Investing in growth

Last month Scottish Power (SPW), the UK's fifth largest energy supplier, announced their first half results. We were pleased with the company's 12 percent improvement in pre-tax profit excluding goodwill. The group's performance in the UK, and at PPM in the US, were especially robust, helping offset disappointing results at PacifiCorp. In spite of the recent under-performance of Scottish Power's US subsidiary, we remain heartened by the company's longer-term earnings outlook as investments in growth begin to bear fruit.

After trading to 446.50p during November, the highest level in more than three years, SPW has since entered a period of consolidation. Following the strong rally in the share price, we flagged the possibility of a correction in our most recent review (FAT57). Corrections are a routine part of upward trends as they allow a stock time to consolidate prior to additional gains. In our view SPW is likely to stabilise and establish a new base around support between 385p and 375p before regaining upward momentum.

Scottish Power's group sales increased a healthy £529 million or 21 percent in the first half to £3,054 million. These results were underpinned by impressive performance in the UK where the Generation and Supply division increased turnover 47 percent, and PPM in the US where sales rose 68 percent. We were equally pleased to see that pre-tax profits excluding goodwill amortisation increased £48 million to £442 million.

The company's management of foreign exchange movements aided reported profits during the period. Although the US dollar has weakened significantly versus the British pound, the company has been able to mitigate the effect on earnings. These benefits will continue throughout the rest of the year as the company's expected hedge translation rate is between US$1.50 and US$1.55.

Scottish Power remains committed to investing for growth. During the half, the group's capital expenditure was £791 million of which £544 million related to additional capacity investment, the other 31 percent going to refurbishment, upgrades and various other projects. Significant examples of growth investments include the 800 MW Damhead Creek plant in Kent, the remainder of the 400 MW plant in Brighton, and the first phase of the 525 MW Currant Creek plant in Utah. We are pleased see management's commitment to capital spending of £1.5 billion this year as these additions to capacity are important to customer growth and future profitability.

The strong performance of the UK's Generation and Supply division was illustrated by the announcement that in the half the division added 460,000 new customers. This brings total new customers in the past year to 800,000, and total customers to a healthy 4.7 million. SPW aims to grow this figure to around 5.5 million in the medium term. The larger customer base is expected to lead to even higher levels of earnings and lower average costs.

In our opinion, the rate of customer acquisition is not surprising. Scottish Power recently came joint first in a J.D. Power customer satisfaction survey in the UK gas market and at the top of Datamonitor's annual survey of Industrial and Commercial electricity users. We believe that the survey results underscore Scottish Power's ability to retain and grow the customer base, which will drive profitability further.

In addition to satisfied customers, we are encouraged that SPW is investing in green power in the UK as these energy sources become more important to the nation's ability to fulfil obligations to cut greenhouse gases. The company's 100 MW Black Law windfarm, which will be the UK's largest, is currently under construction and approval has been granted for the 30 MW Beinn Tharsuinn project in Scotland. The company is also studying the feasibility of wave power with Ocean Power Delivery and Amec.

We are however disappointed by the revelation that PacifiCorp will not meet a US$1 billion full year profit target. Management commented that the lower level of performance is due to warmer weather (which reduces air conditioning requirements), and a higher level of planned and unplanned plant outages this year.

In spite of the forecast earnings disappointment, we were encouraged by other progress made at PacifiCorp. The company has reached an agreement with state authorities in Wyoming and Washington, granting additional recoveries due to higher costs, and a US$111 million rate case in Utah is expected to be decided by April 2005. In addition, customer numbers actually did increase by 2 percent over levels from September 2003. We are also encouraged that management believe operating profit at the division will "grow strongly again from 2007", indicating performance problems are not deep rooted.

Scottish Power's clean energy business, PPM, has also performed strongly on the back of significant investment in wind farms and gas storage. SPW expects to invest US$1.4 billion in the business through to 2010, with targeted capacity of 2,300 MW of wind generation and 125 BCF of gas storage. Part of this investment programme includes the 75 MW Klondike II project in Oregon and the 100 MW Trimont project in Minnesota. Both projects are expected to be completed in 2005.

At the end of November, the Office for Gas and Electricity Markets (OFGEM) announced final proposals for the Electricity Distribution Price Control review for the next five years beginning April 2005. The regulator has proposed prices can rise by 1 percent in the first year followed by increases by no more than the rate of inflation thereafter. Encouragingly, OFGEM also called for a 48 percent increase in capital spending allowances with a modest increase in cost of capital. Not everything went the distributors way though - OFGEM has also called for operating expenditures to decrease by 3 percent. Overall we believe that OFGEM's proposal will be beneficial to SPW and that the worst-case scenario of reduced dividends as a result of the review has been avoided.

In our opinion Scottish Power's business model of investing in growth to meet the needs of an expanding customer base is sound. We are also encouraged by the company's positioning within the renewable energy sector of the business in both the US and UK. We regard Scottish Power's investment fundamentals as compelling with a 2005 price earnings ratio around 10 times, and a generous 5.5 percent yield.

While the latest correction in the share price has been relatively sharp, the overall recovery remains intact in our opinion. We believe recent price action has left SPW oversold which should limit the risk of further downside. Conversely, with the shares trading at historically low levels significant upside potential exists in our opinion. Once the present consolidation is complete, we anticipate SPW regaining upward momentum. Accordingly, SPW remains firmly held within the Fat Prophets Portfolio. For Members without exposure, we recommend SPW as a Buy up to 390p.