Corporate Profile: Tartan army in retreat

When Scottish Power bought Oregon-based PacifiCorp for £7bn in December 1998, it was meant to be a transforming deal. What the company hadn't bargained on was a crisis in the US energy market. Now it has issued a profits warning and all bets are off

Think utilities. Think dependable, if rather dull companies with strong balance sheets, reliable income streams and regular, chunky dividends. In these troubled times, think safe haven, a port in a storm. If only that were so at Scottish Power. The day before the terrorist attacks, Britain's biggest utility issued a profits warning. More than £1bn was wiped off the value of the shares after the new chief executive, Ian Russell, admitted plunging power prices at its troubled US subsidiary, PacifiCorp, had caused a $500m (£249m) loss on electricity trading.

The figure was almost $300m more than previously indicated. Mr Russell said the latest blow would reduce profits at Scottish Power by £166m, or 9p a share, for the year to March 2002. Summing up the mood in the City, analysts at investment bank Dresdner Kleinwort Benson told clients: "We believe this latest news will be likely to strengthen market suspicions that the company is accident prone and it may take some time for credibility to be restored."

Mr Russell later sought to allay investor fears, saying that, despite the setbacks in the US, dividend growth of around 5 per cent a year would be maintained. "We are delivering the promised cost savings, building more generation and looking to increase returns in the business."

But it was his revelation that debt was expected to rise during the quarter that merely added to some analysts' concerns. "Net debt has risen very rapidly from £5.2bn at the year-end to £6bn," says Peter Atherton at Schroder Salomon Smith Barney. "It's a big chunk of money."

On SSSB's forecasts, Scottish Power will have to dip into its reserves this year to pay the dividend because earnings will not cover the total payout. That's effectively giving shareholders money that is already their own. And interest cover, the amount by which operating profits exceed the interest bill, is very thin at 1.2 times. "Things are getting tight, mainly because Pacificorp's operating profits have been shot to pieces," Mr Atherton adds. "Scottish Power can't afford to have another major shock otherwise it will be very stretched on the dividend and would risk breaching banking covenants. This year will be a real financial stretch. Should recovery at Pacificorp not come through next year then Scottish Power is in dire straits." Scottish Power executives declined to be interviewed. But it is clear that the root of its problems go back to the ambitious £7bn acquisition of Oregon-based Pacificorp almost three years ago. It was a deal that stunned investors. For the first time a foreign company had taken over a US utility, and one based in Glasgow at that. Cynics sneered that the then chief executive Ian Robinson had delusions of grandeur. It would never work. The real reason Mr Robinson wanted to do the deal, they joked, was to boost his air miles.

But hopes were high that Scottish Power could defy history and show that a British company could really hack it in the US. During the 1990s, it had an established track record as a canny acquirer of UK utilities, Southern Water for £1.7bn, and Manweb, the north-west of England electricity supplier, for £1.1bn.

Scottish Power was also among the first electricity companies to string telecommunication lines on its electricity pylons. A 49.9 per cent stake in Thus, which operates the telecoms network, was sold at the height of the dot.com boom in 1999. And at first things seem to go well at PacifiCorp. Costs were attacked with typical tartan tenacity and among the early casualties were two corporate jets. But Scottish Power soon discovered that, as in the UK, American regulators were keen to see cost-savings passed to the customer, rather than just to shareholders.

Then came the biggest energy crisis to hit California since the early Seventies. PacifiCorp was not as badly affected as some US electricity groups. But it soon found itself locked into expensive long-term power-purchase contracts at prices between $200/MWh and $300/MWh. To meet customer demand, it had been forced to pay soaring spot-market rates after its Hunter power plant in Utah broke down last year at the height of the electricity crisis in neighbouring California. But power prices have since collapsed to about $30/MWh.

Scottish Power hopes to claw back much of these losses in price rises to customers, but it admits this will take three to five years and regulators will not allow it to recoup the full amount. The Hunter outage cost Scottish Power $1m a day, and an unquantifiable amount of attention from Scottish Power's board.

"PacifiCorp has been a much more difficult business to manage than Scottish Power ever believed it would be," says SSB's Mr Atherton. "Senior management have taken their eye off the UK business because of the time and effort they are spending on Pacificorp."

The crisis at PacifiCorp coincided with Scottish Power's decision to abandon plans to become a multi-utility and concentrate on its core energy businesses in Britain and America. The embarrassing retreat came after Scottish Power failed to make adequate returns from developing a range of products to sell to more than five million of its customers in the UK.

