Utilities Policy 8 (1999) 247–250www.elsevier.com/locate/utilpol

Multi-utility finance: a problematic case

Dennis Thomas*, Mahbub ZamanSchool of Management and Business, University of Wales Aberystwyth, Cledwyn Building, Penglais Campus, Ceredigion SY23 3DD, UK

Received 30 March 2000; received in revised form 23 May 2000; accepted 2 June 2000

Abstract

This paper treats one particular version of the multi-utility strategy as experienced by the Hyder Group. We examine some aspectsof the company’s financial performance and consider the implications. 2000 Elsevier Science Ltd. All rights reserved.

Keywords:Multi-utilities; Profitability; Financing decision

In a previous paper inUtilities Policy (6 (4), 1997)McGuinness and Thomas examined the diversificationactivities of water and sewerage companies in Englandand Wales post privatisation (McGuiness and Thomas,1997). In the case of Welsh Water and North West Wateremphasis was placed on the companies’ cross-utilitymergers, in 1996 and 1995 respectively, into electricitysupply and distribution which saw the former acquiringSwalec forming Hyder, and the latter taking overNorweb to form United Utilities. At the time cross-utilitymergers appeared to have a “simple and seductive logic,based on synergies and cost savings” which were poten-tially greater when, as in the case of Hyder and UnitedUtilities, the geographic fit of the utilities were close.In their analysis of the cross-utility moves the authorsemployed the language and concepts of the resourcebased approach to company strategy including examplesof “asset amortisation” and “asset improvement”together with the possibility of “product bundling”. Mot-ivated by recent reports of Hyder’s problems, culminat-ing in the current tabling of rival takeover bids, thispaper focuses on the financial aspects of the company’smulti-utility experience and considers whether it pro-vides any lessons for multi-utility strategies. To this endwe provide a brief historical account of the HyderGroup’s experience and examine some indicators of itsfinancial performance.

* Corresponding author. Tel.:+44-1970-622514; fax:+44-1970-622740.

E-mail address:det@aber.ac.uk (D. Thomas).

0957-1787/00/$ - see front matter 2000 Elsevier Science Ltd. All rights reserved.PII: S0957-1787 (00)00005-9

1. Background

Welsh Water’s cross-utility move to purchase theSwalec supply and distribution business for £872 mn.was a significant part of a strategy which was to see itbecome a self styled international infrastructure com-pany and a multi-utility provider. With the Hyder Groupadding regional gas supply and distribution (Swalec Gas,1997) to its utility portfolio, as well as operating non-regulated activities including consulting, constructionand management businesses with a world wide presence,the Cardiff based Group became Wales’ largest indigen-ous company. In 1997 Hyder employed over 9000people, with some 1500 working overseas, and reporteda turnover exceeding £1 bn. compared with the £293 mn.of Welsh Water in its first post-privatisation year. By thebeginning of 2000, however, Hyder’s future was indoubt with growing speculation that it could be takenover or broken up.

Following its formation Hyder’s most significant util-ity move came with the deregulation of the domestic gasmarket which saw Swalec launch an aggressive entryinto that market, taking a substantial share of the pre-vious British Gas monopoly. However, any gains in thisarea were to a large extent offset by British Gas acquir-ing Swalec customers following the opening up of theelectricity market. These developments coincided withthe imposition of a £282 mn. windfall tax and substantialprice cuts from two regulatory price reviews, set along-side a large capital investment programme (£1.7 bn.) to

248 D. Thomas, M. Zaman / Utilities Policy 8 (1999) 247–250

meet statutory environmental requirements in the watersector.1

Having sold off the retail energy supply units of Swa-lec to nuclear generator British Energy, the last end ofyear financial results reported a 31 per cent fall in pre-tax profits and a 60 per cent cut in shareholder dividend.At the same time Hyder announced a reduction of some20 per cent (around 1000 jobs) in its utility sector work-force. Specifically blamed on regulatory price rulings, incombination with the effects of the windfall tax pay-ment, these job cuts further added to a workforcereduction which had begun with 900 job losses followingthe original cross-utility merger. In February 2000 thecompany was reported to be looking to sell off its elec-tricity distribution business, retained at the time of thesale of the supply arm, as a way of reducing its largedebt, and March brought the announcement of a reviewof strategic options including the possible sale of theentire company. In contrast to Hyder’s plight UnitedUtilities, while announcing plans to cut operating costsin response to the “extremely tough” price reductionsimposed by the utility regulators, had recently reported(December 1999) a 2.9 per cent rise in its half-yearlyprofits.

