Beware the Offer PowerGen can't refuse

Shares in PowerGen have underperformed the market since September's announcement that it was in talks to buy Midlands Electricity. Confirmation that the pounds 1.95bn takeover will go ahead has underscored investors' fears that winning the bid would expose PowerGen to more flak from Offer, the regulator, and the politicians.

Thus far, PowerGen has done well out of electricity deregulation, as yesterday's interim profits demonstrate. Pre-tax profits jumped 13 per cent to pounds 133m in the six months to 1 October, but the surprise came in a half-way dividend raised 30 per cent to 6.5p. The largesse was possible because the company bought back 7.6 per cent of its shares at the government sell-off in March, which meant the cost of the interim payout rose only 18 per cent.

The medium-term plan is to lower dividend cover from last year's level of over three times to 2.5-2.7 times. But there are doubts about whether PowerGen will maintain the same level of generosity at the year-end. Although the shares rose 13p to 568p on yesterday's dividend news, longer- term the realities of PowerGen's position will determine the price.

The case for buying Midlands rests in large part on its capacity to secure a market for a substantial part of PowerGen's output and to give access to billing, marketing and customer service expertise. The goal is to create a fully integrated electricity company better equipped to compete when the market is fully deregulated in 1998 and the lucrative supply contracts with the regional electricity companies end.

The problem is that any benefits from the Midlands customer base will not be felt in the short term. By 1998, only 16 per cent of PowerGen's expected ouput will not be tied up in long-term contracts with other Recs and so available to Midlands.

In the meantime, by acquiring Midlands, PowerGen will have subjected an estimated quarter of its profits to regulation by Offer and the possibility of a Labour government imposing tighter price or profit controls. It is also facing a continued loss of market share, which will be exacerbated by yesterday's completion of the forced sell-off of two power stations to Eastern, and a possible fall in the price at which electricity is traded.

Long-term, PowerGen may or may not make a go of new activities ranging from overseas power generation to gas distribution. But short-term sentiment will be dominated by whether it gets government clearance to acquire Midlands. Profits of pounds 590m this year would put the shares, up 13p at 568p, on a prospective multiple of only 10. Not expensive, but only weakly supported by a forward yield of 4 per cent.