The Investment column: A key to unlocking value in utilities

Yesterday's news of more ingenious payouts to shareholders in a utility group is further evidence of the sector's emergence from the cloud it has been under for the past three years. This rather amorphous grouping has been hit by a succession of unexpectedly severe regulatory reviews, but it has been the growing certainty with which the market has been factoring in the election of a Labour government that has cast the longest shadow. The water and electricity industries have borne the brunt of these fears, being seen as the most likely target for Labour's "windfall" tax, variously put at anything from pounds 3bn to pounds 10bn.

But, as our chart shows, there has been a definite re-rating of the sector since the latter end of last year. There is a feeling abroad that the gloom has been overdone.

One factor is the robust financial strength of the companies, now being unlocked in buy-backs and the like. The first inkling of this came in Northern Electric's "scorched earth" defence against Trafalgar House in 1995, which promised a 500p-a-share payout to shareholders but would have seen gearing soar to 225 per cent. Although the Trafalgar bid failed, that such audacious financial engineering could be seriously contemplated lifted the lid on the sector. Even after suffering a second regulatory review in 12 months, UK electricity companies still looked succulent morsels to electricity groups from the US, where regulation leaves fewer crumbs for shareholders and gearing of 100 per cent is not uncommon. In the 18 months since the regulator, Professor Stephen Littlechild, completed his second review in July 1995, eight of the regional electricity companies have been taken out by US groups and the remaining utilities are busy gearing up to show how much they can give back to shareholders.

Yesterday's Southern Electric payout comes hot on the heels of a similar deal announced by Yorkshire Water. Both were dreamed up by Max Ziff of the merchant bankers SBC Warburg to get round the cramp put on buy-backs and special dividends by the Chancellor last year.

Although the payback is complicated in the detail, the rationale is simple and for once not skewed in favour of big City institutions. The beauty of Southern's scheme is that the B shares it proposes to issue put an instrument paying around 6 per cent gross - a rate comparable with most building societies' - into the hands of shareholders, while giving them the chance to realise capital by selling back to the company. No one class of shareholder benefits over another and all can still benefit from a progressive dividend policy on their remaining ordinary shares. Southern is projecting payments to shareholders rising between 5 and 8 per cent in real terms until the year 2000.

Other utilities have already won permission from shareholders for buy- backs. The advent of the new scheme from Warburgs will only increase the chances of some form of further payback to shareholders, while gearing of 30 to 35 per cent at Yorkshire Water and Southern even after the latest deals means they could conceivably have a second bite of the cherry.

All this begs the big question of what Labour might do. Earlier this week, Scottish Amicable released a blood-chilling analysis of why utilities are going to prove poor investments for the rest of this century. Part of its argument is that Labour, facing a big government borrowing requirement, will find it hard to resist turning the windfall tax into a permanent annual levy. At the same time, it highlights the potential for a significant tightening of the regulatory screw under Labour.

But both the City and the utility industry generally is coming round to the view that these threats are increasingly quantifiable and containable. Nigel Hawkins at Yamaichi points out that a windfall tax of pounds 3bn on water and electricity alone would represent less than 9 per cent of the combined sector's market capitalisation. At the same time, observers suggest Labour may find the National Health Service and the education system may assume a higher priority than utilities regulation.

With the strength of the pound hammering profits at many other UK industrial companies, the domestic earnings and solid balance sheets of the utilities are looking increasingly attractive. Mr Hawkins singles out PowerGen, Wessex Water and Southern Electric on these grounds.