Severn Trent case still holds water

Whatman looks worth a punt as a recovery play; Express Dairies might finally deliver cream

The last time this column wrote on Severn Trent, the west-of-England utility group, at the time of its annual shareholder meeting in June 2002, we advised readers to sell. Since then, the stock has been picked as one of The Independent's tips of 2003. Why the dramatic change of heart? And what should investors do now?

Most obviously, the difference was the huge decline in the share price after we went short at 787p. It has rightly clawed its way back from a low of 590p. Now it is up 3 per cent on the start of the year, but the group still looks attractive on valuation (compared to assets) and because of the stability of its 7 per cent dividend yield.

Most crucially, Severn Trent managed to persuade Ofwat, the water regulator, to allow it to raise prices to the consumer to compensate for the extra business costs it first revealed at the AGM. These costs – including insurance premiums and the climate change levy – are still offsetting many of the operational cost savings the group has wrung out of its water and sewerage business. But at least it has been allowed to hike prices by 4.75 per cent.

The outlook for prices from 2005 is also looking more benign than many had dared hope. Ofwat has started consulting on the new five-year regime of price controls that starts then, and has already accepted that bills will have to rise. Of course, there are bound to be devils in the detail but water sector shares seem less likely to suffer than they have in the past.

Severn Trent's unregulated businesses have had a tough year. The environmental testing services division in the US has had to shed staff and chase lower-margin contracts as customers there cut back, but the group trading update yesterday showed profits were reassuringly flat rather than down. And Biffa, the waste management business in the UK, is disappointing. In an economic downturn, its industrial and commercial customers produce less waste. Longer term, though, environmental legislation should boost the group.

Hold.

Whatman looks worth a punt as a recovery play

If you have a little spare to punt on an interesting recovery play, try Whatman. The company produces glass fibre, cellulose and membrane filters used in industrial, hospital and drug research labs. It has a strong brand, but the financial strength of the company was sapped by a string of disastrous acquisitions. Bob Thian, installed by angry shareholders as chairman last December, has promised a radical overhaul and talks a good story.

The core business is a solid cash generator trading in a difficult market, and its unimpressive result last year can be improved through a shake-up of sales practices. Significant extra growth might come from products for storing DNA samples at room temperature.

The risks are still high. An ambitious plan to shut down three-quarters of the group's factories over the next 18 months is almost bound to cause some hiccups. But the company has negligible debts and has already taken the big financial hits to cover restructuring, legal bills and asset write-downs. The dividend, yielding 6 per cent, looks safe enough and the shares seem fairly priced at 75.5p yesterday.

Express Dairies might finally deliver cream

Shareholders in Express Dairies enjoyed a rare experience yesterday: the share price went up. In fact it shot up a mouthwatering 17 per cent to 29.75p as the stock returned from suspension following last week's news of the £79m reverse takeover of Arla Foods, the UK arm of a Danish farmers' co-operative.

Shareholders have until 24 April to decide whether to back the deal, which ushers in the long-awaited second round of consolidation in this difficult sector. So is this merger more like gold-top cream or yesterday's sour yoghurt?

The deal will create the UK's biggest liquid milk supplier and yield £20m of cost savings. The combined group will have about 40 per cent of the UK supermarket milk sector, around 25 per cent of the butter market, with brands such as Lurpak and Anchor, and 25 per cent of the declining doorstep delivery market.

The deal only modestly enhances earnings in year one but does create a larger, more stable group with a broader product portfolio. It adds a business with £22m of profits to Express's core operations, which made a loss last year.

For Express shareholders the immediate benefit is a special dividend of 9.6p a share, the equivalent of 37 per cent of their money back. That makes up for disappointment at not getting a premium for ceding control to the Danes, who will own 51 per cent of the new group, to be named Arla.

The one risk is that a competition investigation by Brussels or the UK's Office of Fair Trading could block the deal, but this looks unlikely. Hold.

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