The investment required to develop national brands, win new customers and retain old ones was too high in an increasingly competitive UK retail sector, it admitted. (At Southern Water, for example, Scottish Power only managed to cross-sell gas and electricity to about 10 per cent of customers.) It wasn't the only U-turn. Scottish Power also withdrew from a joint venture with the Royal Bank of Scotland in financial services and with Thus to provide telecommunications. As Scottish Power's former finance director, Mr. Russell was closely identified with these previous strategies. But since taking over from Mr Robinson as chief executive six months ago, focus has been his watchword. Among Mr Russell's first acts was to put Southern Water up for sale.

Kevin Lapwood, an analyst at ING Barings and an early critic of the PacifiCorp deal, believes abandoning the multi-utility strategy is a good move. "Sticking to electricity means Scottish Power is reining back its ambitions and that reduces the risk to investors," he says.

It's been a baptism of fire, though. Apart from the PacifiCorp debacle, Mr Russell has struggled to find buyers for Southern Water. In August, Enel, the Italian state-controlled energy group and front-runner to buy Southern Water, pulled out of the bidding, apparently after a dispute over price. Scottish Power is believed to be holding out for at least £1.7bn, the amount it paid for the subsidiary five years ago.

Also in Mr Russell's in-tray is what to do about Thus. The telecoms operator in which Scottish Power still retains a 51 per cent stake has suffered a share price collapse with the bursting of the dot.com bubble. Thus needs £150m to plug a funding gap and Scottish Power has made it clear it would prefer to find external financing rather than dig deep into its own pockets.

Assuming Southern Water is sold for close to the asking price and Thus financial problems are resolved, the big question is what Scottish Power will do next. Though the jury is still out on the PacifiCorp purchase, Scottish Power is keen to find smaller, bolt-on acquisitions in the US.

It has reportedly talked with Enron about buying Portland General, an Oregon-based electricity utility, but, given Scottish Power's balance sheet constraints, it would need to sell Southern first to cover the purchase price of $3bn, including debt. Buying UK energy businesses may prove just as hard. Scottish Power has been outbid recently for regional electricity suppliers by the deeper pockets of large continental European and American utilities. And this week it lost to American Electric Power, a large US energy group that owns the Seeboard electricity business, in a bid to buy two large power stations at Fiddler's Ferry in Cheshire and Ferrybridge in West Yorkshire.

Mr Russell clearly faces an uphill task in convincing the City that he can deliver a strategic change in the company's direction. The back-to-basics message has gone down well, even if its successful execution is far from complete, especially in the US. For the time being at least, analysts are prepared to give Mr Russell the benefit of the doubt. SSSB's Mr Atherton reflects the general mood, saying Scottish Power was "tremendously unlucky" to be caught out by volatile US power prices.

Another shocker, though, and Mr Russell's job will surely be on the line.

FACT FILE

Market

capitalisation: £7.5bn

Sales: £6.35bn in 2001 (£4.12bn)

Pre-tax profit: £628m (£736m)

Main business: Provides electricity to 1.9 million customers in Scotland and 1.4 million more in the north-west of England through Manweb subsidiary. Southern Water division serving 2.7 million people is earmarked for disposal. Also holds a 50.1% stake in internet service provider Thus. PacifiCorp provides power to 1.5 million customers on the west coast of the US

Key executives: Charles Miller Smith, chairman; Ian Russell, chief executive; David Nish, finance director

Employees: 21,981

THE POWER PLAYS OF A ONCE SMALL SCOTTISH COMPANY

1991: South of Scotland Electricity Board privatised to create Scottish Power

1995: Pays £1.1bn for north-west of England regional electricity company Manweb

1996: Pays £1.7bn for Southern Water

Dec 1998: Pays £7bn for Oregon-based PacifiCorp, the first takeover of a US utility by a foreign company

March 1999: Launches £10m advertising campaign to build consumer brand

Nov 1999: Scottish Telecom subsidiary renamed Thus and 51 per cent stake floated on the stock market. Dot.com boom sees valuation of Thus soar to £4.6bn, more than half Scottish Power's own market capitalisation

February 2001: Quits joint ventures with Thus and Royal Bank of Scotland to sell telecoms and financial services to its 5.5 million UK customers after just 12 months

March 2001: Former finance director Ian Russell succeeds Sir Ian Robinson as chief executive

May 2001: Reveals recent breakdown at PacifiCorp's Hunter generator plant in Utah cost $1m a day, a total of £90m. Loses $210m in electricity trading contracts due to soaring American wholesale electricity prices caused by the Californian power crisis.

June 2001: Exits electrical retailing, closing half its 160 stores and selling the rest to Powerhouse Retail

August 2001: Italian power group Enel pulls out of bidding for Southern Water

September 2001: Profits warning. Company to take a further $290m hit due to plunging power prices at PacifiCorp. News wipes £1bn off SP's stock market value