Electrifying potential

Since privatisation in 1990 Scottish Power (SPW) has pursed a fairly aggressive and diversified growth strategy. During the last fourteen years SPW acquired Southern Water, merged with, US electricity generator Pacificorp, and even set up telecoms company. In recent years Scottish Power has gone back to basics, disposing of telecom and water businesses, and focussing on power generation and distribution. Today SPW provides electricity and gas services to around 6 million customers in the western US and across the UK. In our opinion SPW is now significantly leveraged to rising electricity prices and demand, both here and in the US.

From mid 1996 to early 1999 SPW's shares performed impressively, more than doubling in value as the company expanded into new industries and markets. However as is inevitably the case, soaring prices were followed by a deep correction. SPW plummeted from an all time high of 682p in 1999, to a low of just 293p in 2002 as the company's expansion strategy became blurred, and as electricity prices slumped. Although the shares have since recovered somewhat SPW remains a long way below peak levels. In our opinion the foundations for a lasting upturn in the shares are now in place, given a positive chart structure and improved earnings outlook.

Group turnover for the first quarter ended 30 June 2004 increased by 19 percent on last year to £1,481 million. Encouragingly earnings from all UK businesses increased substantially due to price increases and customer growth. Overall group operating profit (excluding goodwill amortization) fell 6 percent to £250 million as a result of a disappointing performance in the US, although management has reconfirmed this business will still meet full year earnings targets.

In the UK the company gained 250,000 customers over the quarter taking the total to 4.5 million. Operating profit improved by a substantial £22 million to £24 million on the back of robust customer growth, higher electricity prices and the first contribution from the Damhead Creek power station which SPW acquired in June.

Operating profit at US subsidiary PacifiCorp fell £52 million to £117 million for the quarter. The division was not only hampered by a weaker dollar but also a lack of rain. PacifiCorp's hydro-electric plants could not operate at full capacity and had to buy more expensive coal and gas-generated power in order to supply customers. Nevertheless we are heartened by management's comments that weather conditions have since returned to normality, with PacifiCorp expected to hit a US$1 billion earnings target for 2004-05.

Scottish Power's clean energy business, PPM Energy has maintained an impressive growth record in both the US and UK. Operating profit rose by £3 million to £8 million as the opening of new wind farms led to an increase in electricity output. We regard this as a significant growth business (albeit from a low base) for SPW going forward. Increasing government legislation has resulted in growing demand for renewable energy. Concerns towards carbon emissions having a negative impact on the environment along with international pressure for countries to sign the Kyoto Treaty, has provided considerable impetus for this growth industry.

PPM was responsible for almost a third of new wind developments in the US in 2003, and new developments in Minnesota and Oregon are planned for early 2005. Earnings within this division should grow significantly in the years ahead following PPM's commitment to generate 10 percent of supply from renewable energy sources by 2010, from approximately 3 percent now.

The Infrastructure Division which owns and manages the company's transmission and distribution assets delivered a solid performance, increasing operating profit by 11 percent to £101 million. The business may be set to benefit further pending the outcome of the regulator's Price Control Review in November. SPW is pressing the Office of Gas and Electricity Markets (OFGEM) to be permitted higher rates of return and capital expenditure allowances to ensure long-term supply expectations are met.

In addition to a solid operational performance this quarter we are highly encouraged by the manner in which SPW is investing for future growth. During the quarter SPW invested £522 million of the £1.5 billion 2004/5 planned spend on generation, networks and gas storage. The largest investment thus far was £320 million for Damhead Creek, which already appears to have been a particularly astute purchase. The modern, highly efficient facility was acquired for a distressed price of around £275 per kilowatt of installed capacity, and is already contributing to profit. SPW has also proven adept at managing large projects, consistently achieving target return rates, which bodes well for successful future investment in our opinion.

Cash flows from operating activities fell by £160 million to £136 million in the quarter due to reduced operating profits from PacifiCorp and an increase in working capital needs .We are however comforted by comments that earnings at the US business are now returning to previous levels, and that high levels of gas and coal stocks will boost net cash flows later in the year. Although gearing (net debt/shareholders funds) rose from 79 percent at 31 March to around 91 percent, this remains fairly conservative compared to industry peers and relative to the company's 'A' credit rating.

Going forward we expect improving earnings at the US businesses to be a key driver of profitability for SPW. Over half of SPW's earnings are generated from the US business which is set to be a major benefactor of the forecasted increases in energy demand and electricity prices. Added to this the US is a less regulated market which means that returns to capital are higher. SPW is targeting a return on capital of 10 percent in the US this year which is significantly higher than the 8 percent permitted by regulators in the UK.

PacifiCorp successfully gained US$6 million of rate increases from US State regulators this quarter and the prospects for further uplifts look strong. Last month the company filed a request in Utah for a rate increase of around US$10 million, which would equate to a return on equity of 11.1 percent. Today it was also confirmed that the company had obtained a US$9.25 million rate increase in Wyoming.

We are impressed by the pace of customer acquisition in the UK with the operation now close to critical mass. The acquisition of Damhead doubled SPW's generating capacity and means most of the company's UK needs are internally supplied, which increases SPW's leverage to wholesale electricity price rises. The company has also arranged forward contracts to secure much of the coal and gas needed to power electricity generation for the next two years, so profits should be insulated from rising fuel costs.

From a technical perspective SPW has rallied off a strong support base between 350p and 330p in the past twelve months. This suggests to us that a lasting low is in place and that solid buying interest underpins the stock. More recently prices have broken above resistance at 400p which indicates that a lasting recovery is underway.

At current levels we believe that SPW offers compelling value with a forward price earnings multiple of 11 times and a yield of around 5 percent. We expect further earnings growth to be significantly boosted by rising electricity prices and robust demand, both domestically and in the US. Accordingly, Fat Prophets recommends that Members buy up to 415p. Our initial target is for a move towards resistance at 440p, however over time, we believe that higher levels are achievable.