Fat Prophets take profits

The European utility sector is undergoing a tremendous amount of change. Whether in the form of government inspired efforts to form national champions, self preservation or the attractive cash flows gaining the attention of private equity players, it would at times seem every group is part of a potential merger or acquisition.

As we highlighted back in FAT152, Scottish Power (SPW) was transformed into a very attractive takeover target following the disposal of PacifiCorp in America. At the time we were of the opinion a continental partner would make the most sense due to the competition hurdles a tie-up with Scottish & Southern Energy would create.

While speculation still surrounds the potential buyer, there is no doubt Scottish Power is now 'in play'. Following yesterday's announcement to the stock market that it was in discussions about a possible takeover, an extensive slate of possible suitors has made the rounds. Bilbao based Iberdrola, however is at the top of most lists.

Both companies are refusing to confirm whether they are in talks, which often times means they are. If you believe 'where there is smoke there is fire', then a Scottish Power /Iberdrola combination appears likely.

Just as with the protagonist, the potential price tag is equally unknown. However, once again speculation is offering a guide price of 800p. In light of last year's rejected 570p offer from E.ON of Germany, we believe this would certainly be enough to focus management's attention.

Meanwhile, away from the glare of takeover speculation, a trading update in October served as a reminder that as a standalone prospect, Scottish Power is performing at the high standards we expect. In fact, due to robust performances from clean energy wholesaler PPM in America and Energy Retail and Wholesale in the UK, Scottish Power is on track to exceed expectations.

As such, we keenly await results later this month for the six months to 30 September. PPM is benefiting from full contributions from its developing renewable energy business as well as the more established gas storage and energy management activities.

Energy Retail and Wholesale is making gains due to several positive developments. First from an operational perspective, the group is cutting costs, successfully hedging higher commodity prices and getting strong performance from their electricity plants. Second, recently implemented prices increases are also beginning to help offset the rise in wholesale electricity and gas costs.

Scottish Power's third core operation, Energy Networks is performing in line with management expectations.

Looking ahead we anticipate a further improvement in current regulatory pricing proposals which should provide a further fillip to earnings. In September, Ofgem, the gas and electricity regulator updated June's initial transmission pricing plans. Final proposals, which are due in December, will cover the period 2007-12.

As it stands, Ofgem are proposing a doubling of investment in infrastructure compared to the previous price control. However, we believe the regulated return on this investment has been set too low. By arguing that interest rates are rising and the urgent requirement to upgrade the country's infrastructure, we believe the power companies may be able to negotiate a higher return. Then over the five-year period, Scottish Power will be able to augment earnings with a higher allowable return on the larger capital investment.

On the charts, Scottish Power has been a solid performer for more than four years. At the time our last report in September, the stock was rallying strongly, on track for a test of the December 1998 high of 659.19p. Since then, Scottish Power went on to set a new high of 687.5p in October. Yesterday, the stock jumped sharply to a new all-time intra-day high of 798p before closing at 730p following the talk of a takeover.

In all, we believe Scottish Power offers appealing upside as a standalone business. This has been the case in particular since the sale of the troublesome US subsidiary PacifiCorp. However, the talk of a takeover has presented the opportunity to lock in substantial profits immediately.

Therefore, we believe it would be prudent to book some of these gains now. Accordingly, we recommend Members sell half of their holdings in Scottish Power at around 726p.