The Motley Fool

Why this dividend stock has 15%+ upside in 2017

Finding a utility stock with a 4.6% yield and 15% potential upside may sound rather unusual. Certainly, utility companies aren’t known for their capital gain prospects. However, with results released today which show the company in question is performing in line with expectations, it seems to have a bright future. Furthermore, with a higher yield than its historic average and continued uncertainty in the outlook for the FTSE 100, its shares could rise significantly this year.

Solid performance

So what’s the company? In a relatively brief statement, water and waste services firm Pennon (LSE: PNN) stated it’s performing in line with expectations and is on track to deliver a good set of results for the 2017 financial year. It’s set to deliver cost savings and synergies, which are due to improve its earnings over the next couple of years. Much of this growth is due to its Viridor operation’s portfolio of 12 Energy Recovery Facilities (ERFs) across the UK.

In fact, Viridor is expected to contribute around £100m of EBITDA (earnings before interest, tax, depreciation and amortisation) this year. This is forecast to contribute to a rise in Pennon’s bottom line of 7% in the current financial year. Next year, further growth of 6% is expected, while the company’s earnings are set to rise 12% in the 2019 financial year. This shows that while Pennon is a relatively stable utility stock, it has the potential to beat the wider index when it comes to earnings growth.

Upside potential

Pennon currently yields 4.6% from a dividend which is covered 1.2 times by profit. In the last five years, its dividend yield has averaged around 4%, which indicates that its share price could move higher without becoming overvalued. If it was to rise 15% during the course of the year, it would leave Pennon with a yield of 4%, rising to 4.2% next year.

With an upbeat earnings outlook, there appears to be an obvious catalyst to improve investor sentiment and push its shares higher. That’s especially the case since demand for defensive shares could rise if uncertainty remains high throughout the course of 2017.

Sector peer

Of course, Pennon’s yield is lower than that of sector peer Centrica (LSE: CNA), which yields 5.5% from a dividend covered 1.3 times by profit. While Centrica offers less stability than its sector peer as it gradually exits from Oil & Gas production, it also arguably has even more growth potential in the long run.

Centrica is aiming to become more efficient and deliver major cost savings over the coming years. They have the potential to boost its dividend payments, while a return to positive earnings growth in the current year and a 9% rise in its bottom line next year could push its share price higher. Clearly, for lower risk investors Pennon may be the better buy, but in terms of reward potential, Centrica’s turnaround prospects and higher yield could make it the superior long-term buy.

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Peter Stephens owns shares of Centrica and Pennon Group. 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.