The next electric avenue

A wave of deals about to hit the privatised utilities is likely to mean much tighter consolidation, says Richard Thomson
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TRAFALGAR House has fired the first shots in what is likely to develop into the second revolution in the electricity industry since the Government's decision to privatise it five years ago.

Trafs wants to bid for Northern Electricity, one of the medium-sized companies. The assumption now being made in the industry, the Government and the City is that a wave of acquisitions and mergers is about to consolidate the regional electricity companies (RECs), much as the independent television companies have been consolidating over the last few years. According to some scenarios, of the 12 existing RECs there may be no more than three or four left in five years' time.

This process cannot begin immediately because of the Government's decision last week to hang on to its golden share in the industry until it expires on 31 March. Trafs could still bid before this so that its bid would not go unconditional until the golden share had gone.

For the moment, however, it seems in no particular hurry, while the industry is awash with speculation over what other deals may be in the pipeline. "There are five different possibilities that we can see," says Nigel Hawkins, utilities analyst at Hoare Govett.

There are likely to be bids from conglomerates like Trafs, from larger RECs for their smaller brothers, or from foreign companies. There may also be mergers between RECs. Last, but least likely because of the political implications, there may be management buyouts.

The logic for a company such as Trafs, Hanson (which bid for PowerGen, the electricity generator, before it was privatised) or Tomkins is simple. The RECs, like most utilities, are cash generative and their steady business would be a useful antidote to the cyclical profits of a business such as international contracting.

In addition, Trafs has substantial tax losses, which it could offset against earnings from Northern. "For many conglomerates, buying an REC would have a large element of financial engineering in it," says Jeremy Tigue, manager of Foreign & Colonial's utilities fund.

Foreign companies looking to diversify their international assets might be tempted for much the same reasons, just as French water companies bought British water utilities several years ago.

Financially, after all, the RECs are an attractive proposition, with low gearing and dividend cover of three times or more. The smaller ones such as Seaboard, Manweb, Southwestern, Midlands, East Midlands and Northern are all worth in the region of £1bn - a relatively easy mouthful to swallow for a decent-sized conglomerate. Swalec is even smaller, worth around £850m.

Equally, however, there is the possibility of takeovers by the larger RECs. Eastern and Southern are each worth around £2bn and ScottishPower is already believed to have looked at a bid for Northern. Mergers between the smaller companies are also a possibility. "In the new year we will see RECs talking to each other," Mr Hawkins says. It would be extraordinary if the phones were not buzzing last week, after Trafs' ambition was flushed out by the rise in the Northern share price.

The advantage to RECs of both acquisitions and mergers would mainly be in cost-saving economies of scale: combined companies would share operations such as head offices and metering and billing facilities.

However, the eventual outcome of the industry reorganisation could be more complex still. "In five years' time it will be something of a muddle," Mr Hawkins says. There is no reason why, for example, large regional utility groups should not emerge comprising water, electricity and gas companies. They would share much the same customer base in their area and, again, reap the benefits of scale. Into this mixture might also come cable TV companies operating in the same region with the same customers.

Steps towards this have already been tried. Southwestern Electricity has already been involved in a TV franchise bid, while Welsh Water attempted to buy into South Wales Electricity before the regulators stopped it.

From the investor's point of view, the shake-up is mostly good news. REC shares soared last week in anticipation of the takeover bonanza to come.

The prospect of steadily rising dividends for the next few years also looks secure. Indeed, dividends may start to rise extremely rapidly, accompanied, perhaps, by special payouts to shareholders. This is because RECs will not want to be caught with large piles of cash if a predator makes a play for them.

The urge to pay large dividends will also be affected by politics. Most industry insiders accept that a Labour government would impose some form of windfall tax on utilities soon after taking office. With last week's Dudley West by-election appearing to confirm a Labour win in two years, RECs will be keen to reduce their cash reserves to avoid having to hand over too much tax later. The next two years could, therefore, prove to be a bonanza for shareholders.

By the same token, the longer-term prospects of the RECs may not be that exciting. Not only may they be more heavily taxed but a review of the regulatory framework is due for the industry in the year 2000. "That will almost certainly produce tighter regulation than now, with more restraint on electricity pricing and hence less potential for high profits," Mr Tigue says.

As in any utility industry, the attitude of the regulators is crucial. But at this stage there is no sign that either the Government or Professor Stephen Littlechild, director- general of the Office of Electricity Regulation (Offer), has any philosophical objection to consolidation within the industry.

Offer's role is to promote competition and protect customer interests - although in practice competition issues thrown up by mergers and acquisitions in the industry will be handled first of all by the Office of Fair Trading. Offer itself will be more concerned to make sure the consumer gets any benefits arising from the reorganisation of the industry.

"There could be economies of scale, but would that do anything for consumers?" asks Mike Walpole, a spokesman for Offer. "We would want to see that it did." In other words, Offer will expect at least some of the cost savings from mergers to be passed on to customers. That will not necessarily nullify the value of such deals, but it will hold back their profitability.