At the time of writing (June, 2000) two rival bids hadbeen reported for the Hyder Group. The first involvingNomura, the Japanese based investment bank, amountedto a £402 mn. offer, which is less than half of Hyder’s1996 market value and would effectively mean Nomuraobtaining the company’s regulated assets at book valueand paying nothing for the unregulated assets. This wasfollowed by a counterbid of £464 mn. from a consortiumcomprising of the US owned Western Power Distri-bution (WPD), with financial backing from Citibank(USA), together with United Utilities.2 In this alternativecase the Bristol based WPD would run the electricity

1 It may be noted that the windfall tax charge of £281.9 mn., whichwas paid in two parts on 1/12/97 and 1/12/98, represented 24% ofHyder’s market value compared with a water sector average of 10%and 12.5% for United Utilities, and implying a greater burden for thecompany than for other utility providers. We may also note Hyder’sclaim that it particularly suffered from Ofwat’s failure to take intoaccount in its regulatory determinations the considerable differencesin the operating environments of the various water and sewerage com-panies in England and Wales. For example, Dwr Cymru/Welsh Waterhad 842 waste water treatment plants to serve the same population asone for London.

2 The WPD counterbid was made on May 31st at the first closingdate of Nomura’s offer. This bid, unlike that from Nomura, was notrecommended to the shareholders for various reasons including fearsthat it raised greater regulatory uncertainty. An earlier version of theWPD proposal involved Hyder’s break up with the ownership of WelshWater’s pipe network and water treatment assets separated into a newnon-profit making body financed entirely by debt. This proposal wasdropped following initial difficulties in obtaining financial backing, andindications that such a move would run into regulatory problems withOfwat having expressed concern regarding proposals by water compa-nies to create separate non-profit making activities to own assets.

distribution business which would fit alongside its(formerly Sweb) electricity operations in the south westof England, with the business management of Hyder’spipeline network and water treatment assets sub-contrac-ted to United Utilities, which would also purchase oneof Hyder’s non-regulated businesses — Hyder BusinessServices. The retailing of water services would continueto be run by Hyder, with both arms of the water businessowned by WPD. The total value of both the rival bidsreportedly amounted to more than £2.3 bn. including£1.9 bn. of Hyder debt, a significant portion of whichrelated to Welsh Water.

While it is currently idle to speculate on future devel-opments and their various implications at company andregulatory authority levels, recent events indicate that theHyder Group’s life as an independent entity is at an endsuggesting that its version of the multi-utility strategyhas failed. This would seem to be in direct contrast tothe experience of United Utilities as may be indicatedby the latter’s own involvement in a bid for Hyder.

2. Financial performance

A critical indicator of the success of the multi-utilitystrategy pursued by Hyder is its reported financial per-formance. It has to be recognised that good financial per-formance is not solely dependent on a sound corporatestrategy but the method used to finance the strategy isalso of significance. While it is important that a companyshould be profitable, it is just as important that it shouldbe liquid and solvent (i.e. able to pay its debts as theyfall due). Shareholders may concentrate on the long-termcash generating prospects of a company but if short-termcash flow difficulties takes the firm into receivership thelong-term becomes rather irrelevant. In contrast, liquid-ity is probably more important for short-term lenders,especially suppliers of goods and services on credit, andbanks and other providers of short-term unsecured debt.

Some indicators of Hyder’s financial performance forthe last five years are provided in Table 1 which containsfigures for profit, net assets, long-term debt, and netinterest payable. These variables are important as theyenable us to consider Hyder’s capital structure in termsof the debt and equity finance mix which may potentiallyexplain the failure of the company’s multi-utility strat-egy. In consideration of the regulatory climate affectingHyder the table also includes figures for ordinary tax-ation.

The table highlights the two key aspects of Hyder’sfinancial performance: profitability andliquidity/solvency. Each of these warrants some com-ment.

