Utilities pay the price for diversifying

IT HAS long been received wisdom among the utilities that, with earnings in their core business controlled by a regulator, the most sensible thing they can do is diversify. Hence the post-flotation spree that saw the regional electricity companies (RECs) expand their retail divisions and move into generation, while the water companies splashed out on waste management and consultancies.

Last week, East Midlands Electricity confirmed what many people in the City already suspected: that the rush into unregulated activities has cost the utilities dear. The company is to cut 700 jobs and curtail its ambitious programme of diversification - widely regarded as the dreamchild of John Harris, the former chairman who retired unexpectedly last month - with an accompanying writedown of pounds 80m. 'The analysts all expected a hit but certainly not one of this magnitude,' concluded Nigel Hawkins, utilities analyst at Hoare Govett.

The RECs inherited their retailing and contracting interests, and in the heady days immediately after privatisation, all except Manweb enhanced their role in the high street. With the exception of Norweb, which expanded aggressively and bought Thorn EMI's Atlantis appliance stores, all have also been forced to rethink this strategy.

A report by Stephen Littlechild, director-general of Offer, published last November in response to complaints by Dixons that the RECs were cross- subsidising their retail activities, showed that since 1990 they have collectively lost more than pounds 104m on their shops.

London Electricity and Swalec, formerly South Wales Electricity, have now pulled out of retailing altogether, while Eastern, Southern and Midlands Electricity have merged their interests, fuelling speculation that this is a preliminary to disposal.

Meanwhile, despite joining forces with Yorkshire Electricity, East Midlands has still been compelled to write down the pounds 19m assets on its retail business to zero.

The RECs' track record in contracting has proved almost as bad, although the move into generation looks set to make a significant contribution to their unregulated earnings.

Eleven have also signed up with partners to become independent gas suppliers in anticipation of securing access to the domestic market. But with prices likely to be intensely competitive, they will probably make little in the way of profits, according to Angelos Anastasiou, utilities analyst at Panmure Gordon.

If the RECs' performance outside their core business has been unimpressive, the water companies have seen even more shareholders' money go down the drain. According to figures from SG Warburg, by the end of last year investment in unregulated activities had cost the RECs a total of pounds 432m, including pounds 223m on generation. This is just a third of the pounds 1.2bn invested by the 10 water companies since flotation in 1989.

Severn Trent went down the waste management route. Under John Bellak, former chairman, it paid pounds 212m for Biffa in 1991. Although the company is widely regarded as sound, high financing costs mean that Severn Trent is losing pounds 10m a year on the business.

North West Water has gone abroad for its money, with contracts to run water services from Mexico to Malaysia. However, these are long contracts of between 15 and 30 years. 'Everybody has been chasing them, so the company probably won the business on price, which suggests the profits can't be very great,' Mr Anastasiou cautions.

Northumbrian Water came unstuck after heavy losses on its pipe-cleaning business reduced unregulated profits from pounds 5.6m to pounds 2.8m, while Thames Water also took a bath at the interim stage, with provisions of pounds 25m against two contracts and a restructuring in the US. An impeccable performance in its core business has been damped by disappointing results elsewhere. Turnover of pounds 240m in its unregulated activities produced just pounds 1m in profits last year.

Wessex Water is in a slightly different category. Its joint venture with Waste Management, the US giant, is expected to deliver profits of some pounds 8m this year. However, Wessex will see its value diluted in 1997, when Waste Management takes up preferential shares in the company. It needs to make profits of pounds 10m to pounds 15m a year to offset the impact, but is currently making more like pounds 3m after tax.

Arguably, Welsh Water is one of the few companies to have done well out of diversification, although this is more by good fortune than good judgement. The company attracted a lot of flak for its purchase of five hotels. Three have since been leased to Voyager, Richard Branson's subsidiary, prompting City cracks about the virgins in Wales.

But if that move earned the board red cheeks, at least it can point to the pounds 17m profit it made from buying and selling a 14.9 per cent stake in Swalec.

(Photographs omitted)