Interim results - six months to 30 September 2019

Chief Financial Officer's Review

We have delivered a good financial performance in the first six months of 2019/20. Our results reflect continued cost control in our regulated business, substantial investment in our infrastructure and our conscious deferral of rewards to benefit AMP7. We achieved good growth in our Business Services operations but property profits were lower compared to last year's notable gains.

Underlying PBIT in our Regulated Water and Waste Water business was, as expected, lower than the first half of the previous year, after the increased expenditure on infrastructure renewals to complete our AMP6 programme.

In Business Services, our Operating Services business showed strong PBIT growth on stable revenue and our Green Power business benefited from the rapid integration of the food waste business acquired from Agrivert last year. Overall Business Services PBIT was down, as the £6.2 million earned from property disposals was lower than 2018/19 (£18.4 million, which included the sale of Teal Close). We remain on track to generate £100 million of PBIT from property over the ten years to 2027, with £33 million delivered to date.

Our underlying basic earnings per share were 68.8 pence (2018/19: 76.2 pence) as the lower underlying PBIT in our two segments and the loss from our joint venture were only partially offset by a lower effective tax rate. Basic earnings per share from continuing operations were 61.7 pence (2018/19: 69.8 pence).

The interim dividend has increased to 40.03 pence in line with our policy for the remainder of AMP6 to increase the dividend by RPI plus 4%.

Our funding position is strong. Capital investment and other cash flow needs through to September 2021 are covered by cash and committed facilities. During the period we took action that:

·     increased the proportion of our debt at low fixed rates;

·     reduced our effective interest rate; and

·     moved more of our index-linked debt to CPI.

We are in a strong position to raise the £3 billion needed in AMP7 with a diverse range of sources to lock in favourable rates, now supported by a Sustainable Finance Framework.

On pensions the IAS 19 position at 30 September reflects strong investment performance and the protection provided by a sound hedging policy, with the deficit down £62 million to £391 million (net), despite a significant reduction in the discount rate. And we have now reached agreement in principle with the Trustee, ahead of schedule, on the 2019 triennial pension valuation, providing certainty on cash contributions over AMP7, broadly in line with the amounts included in our Business Plan. Full details of the revised contribution schedule are included on page 13.

We are pleased to have been awarded the Fair Tax Mark, an independent accreditation awarded to companies for paying the right tax at the right time and applying the 'gold standard' of tax transparency. We were also pleased to have our low risk category rating renewed for a further three years by HMRC.

A brief overview of our financial performance for the six month period is as follows:

·     Group turnover from continuing operations was £910.0 million (2018/19: £881.5 million), an increase of 3.2%, due to tariff increases in Regulated Water and Waste Water revenue and growth in Business Services' external turnover.

·     Underlying Group PBIT decreased by 4.3% to £286.3 million (2018/19: £299.1 million). Profits in our Regulated Water and Waste Water segment were down by 3.1% due to below inflationary revenue growth and higher infrastructure renewals expenditure. Underlying Business Services PBIT was down £7.4 million as increased operating profits in our Renewable Energy business in the current year following the acquisition of Agrivert's food waste business in November 2018 were offset by lower property profits of £6.2 million following the prior year £18 million sale of Teal Close near Nottingham.

·     Reported Group PBIT was £285.3 million (2018/19: £299.1 million). There were no exceptional items in either period.

·     Net finance costs increased marginally to £93.8 million (2018/19: £93.1 million) as higher net debt in the period was mitigated by our lower effective interest rate. We continue to maintain a low average interest cost well below the draft AMP7 embedded debt allowance.
 

·     Our share of the loss from our joint venture Water Plus was £9.3 million (2018/19: loss of £0.9 million). Market data issues in this and prior periods have impacted Water Plus's ability to bill to and collect from its customers in a timely and accurate way. Work is well underway to resolve these issues, but the business has taken a prudent view of potentially irrecoverable revenue, leading to the loss recorded in the first half of this financial year.

·     The current tax charge of £18.2 million (2018/19: £23.7 million) benefited from capital allowances on our increased investment programme. The deferred tax charge was £15.8 million (2018/19: £14.8 million) giving a total tax charge of £34.0 million (2018/19: £38.5 million) and a full effective tax rate of 18.8% (2018/19: 19.1%).

·     Net cash capital expenditure was £374.1 million (2018/19: £340.1 million).