249D. Thomas, M. Zaman / Utilities Policy 8 (1999) 247–250

Table 1Hyder Plc financial performance (£ mn.)a

Profit and loss and balance sheet 1995 1996 1997 1998 1999

1. Turnover 521.9 651.6 1140.2 1185.1 1294.42. Operating profit 127.2 125.9 277.6 244.7 296.63. Profit before interest and tax 128.2 128.6 284.4 264.2 331.34. Net interest payable 7.8 15.7 76.2 95.7 123.65. Ordinary taxation 19.0 19.0 23.6 13.9 10.36. Profit after interest and tax 101.4 93.9 184.6 2127.3 197.47. Profit available for equity holders 101.4 86.1 168.1 110.9 181.08. Net assets 1180.9 848.1 952.5 773.5 900.49. Long term debt (LTD) 435.4 1167.9 1123.7 1622.4 2147.010. Equity shareholders’ funds 1180.8 641.5 746.0 566.9 691.211. Market capitalisation 897.0 1053.0 1130.0 1459.0 1187.0Ratio Analysis12. Gearing: LTD/market capitalistion 49% 111% 99% 111% 181%13. Gearing: LTD/net assets 37% 138% 118% 210% 238%14. Return on capital employed 7.9% 6.4% 13.7% 11.0% 10.9%15. Return on equity 8.6% 13.4% 22.5% 19.6% 26.2%16. Interest cover (no of times) 16.4 8.2 3.7 2.8 2.7

a Source: Hyder Plc Annual Report 1999 and Hemscott.

2.1. Profitability

O The figures reported in rows 2–3 and 6–7 show Hyd-er’s profitability. Regardless of which measure of pro-fit is used the figures indicate a general upward trend.Compared to the 1995 position both operating profitand profit after interest and taxation have more or lessdoubled in 1999. This trend is further confirmed bythe ratios relating to return on capital employed(ROCE, row 14) and return on equity (ROE, row 15).While ROCE (defined as profit before interest andtaxation over capital employed) relates the net incometo all sources of capital, ROE (defined as profit avail-able for equity shareholders over equity shareholders’funds) is often deemed to be the critical measure asit is return on investment that is the motivation forinvesting in shares. Both ROCE and ROE show ahealthy picture of Hyder’s profitability, althoughadmittedly the large increases in ROE may be attri-buted to the changes in capital structure (see below).

O In analysing Hyder’s performance it is important toconsider the effect of taxation. The figures in row 5show that the ordinary tax burden on Hyder has notaffected its overall profitability. Although the impo-sition of the one-off windfall tax explains the afterinterest and tax loss of £127.3 mn. in 1998 its impo-sition does not appear to have had any significantimpact on either ROCE or ROE.

2.2. Liquidity and solvency: the financing decision

While the above analysis indicates that Hyder hasbeen a profitable concern; it is equally important to

examine the company’s liquidity position enabling debtrepayments to be made when they are due. Companiescan normally finance their activities from two sources:equity provided by shareholders and long-term debt.Neither source of capital is free: the cost of debt is theinterest that has to be paid and the cost of equity is thereturns expected by shareholders. However, while inter-est payment is a fixed obligation (not dependent onprofitability) the company is not obliged to pay a divi-dend, which can only be paid out of profits, to its share-holders every year. In practice companies aim for a tar-get level of gearing (long-term debt/net assets) and anadequate interest cover ratio. In pursuing a multi-utilitystrategy, primarily through acquisitions, Hyder has reliedprimarily on debt finance. This financing decision, orchoice of financing method, may be linked to the follow-ing consequences:

O Table 1 (row 4) reveals that over the last five yearsHyder’s interest payments have dramaticallyincreased from a low of only £7.8 mn. to £123.6 mn.in 1999 amounting to around a third of the profitbefore interest and tax figure of £331.3 mn. The inter-est cover ratio (row 16) shows the effect of theincreasing use of long-term debt (row 9) to financeHyder’s operations and acquisitions.

O Hyder’s gearing ratio (rows 12 and 13) has dramati-cally increased over the last five years. In 1999 itsgearing, based on market capitalisation, was morethan 180 per cent, indicating a long-term debt almosttwice the then market value. The long-term debt,which is primarily made up of bonds and financeleases, is almost 2.5 times greater than the book valueof Hyder’s net assets.

