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On the one hand Standard Life, and other mutual companies, are coming under pressure to demutualise, while on the other Kelda (LSE: KEL) yesterday announced a scheme to return capital to shareholders and convert itself to a mutual company. Can it be possible that both are right, or is one making a huge mistake?
To answer this question perhaps we should ask what a stock market is for. Really that is quite simple; it is to allocate capital efficiently. The stock market is a place where people with too much money meet people with not enough money and play swapsies. The currency of exchange is a share of the ownership of the underlying business. The better the business the more capital it attracts. Conversely, if the business it not attractive capital will move away from it and find better places to get superior returns.
Standard Life is enjoying very good business at the moment and the prospects for the finance sector look good. But, because it is a mutual, there is no easy way for capital to migrate towards it. And, in truth, it doesn't actually need any more capital. Nonetheless, capital wants to go there because it believes it can earn a good return and, in the true spirit of Adam Smith and his invisible hand, it found a way through the TEP (traded endowment policy) market. Consequently it very likely that this will activity will trigger a change in its status and unlocking value.
The situation with Kelda, and the rest of the water sector, is the complete opposite. Even though the company made a profit before tax of £222m in the year to end March capital is deserting it and other water businesses. At the beginning of last year the shares were trading at 550p, but they fell as low as 230p before bouncing back to the current level of 359p on the news of the restructuring. And it is not alone. The water sector as a whole has lost 31% of its value in the last two years. It is not hard to find the reason for this move. Water is a regulated industry and the new pricing structure that was announced last year, and comes into force from April 1st for the next 5 years, will make it very difficult for that business to earn a good return. Last year Kelda made 16.8% on its capital employed, a good result by most standards. Though it is not disclosed, it is a fair bet that much of this came from the non-regulated business. This year, with a 14.5% price cut and no change for four years after that, returns on the capital employed in the water business will be even lower.
It is conventional wisdom that although utilities are low growth businesses they generate substantial amounts of cash that can fund a generous dividend payment. The shares therefore become attractive to yield investors. Indeed, last year Kelda generated £389m of operating cash flow and £113.5m of that went on dividends giving it a yield of 6.4%.
On top of that it has to fund an ongoing capital expenditure programme. Last year that was £432m, almost four times the dividend payment. Even though the bulk of the capital investment for the water industry is over OFWAT, the Office of Water Services, projects that annual average capital expenditure will be £291m, a 25% increase in capital maintenance expenditure. To fund that and rising dividends in the new regime is not feasible.
The implications are therefore that dividends will be progressively cut. Moreover, because the prospect is for falling earnings paying out dividends will actually have little effect on the share price. To some extent, therefore, that cash is wasted.
So to cope with this migration of capital Kelda has come up with this scheme:
* Kelda will shed its renewable energy and other environmental businesses. Like most utilities its diversification strategy has been disastrous.
* It will create a community-owned corporation (Registered Community Asset Mutual, or RCAM) to acquire the assets of Yorkshire Water for a consideration close to its regulated asset value. Its customers will then own this enterprise. That way they are expected to benefit from the lower charges that should arise because the utility will no longer have to support equity capital through dividends. The capital structure of the new beast will be 100% debt.
* The RCAM would ensure a low cost base by ensuring as many operational activities as possible were subject to competitive tendering. However, in the initial phase it is envisaged that most of this business will go to Kelda to ensure continuity.
* As a consequence of this deal the company expects to return substantial value to shareholders. But in a statement typical of the Orwellian newspeak of corporate financiers they say that this "simplification of the business profile" will generate £10m of cost savings in a full year.
There is another twist to this story as well. As the prospects for "new economy" stocks get better, the opportunity cost of sitting in underperforming old economy stocks increases. This makes high dividend payments even more pointless. Given this wholesale move of capital away from utilities Kelda's strategy makes eminent sense. By moving all the fixed assets into the mutual it means that the rump can be re-labelled as a sexy service company. And with kind of label it won't need to pay much in the way of dividends
And then presumably all this money from Kelda can go to buying shares in Standard Life when it is listed. So perhaps they are both right.
Related Links
• Kelda discussion board
• Standard Life discussion board
• Rob Davies meets Fred Woollard, Standard Life carpetbagger