Regulated Water and Waste Water

Turnover for the Regulated Water and Waste Water segment was £807.5 million (2018/19: £795.0 million) and underlying PBIT was £260.1 million (2018/19: £268.4 million).

Turnover increased by 1.6%. Higher tariffs, including the impact of the annual RPI increase on prices, increased revenue by £24.1 million, and the adjustment for prior period revenue billed in excess of the wholesale allowance was £4.0 million favourable. These were offset by a reduction year-on-year of £10.8 million on the level of customer ODI outperformance payments taken into revenue. A number of other smaller variances resulted in a further net reduction of £4.8 million.

Net labour costs were £2.4 million (3.6%) lower period-on-period. Gross employee costs increased by 6.2%, due to the continuation of our strategy to bring more work in-house and the annual pay award. The value of own labour capitalised, was up £10.5 million on the previous year due to the significant growth in capital project activity.

Net hired and contracted costs were flat year on year. Increases in leakage activity and some outsourced debt collection activity offset the benefit from the in-sourced capital design team and from the comparable £7.2 million of cost incurred in the hot, dry summer in the previous year.

Power costs were £2.2 million higher than the previous period. Consumption was down by 2% year-on-year, but was more than offset by increased pass through costs and other price variances.

Bad debt charges were £5.2 million higher period-on-period and represent 2.4% of household revenue, (2018/19 full year: 2.0%). We continue to see good progress in our collection performance on current debt, but recovery of aged debt, particularly balances at the end of the dunning process, remains slow. We have launched an extensive programme of activities focused on collection of this older debt and we expect to see the benefits of this start to be realised in the second half of the year.

Infrastructure maintenance expenditure was £10.7 million higher in the period, as we complete a number of AMP6 projects and step up our trunk mains renewal programme.

Depreciation was £4.8 million higher period-on-period following increased capital spend in the second half of 2018/19, and a shift in capital expenditure towards shorter life, data technology assets.

Business Services

In Operating Services, turnover remained broadly consistent, but good margin management increased underlying PBIT by £1.8 million.

In Green Power, turnover increased by £16.2 million and underlying PBIT increased by £4.4 million. The business acquired from Agrivert in November 2018 increased turnover by £14.9 million and we are pleased with the rapid integration of the business into the Group.

In our Property Development business, there was a significant sale of at Teal Close near Nottingham in the previous year that generated a profit of around £18 million.

Corporate and other

Corporate overheads were lower at £4.1 million (2018/19: £7.2 million), as the prior year included Agrivert acquisition costs of £3.6 million.

Net finance costs

The Group's net finance costs for the six month period were £93.8 million, marginally up on the prior period (£93.1 million). Average net debt in the period increased to £5,902.9 million (2018/19: £5,405.7 million), and our effective cash cost of interest (excluding the RPI uplift on index-linked debt) was 3.1% (2018/19: 3.1%) as we continue to benefit from lower interest rates on new and refinanced debt. Interest cost on RPI debt decreased by £1.0 million due to lower inflation. Interest capitalised of £21.1 million was £5.4 million higher than the prior period due to the higher level of capital work in progress.

As a result, our effective interest rate for the period was 3.7% (2018/19: 3.8%).

The Group's EBITDA interest cover was 5.3 times (2018/19: 5.5 times) and PBIT interest cover was 3.2 times (2018/19: 3.5 times). See note 17 for further details.

Gains/losses on financial instruments

The Group uses financial derivatives solely to hedge risks associated with its normal business activities including:

·     Exchange rate exposure on borrowings denominated in foreign currencies;

·     Interest rate exposures on floating rate borrowings;

·     Exposures to increases in electricity prices; and

·     Forthcoming changes in the regulatory model from RPI to CPIH.

The Group holds:

·     Interest rate swaps with a net notional principal of £225 million to balance our interest rate mix in line with our strategy;

·     Cross currency swaps with a sterling principal of £98 million, which economically act to hedge exchange rate risk on certain foreign currency borrowings; and

·     Inflation swaps with a notional principal of £350 million, which swap RPI linked cash flows for CPI linked cash flows.

The Group has chosen not to apply the hedge accounting provisions of IFRS 9 to these instruments. Therefore the changes in fair value are taken to gains/(losses) on financial instruments in the income statement.