250 D. Thomas, M. Zaman / Utilities Policy 8 (1999) 247–250

Table 2Hyder Plc cash flow (£mn.)a

Cash flow 1995 1996 1997 1998 1999£’000

Net operating 195.2 189.8 324.6 296.7 383.8cash inflowInterest paid 34.5 47.2 64.8 99.9 115.5Taxation 9.0 13.6 17.0 162.6 156.7Investing 179.8 755.6 265.6 382.2 381.6activitiesNew 93.1 569.2 615.0 482.8 621.5borrowingsRepayment of 3.4 3.1 533.4 150.1 9.5debtIncrease in cash 210.0 4.2 19.0 229.7 28.9

a Source: 1995–1998 OneSource for Windows and 1999 HyderAnnual Report.

O The capital structure, mix of debt and equity finance,explains the higher ROE compared to ROCE. ROEdoes not reflect the profitability of the firm as a wholeand the case of Hyder illustrates how a higher ROEcan be reported purely by increasing the proportionof the firm that is financed by long-term debt. Firmswith high gearing are expected to earn a higher returnon equity than firms with low gearing, but this is asso-ciated with higher risk which is not incorporated inthe ROE measure. The dramatic rise in gearing anddrastic fall in the interest cover ratio shows the highrisk of Hyder’s financial strategy.

O Further insight into the consequence of Hyder’sfinancing decision can be obtained by examiningHyder’s cash flow which provides evidence that it hasbeen continuously increasing its debt to finance itsactivities and expansion. The huge increase in newborrowings and investment activities in 1996 may beexplained by Hyder’s purchase of Swalec, and Table2 indicates that the company’s cash flow difficultiesbegan at that time with enduring consequences.3

O A comparison of Hyder’s new borrowings with cashoutflows on investing activities and interest paymentsshows that in 1999 cash outflow on investment activi-ties amounted to some 61% of the new borrowingsfigure with interest payment amounting to 19%. Therespective figures for 1998 are 79% and 21%, and43% and 11% for 1997. This clearly indicates that asignificant amount of new borrowings was necessi-tated by the need to service debt finance and to fin-ance investment activity which, for example, included£447.4 mn. in 1999 (and £412.3 mn. in 1998) for pur-chase of tangible fixed assets.

3 Hyder also paid the windfall tax out of borrowing with thedecision taken after early reluctance to do this given the initial prefer-ence (unlikely to have received Ofwat approval) to cut back on dis-cretionary environmental spending and abandoning the customerrebate scheme.

O A comparison of Hyder’s cash flow with that ofUnited Utilities is also quite revealing. In 1999 Hydergenerated £383.8 mn. cash from operating activitiesand had to borrow £621.5 mn. In contrast United Util-ities generated £811.4 mn. from operations andneeded to borrow only £152.3 mn. Moreover, UnitedUtilities annual cash outflows on investment activitiesover the period 1997 to 1999 were £616.4 mn., £696.7mn. and £649.3 mn. respectively. Despite its invest-ment activity being more or less twice that of Hyder’sfor the same period, United Utilities has not experi-enced similar difficulties. This further indicates thatHyder’s cash flow difficulties primarily relate to itsdebt finance position.

3. Concluding remarks

The above analysis indicates that the Hyder Group hasbeen a profitable company. Moreover, it suggests thatthe company’s current difficulties are a consequence ofits financing decision, in terms of its choice to financeits multi-utility strategy using debt, rather than a reflec-tion of endemic or generic flaws in multi-utility stra-tegies. On a more general issue, however, it may benoted that while it is true that Hyder, like United Util-ities, has been affected by the determinations of tworegulatory regimes, the negative effects of this exposurewere (or should have been) obviously apparent at thetime of the multi-utility move and would seemingly con-tradict any desire to diversify away from the constraintsassociated with the original core, regulated activities. Assuch, it would seem somewhat disingenuous for thecompany to blame its problems on regulatory decisionsor the imposition of the utilities’ windfall tax which hadbeen signalled by the Labour Government in advance ofits election.

Acknowledgements

The authors wish to thank the editor for helpful com-ments on an earlier draft of the paper.

Reference

McGuinness, T., Thomas, D., 1997. The diversification strategies ofthe privatised water and sewerage companies in England andWales: a resource based view. Utilities Policy 6 (4), 325–339.