COMMENT: Thames' pot of gold turns out to be junk

`Essentially the company is retreating back to its core utility business. Dull and boring though that strategy might be, it's obviously the way forward'
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When Thames Water was privatised in the late 1980s, Roy Watts, then chairman, dreamt of a diversified international water services group encompassing everything from contracting through to waste management. He wanted to take Thames to all four corners of the world. The boring old lowly paid civil servants who used to run our water utilities (reasonably effectively in most cases) were to give way to go-getting, highly paid, option-incentivised businessmen, expensive limousines, flights to exotic locations, and the pursuit of the deal. To help him create such a group, he recruited Mike Hoffman as chief executive. The aim was to have at least 20 per cent of revenue derived from sources other than the central, regulated water utility business within five years. So they set about using the utility's money to make acquisitions.

Strategically most of these appeared to make a good deal more sense than what others were doing. There were no hotels or holiday companies, for instance; nor has Thames ever been harebrained enough to try to merge with an electricity utility (two of the others have). Rather, Thames concentrated on businesses that were at least in some way related to water - mainly contracting and water treatment equipment.

Whenever there is a pot of gold for diversification, however, it usually ends badly and Thames is no exception. Five years after embarking on the search for other forms of revenue, Thames is now retrenching. The years of acquisition-making, flying the world and big salaries have in truth resulted in no more than a great ragbag of junk. Many of these companies, including the German contracting business, have been abject failures. Collectively, they have added significant negative value to the group.

The cost of getting out is a whopping great pounds 95m. Out too goes the chief architect of the strategy, Mr Hoffman, with his golden handshake still to negotiate. Did he jump or was he pushed? In the end, it was probably a mixture of both, for it was Mr Hoffman who headed up the review of operations that led to yesterday's write-offs. By the time it was complete, it was obvious not only that the City would require a scapegoat but that there was not much of a job left for him to do; Mr Hoffman was chief executive of the group but the money-earning utility business has always been managed by others.

Thames is to keep six of the big international projects it is involved in, all of them in water delivery and treatment of some sort. But essentially the company is retreating back to its core utility business. Dull and boring though that strategy might be, it's obviously the way forward. Mr Hoffman's departure comes hard on the heels of the top management clear- out at Yorkshire Water. The circumstances are very different, of course, but there is a theme here. Lax regulation in the early years of privatisation tends to mean that even managements of questionable quality can prosper, their faults and mistakes hidden by a cascade of monopoly profit. As public expectations rise, and the regulatory screw tightens, only the best management teams are going to flourish. The shake-out in utility management has a lot further to run.

Why has Severn Trent picked on South West?

In balance-sheet terms, a Severn Trent takeover of South West Water looks a perfectly respectable deal, and beats the rival proposal from Wessex Water hands down. It is when you look at other aspects of the deal that it seems not quite right. First, the arithmetic, which is hard to fault. Both potential bidders can afford to pay cash. But Severn Trent has low borrowings and at a capitalisation of pounds 2.3bn is nearly three times the size of both Wessex and South West.

The gearing of a Severn-South West combination would rise to no more than 70 per cent, interest cover would not fall to less than 4.5 and at pounds 7 a share such a deal would raise earnings by 15-20 per cent, according to Smith New Court. No contest then. In terms of financial engineering it makes eminent sense for the biggest water company to swallow the smallest, rather than have two tiddlers merge.

Niggling doubts remain, however. Why has Severn Trent settled on a bid for the only water company currently under offer when there so many other fish left in the pond? This pitches it into a contested bid that - despite promises not to overpay - could make South West Water an expensive proposition. Furthermore, Wessex has a better fit with South West that could justify it forcing the price up. The two have a common border and could probably make more operational savings than a company based in Coventry. Much of the argument Lyonnaise des Eaux used for buying Northumbrian Water was based on the fact that it already owned the water company next door.

The best explanation for Severn Trent's choice is caution. South West Water is small enough to be easily digestible at pounds 750m. On that basis it would make just as much sense to bid for Wessex, which is the same size. The other explanation is that Severn figures a bid for a non-contiguous company stands a better chance with the regulator, who is suspicious that mergers between adjacent companies will consolidate big regional monopolies. If this line of reasoning is correct, it could tip the balance of the bid.

Inflation is not dead yet

Inflation is dead, according to one of the City's most prominent economic commentators, Roger Bootle of HSBC Markets. The trouble with epitaphs like this is that they often have a nasty habit of signalling a new burst of life.

It is indeed a generation since Britain enjoyed such a good inflation performance, as the Prime Minister was swift to point out again in the House of Commons yesterday in response to the excellent inflation figures announced earlier. Mr Major and his Chancellor deserve congratulations. The question is whether the good performance will last for another generation.

The debate is between those who think there has been a profound structural change in the economy and those who believe the bad old British tendencies have merely been tempered by recent trends. Mr Bootle's case is that global competition, technology and labour market deregulation have made the inflation process irrevocably different. In the opposite camp are those who think wage pressures and margin building are not as bad as they were but have not been obliterated.

In the pessimists' favour is the fact that every other economy is also enjoying the lowest inflation for a generation. And Britain's headline rate - which fell to 2.7 per cent in February - remains above inflation on a comparable basis in 11 out of our 14 EU partners and five of the six G7 countries.

Nobody is suggesting that economic policy in Britain is so irresponsible that we will see inflation returning to 25 per cent. But the gloomier forecasts suggesting 5 per cent within a few years are entirely possible.

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