An analysis of the amounts charged to the income statement in the period is presented in note 4 to the financial statements.

The Group has fixed around 58% of the estimated wholesale energy usage for the remainder of 2019/20 through a combination of forward price contracts and financial derivatives.

Taxation

We are committed to paying the right amount of tax at the right time, and were pleased to have been awarded the Fair Tax Mark this month.

As well as corporation tax on profits, which is included in the tax charge in our accounts, we incur a range of other taxes, charges and levies imposed by government agencies including business rates; employer's National Insurance; the Climate Change Levy; Carbon Reduction Commitment; Landfill Tax; and Insurance Premium Tax. Our 2018/19 Annual Report and Accounts sets out an analysis of the taxes incurred in that year and we will set out this year's amounts in our Annual Report to be published in June 2020.

The corporation tax charge reported in the income statement is calculated at a rate of 18.8% (2018/19: 19.1%), representing the best estimate of the annual average tax rate expected for the full year, applied to the profit for the six month period. The current tax charge for the period was £18.2 million (2018/19: £23.7 million) and the deferred tax charge was £15.8 million (2018/19: £14.8 million).

The benefit of the capital allowances on our increased capital programme reduced our underlying effective current tax rate (in line with guidance) to 10.3% (2018/19: 12.1%). Our tax payments increased to £22.4 million (2018/19 £5.8 million) as the timing of quarterly instalment payments is changing in the current year so that all instalments are paid in the year to which they relate. In the first half of the current year we have paid the final two instalments for 2018/19 and the first two instalments for 2019/20.

Profit for the period and earnings per share

Reported profit for the period from continuing operations was £146.7 million (2018/19: £165.1 million).

Basic earnings per share from continuing operations decreased by 11.6% to 61.7 pence (2018/19: 69.8 pence). Underlying basic earnings per share were 68.8 pence (2018/19: 76.2 pence). For further details see note 7.

Cash flow

Six months ended 30 September

Net debt comprises:

At 30 September 2019 we held £23.3 million (31 March 2019: £39.6 million) in cash and cash equivalents. Average debt maturity is 14 years. Including committed facilities, the Group's cash flow requirements are funded until September 2021.

We invest cash in deposits with highly rated banks and liquidity funds and the Board regularly reviews the list of counterparties.

Net debt at 30 September 2019 was £5,956.8 million (31 March 2019: £5,834.1 million). Balance sheet gearing (net debt/net debt plus equity) at the half year was 82.9% (31 March 2019: 83.3%). Group net debt, expressed as a percentage of estimated Regulatory Capital Value at 30 September 2019 was 63.1% (31 March 2019: 63.0%).

In April we took action to reduce our exposure to interest rate risk by closing out pay floating swaps with a notional principal of £575 million that were "in the money" and using the proceeds to close out pay fixed swaps with a notional principal value of £100 million and a fixed rate of around 5%. This reduced our floating rate exposure by £475 million at a net cost of £0.3 million while also reducing our effective interest rate. We now hold 60% of our debt at fixed rates. In preparation for the introduction of CPIH indexation in AMP7 we amended and extended an existing RPI index-linked loan to a £125 million ten year CPI index-linked loan in May and in August we entered into a further £100 million forward starting ten year CPI/RPI basis swap, taking the total amount of such swaps to £350 million.

The estimated fair value of debt at 30 September 2019 was £1,640.1 million higher than book value (31 March 2019: £1,219.6 million higher). The increase in the difference to book value is largely due to lower prevailing market long-term interest rates.

Pensions

Formal three-yearly actuarial valuations were completed as at 31 March 2016 for the Severn Trent schemes and as at 31 March 2017 for the Dee Valley Water scheme.

The Group operates three defined benefit pension schemes, of which the Severn Trent Pension Scheme (STPS) is by far the largest. The STPS closed to future accrual on 31 March 2015 and from 1 April 2015 new benefits have been provided within the defined contribution Severn Trent Group Personal Pension Scheme. A formal triennial actuarial valuation and funding agreements for STPS were last completed as at 31 March 2016. The triennial valuation exercise for 31 March 2019 is well advanced, and the Company and the Pension Trustees have agreed the future funding plan, which is summarised below.

A revised schedule of deficit reduction contributions (replacing the previous schedule agreed for the 2016 triennial valuation) will be put in place to meet the deficit and ongoing administration expenses that will include:

·     Inflation linked deficit recovery payments starting at £32.4 million in 2020, for eight financial years ending 31 March 2027.

