Light is kind to power shares

While electricity companies are still boosting returns, the upside is already in their prices
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IMAGINE an investment that has massively outperformed the market since the Government sold it off on the cheap, which has a local monopoly on supplying an essential and relatively predictable service, pays a dividend effectively half as much again as the market average, is expecting another Government handout later this year and has just been thrown open to wealthy predators.

Welcome to the exhilarating world of the 12 electricity distribution companies, where the only difficulty for shareholders is knowing when it is time to reach for the off switch.

After last week's hostile take-over bid for the West Country distribution company Sweb by America's Southern Electric, the market was mesmerised by the prospect of other bidders - Scottish Power, Hanson, utilities from obscure American states - waiting in the wings.

Shareholders who bought into electricity companies at 240p in the heavily oversubscribed flotation in 1990 have already watched with relish as the public sector fat was stripped away.

Price increases of more than 10 per cent a year, higher-than-expected sales, lower capital expenditure and cost-cutting to an extent strangely unforeseen at flotation time brought big rewards to investors, and of course to management, whose gains from options, salaries and perks soared.

This March marked the expiry of the Government's "golden share" takeover protection. The sector crackled into life as Trafalgar House's bid for Northern Electric pushed the latter's share price above pounds 10.

But Northern's defence strategy, a plan to give shareholders a package worth pounds 5, at last alerted the regulator, Professor Stephen Littlechild, to the riches buried in the distribution companies' accounts.

Professor Littlechild announced a new price review, which caused Trafalgar to cut its offer and trimmed pounds off each company's share price.

However, the new regulatory regime, announced 10 days ago, has left balance sheets reasonably unscathed. The companies' ability to load up with debt and boost shareholder returns is still formidable.

Growth in pre-tax profits is limited to an average of just 1.1 per cent. But dividend growth over and above inflation is still forecast at an average of 5 per cent, according to Adam Forsyth at NatWest Securities, and some analysts are going for even more. The companies will finance this, despite decreasing profit growth, by cutting dividend covers, but that is less alarming than at an ordinary business, since severe financial pressure and dividend cuts are unlikely at a utility.

Still to look forward to is the expected distribution of shares in the National Grid, come November. For a smaller company such as Swalec, for example, the National Grid shares are worth over pounds 2 a share.

Yield is the best route to valuing these shares, and they are all still paying out at a rate more suited to a business in real trouble than to safe utilities. Mr Forsyth rates Midlands, Swalec and Norweb as best for dividend growth prospects.

The trouble is that all these factors are already reflected in the price. What is also in the price, at least for the time being, is the bid speculation. Mr Forsyth believes the relatively small and manageable Swalec, Norweb, Manweb, and Seeboard are the best takeover bets.

The thinking is that American utility companies need to diversify and see Britain's electricity companies as a natural buy, as do ScottishPower and the conglomerate Hanson.

But most analysts are oddly reluctant to put their names to any particular targets, suggesting that while they are keen to talk up their clients' shares, they fear the blame if no more bids materialise. That means it looks like time to sell while the takeover speculation is in the price for certain.

Another reason for small shareholders who take a long-term view to sell is the fact that utility bosses will have few friends in a Labour government.

The UBS view is that foreign companies will rightly be concerned about Labour's proposals for a windfall tax on electricity profits, or at least tougher regulation, so both current takeover hopes and profit projections are unjustified.

Shareholders in East Midlands, with no earnings from retailing or generation, should note that they are the most exposed to changes. The exception is Southern. It has a close relationship with the similarly named American bidder for Sweb. If the Sweb takeover goes ahead, the two might one day be able to work together, saving an estimated pounds 35m a year.

Where will the sparks fly?

Price Prospective Takeover

(pence) dividend growth* prospect?

Eastern 707 9.5% No

East Midlands 704 9.7% No

London 720 9.7% No

Manweb 749 9.4% Yes

Midlands 758 13.6% No

Northern 883 9.4% Yes

Norweb 776 13.4% Yes

Seeboard 432 40% Yes

Southern 706 13.3% No

Swalec 825 9.5% Yes

Sweb 935 13.4% Yes

Yorkshire 780 9.5% No

*BZW estimate