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Investing.com -- Pennon Group (LON:PNN) has received an upgrade from Citi Research, which has raised its rating to ’buy,’ citing an upside potential despite ongoing uncertainties in the UK water sector.
Following a brief rally after its recent rights issue, shares of Pennon have slipped back, currently trading at a discount to their regulatory asset base.
Citi Research believes the market has been overly pessimistic, factoring in an operational underperformance of over £500 million—equivalent to a quarter of Pennon’s market capitalization.
Their valuation framework suggests this discount is excessive, making the stock an opportunity for a mean-reversion trade.
The UK water sector faces regulatory challenges, including ongoing sewage investigations and an independent water commission review. Pennon is also expected to receive a low 2024 Environmental Performance Assessment (EPA) rating.
However, Citi Research notes these risks are well-known and already priced into the stock. Pennon is currently trading at a 2% discount to EV/RAB, whereas sector peers trade at premiums of 7% and 20%.
The upcoming Capital Markets Day on March 13 presents a potential catalyst for a stock re-rating. With low expectations ahead of the event, any positive updates on EPA metrics and cost-control measures could drive the shares higher.
Pennon’s balance sheet is now stronger following its rights issue, resolving previous financial constraints. While operational spending remains a concern, Citi Research expects AMP8 to offer greater cost controls, mitigating the risk of major overspends.
The market appears to be pricing in an operational overspend of around £540 million for AMP8, even though South West Water’s underperformance in AMP7 was only £132 million.
Citi Research maintains its price target at £4.97 per share, representing a 26.8% upside from the current trading price of £3.92. The expected total return, including dividends, stands at 34.2%.
Despite sector-wide headwinds, Citi Research sees an asymmetric risk-reward profile for Pennon, justifying the upgrade and initiating a 30-day positive catalyst watch leading up to the CMD.
If management provides reassurances on operational and regulatory fronts, the stock could benefit from a near-term recovery.