·     Continued payments under the existing asset-backed funding (ABF) arrangements which provide the following:

o  £8.2 million per annum, potentially continuing to 31 March 2032. These payments will only continue beyond the 2025 valuation if the Scheme assets (excluding this ABF) are less than the value of the Technical Provisions at this time.

o  Inflation-linked payments, which started at £15 million per annum in 2017/18, potentially continuing to 31 March 2031. These payments will cease earlier should a subsequent valuation of the STPS show that these contributions are no longer needed

·     In addition to these payments, the Company will continue to pay the annual Pension Protection Fund levy incurred by the STPS (£1.4 million for 2018/2019).

Payments are typically made in the second half of the year and there were no material payments in the six month period to 30 September 2019.

On an IAS 19 basis, the estimated net position (before deferred tax) of all of the Group's defined benefit pension schemes at 30 September 2019 was a deficit of £390.6 million. This compares to a deficit of £452.9 million as at 31 March 2019.

The movements in the net deficit during the period were as follows:

The obligations increased as the impact of the lower discount rate applied at the end of the period was only partially mitigated by the lower long-term inflation assumption. However, strong asset performance more than compensated for this and, on an IAS 19 basis, the funding level has improved to 87% (31 March 2019: 84%).

Dividends

The Board has declared an interim ordinary dividend of 40.03p per share (2018/19: 37.35p per share), which will be paid on 3 January 2020 to shareholders on the register at 29 November 2019.

Principal risks and uncertainties

The Board considers the principal risks and uncertainties affecting the business activities of the Group for the remainder of the financial year to be those detailed below:

Customer perception

·        We may be unable to improve or maintain our levels of customer service sufficiently to deliver what our customers tell us they want.

Legal

·        There is a risk that processes may fail or that our processes may not effectively keep pace with changes in legislation, leading to the risk of non-compliance.

Operations, assets and people

·        We may experience loss of data or interruptions to our key business systems as a result of cyber threats.

·        We may fail to meet our regulatory targets including targets from Ofwat in relation to operational performance of our assets resulting in regulatory penalties.

·        Failure of certain key assets or processes may mean we are unable to provide a continuous supply of clean water and safely take waste water away within our area.

·        Due to the nature of our operations we could endanger the health and safety of our people, contractors and members of the public, as well as negatively impact our local and wider environment.

·        We are unable to deal with the impact of extreme and unpredictable weather events on our assets and infrastructure and/or are unable to successfully plan for future water resource supply and demand due to climate change.

Political and regulatory environment

·        PR19: The regulatory landscape is complex and subject to ongoing evolution. We have now received our Draft Determination for the period 2020 to 2025, however we will not have full clarity on our plan until we receive our Final Determination on 16 December 2019.

·        The UK's decision to leave the European Union (EU): At the time of writing, the terms of the UK's departure from the EU ('Brexit') remain uncertain. Brexit does not give rise to a new principal risk for the Group, but it does have the potential to impact risks in other areas of our operations, such as supply chain, interest rates, availability of funding, regulatory changes and uncertainty for the domestic economy.

·      Renationalisation: The renationalisation of the water industry remains a possibility in the event of a change of Government, and any associated changes in Government policy may fundamentally impact our ability to deliver the Group's strategic objectives, impacting shareholder value. Our aim is to ensure the water sector in England and Wales continues to deliver a world class service for customers, is able to invest for the future and maximises the benefits to wider society and all stakeholders through the social and environmental benefits the current model allows us to deliver. We seek to minimise potential risk and maximise opportunities through regular communication and robust scenario planning as Government policy evolves.

Technical Guidance 2019/20

Footnotes to technical guidance

1.     Includes £7 million net penalty for customer ODIs (Customer Outcome Delivery Incentives, quoted pre-tax in 19/20 prices) relating to 2017/18 with the balance of that year's net reward deferred to AMP7.

2.     Quoted pre-tax at 2012/13 prices.

3.     Excludes AMP6 SIM customer ODI outcome.

4.     2019/20 dividend growth is based on November 2018 RPI of 3.19% plus 4%.

Further Information

For further information, including the Group's interim results presentation, see the Severn Trent website (www.severntrent.com).

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