Water, water everywhere - and RBS knows how to turn it into profits

IT'S amazing what banks get up to. While Royal Bank of Scotland's (RBS) £48 billion bid for ABN Amro continues to be the focus of attention at Gogarburn Towers, it would not do to overlook some of the smaller pots that chief executive Sir Fred Goodwin has on the boil.

The business of Southern Water is one of these. But it is one RBS has now nicely brought to the boil.

RBS never really meant to desert its adding machines to go into the business of water supply and leakage control for four million customers in the south-east of England. But it came by a business financing route to acquire a 49 per cent stake in Southern Water and a "majority economic interest" five years ago.

Now it has appointed Deutsche Bank to prepare a sale. The rumoured price is 4bn - a valuation that might come to mark the top of the cycle for water companies.

It's certainly a figure that will cause some spillage among Southern Water's former owners - ScottishPower (SP).

Those who think that utilities are best owned by utilities (and banks by banks) will find this episode a telling coda to the demise of ScottishPower and its recent disappearance into the hands of the Spanish concern Iberdrola with barely a note of shareholder dissent. The Southern Water saga may be one of the reasons.

ScottishPower acquired the company in a contested bid back in June 1996 paying an inflated price of 1.7bn. Even the Scottish Council for Development and Industry (SCDI) weighed in with a sonorous endorsement and backing for the bid. Since the SCDI is so often wrong, this should have acted as a warning cone. Sadly, few noticed.

Six years later, in the spring of 2002, with little evident contribution to the bottom line and water utilities wildly out of favour, ScottishPower chose this time to offload the business for 2bn. Clearly the synergies had not materialised to the extent imagined.

The announcement was notable for the 6.6 per cent tumble in ScottishPower's shares that day. Ian Russell, then chief executive, also announced that SP would be paying "a significantly lower dividend" from 2003-4. As the main reason for holding utility shares was the dividend stream, the news caused pandemonium. Shareholder loyalty never recovered from this blow.

Analysts calculate that the mooted 4bn price would represent a premium of between 25 and 33 per cent to the value of its asset base, against a premium of just 4 per cent achieved by ScottishPower.

Small in relation to RBS' other concerns at present, it looks a sensible non-core disposal that would help release cash at a useful time.

Mega-stock performance

HAVING extolled the defensive virtues of large capitalisation stocks here last week after the huge outperformance by smaller companies, I was (almost) talked out of it by Ed Beal, manager of the highly successful Dunedin Smaller Companies Investment Trust, at a packed AIC roadshow in Dunblane last Wednesday.

Smaller companies, he reminded us, have had a great run, they have shown greater earnings growth and their forward price earnings multiples are only marginally higher than their mega-stock counterparts. Other positives included the level of merger and acquisition activity and investor appetite for risk. Why desert them now?

A gently bearish Brian Tora put the opposite view with great elegance. And being rather wary of what may be in store for markets as interest rates rise further, I re-iterated the defensive case for big cap companies.

Last Wednesday was not a good day for shares large or small: the FTSE100 index closed more than 100 points down, and Thursday saw a continuation.

But there are currents within currents. And I noticed that a key feature of trading on Thursday was the strength of the large cap stocks. Seven of the FTSE100's largest - Vodafone, GlaxoSmithKline, BHP, Billiton, Royal Dutch Shell, BP, RBS and HSBC - were among the day's 11 blue-chip risers.

A day's experience doesn't prove much. But on a day when the mid cap FTSE250 fell by 156 points, or 1.3 per cent, on significantly higher volumes, the market does look to be shifting to a more cautionary position.

Unilever bite

ONE mega stock of interest is Unilever, one of the world's largest manufacturers of packaged consumer goods.

It has not always been interesting. Indeed, for most of the past five years it has underperformed the FTSE100 (see chart).

But the group may be coming back into favour, helped by the global rise in food prices, new management and a commitment to turnaround.

It enjoys a thriving business in the developed world and has attractive growth opportunities in large emerging markets.

Shares in Unilever currently stand at 1,515p (down from 1,674p recently), where they yield 3 per cent. Pre-tax profits this year are set to hit 4bn.

Fund management group SVM expects the stock's rating to move up closer to its competitors, such as Nestl, as management restructuring takes effect. I see no reason to differ.