British Gas investors could be in for a bumpy ride

The Investment Column

British Gas paved the way for the demerger of its Centrica gas production to distribution business yesterday with an overwhelming show of support from shareholders at an extraordinary meeting in Birmingham. But investors could be in for a bumpy ride when the new shares start trading separately from the British Gas rump, to be imaginatively renamed BG, on Monday.

Already the grey market, which started at the beginning of the week ahead of official dealings, is pointing the way. Last week a Centrica warrant launched by Barclays de Zoete Wedd was putting an implied price of around 50p on the shares. Yet in grey market trading yesterday the price was up another 5p to 75.5p. Meanwhile, the rump BG has steadily slid from a 186p opening to 163.5p, down 3.75p yesterday.

Although grey market dealings are notoriously unreliable in predicting the level at which real trading eventually settles down, the trend is supported by those reading the runes. Analysts reckon Centrica has more going for it than BG, over which the cloud of the gas regulator's proposals last year to slash 20 per cent from its revenues still hangs.

The old management team which locked Centrica into buying gas at way above market prices has gone while, paradoxically, the spot price has been going up again this winter. How close it gets to Centrica's average cost of gas, put at just under 20p a therm by NatWest Markets, will be crucial for valuing the company. At 14p, NatWest reckons the asset value is 66p, rising to 99p if the price rises to 16p.

Key questions will be how many people switch away from the company's necessarily high prices as the market is opened up to competition. In the limited competition trials thus far, the British Gas brand, which Centrica keeps, is limiting the damage.

Centrica is also being spun off with a very useful dowry in the shape of the Morecambe Bay gas field. It is only the profits and cash from that highly valuable asset, worth pounds 2.5bn according to analysts, which will keep the group in the black for the first few years of its independent existence. It could also prove a useful bargaining tool in any further deals with oil companies to shed the burden of the long-term gas contracts.

Finally, both Morecambe and Centrica's customer base could prove attractive to bidders ranging from US utilities to big oil groups like Shell and even perhaps electricity companies like PowerGen, already big in gas, or Scottish Hydro, which nearly bought the Scottish end last year.

BG, meanwhile, looks something of a Cinderella stock. It is heavily regulated, yet with a golden share which would prove a potent block to takeover and a dividend which could tumble from 14.5p to 5.5p on some estimates. Centrica shares, promising no dividend yield, will be subject to selling pressure from income funds, but bid talk makes them worth holding.

Disposals cheer Rexam

Shares in Rexam, the former Bowater packaging business, have underperformed the FTSE All-Share by a thumping 40 per cent in the last two years so it is hardly surprising that the company is facing a mountain of negative sentiment.

After two profits warnings in a year under the previous management investors have seen the stock slide from 517p in summer 1995 to 328p, down 1.5p yesterday.

But with new management, led by Swedish chief executive Rolf Borjesson, in place since last July, the City is weighing up whether Rexam is on the turn.

In December Mr Borjesson announced his intention to sell 20 underperforming businesses. Yesterday, two found early buyers, with Otis Specialty Papers going to Wausau Paper Mills, the US market leader, for pounds 36m and PT Rexam Mulox of Indonesia sold to a local group for pounds 1.3m.

These deals came earlier than many in the City had been expecting and there were encouraging noises from analysts yesterday about the rhetoric being backed up by some action.

Going forward, disposals are likely to prove harder and more costly. The two businesses sold yesterday were two of the more attractive divisions in Rexam Octagon, the special unit set up last year to encompass all the assets due for disposal. Some of the other businesses are loss-makers whose sale is likely to see Rexam incur asset write-offs.

Other businesses tipped for sale include folding cartons for food and drink and non-lipstick cosmetic packaging. The healthcare, building and engineering operations are not affected.

As Mr Borjesson gets to grips with Rexam he should be able to wring more cost-cutting out, with some removal of surplus capacity expected. With pulp prices near the bottom of the cycle the trick will be to hang on to packaging margins rather than being forced to cut prices.

Rexam's 1996 results, due next month, should show pre-tax profits of pounds 164m, with Charterhouse Tilney forecasting pounds 190m in 1997. That puts the shares on a forward rating of 15 falling to 13. Not cheap but worth holding to see if the new management can deliver on its promises.

Compel set for re-rating

Compel has flourished on the back of rising demand from large corporations for someone else to come in and deal with all that confusing information technology stuff. It's a competitive market, but the margins squeezed out of clients such as the Post Office, British Nuclear Fuels and Robert Fleming are healthy and rising.

Compel came to the market in 1994 via a placing at 125p. Yesterday shares bounced 9p to 197.5p after a useful 18 per cent jump in half-year profits to pounds 1.7m. Earnings per share were up by a similar margin to 7.09p.

Focusing on the networks of desktop computers that are gradually taking over from previous generations of mainframes, Compel designs systems, supplies the hardware and software to run them, installs the equipment and trains the staff who will use them. As systems become more complex, Compel becomes ever more important to the end-user and relationships tend, as a result, to be fairly stable and long-term

About 80 per cent of Compel's turnover is accounted for by only 30 clients, which might cause some concern about earnings quality except that in the past 12 months the company has not lost one large customer.

Growth will come from a number of areas. The trend away from mainframes towards shared servers will continue and corporates will continue to increase their IT budgets. That will increase the size of the cake, while Compel should continue to increase the size of its slice by taking share from smaller competitors.

On the basis of forecast profits of pounds 4.75m in the year to June and pounds 7m the following year, the shares trade on a forward price/earnings ratio of 12.5 falling to 11. That's a stingy rating for growth of more than 20 per cent and the shares look set for a re-rating. Good value.

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