, this could further squeeze its already shrinking bottom line.

Upstream operations have performed even worse with the plummeting price of oil in the international markets, and this is only made worse by the recent acquisitions in regions where production costs are high, including the North Sea and Canadian oil sands. With debt steadily rising and free cash flow diminishing, Centrica could yet make further cuts to its dividend.

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Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended Centrica. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.