Oh power of Scotland: the surge to merge

If ever there were two companies that needed each other, it is Scottish & Southern Energy and Scottish Power. Both FTSE 100 busi- nesses, they have nevertheless been left out in the cold in the grim climate of the British electricity market.

The crash in wholesale prices, the virtual collapse of nuclear generator British Energy and the growing dominance of continental predators have made the sector an inhospitable place to trade in.

Both companies will put a brave face on things this week when they post their financial results. They are expected to reveal solid figures. But at their respective presentations, Scottish & Southern's chief executive, Ian Marchant, and Scottish Power's Ian Russell will face more than just the usual questions on earnings per share and margins.

There is growing pressure on the two companies to merge. Many City analysts and shareholders believe that by huddling together for warmth, the two independent survivors of the deregulated electricity market will stand a chance of competing against Germany's formerly state-owned E.ON and RWE and France's soon-to-be privatised EdF.

If they fail to tie the knot, it's only a matter of time before they too will be taken over by a continental empire builder.

For nearly a year there has been chatter in the Square Mile and its Edinburgh equivalent, Charlotte Square, that the companies are in talks. When asked this week, both will deny it. But sources at Scottish & Southern and Scottish Power aren't closing the door on the idea. "There is nothing going on at the moment. Who knows for the future?" said one.

The companies have a similar market capitalisation. They both own two distribution businesses and a modest portfolio of power stations. Their fortunes, on the other hand, have little in common.

Scottish & Southern is a success story. Formed by the merger of Scottish Hydro and Southern Electricity four years ago, the business has earned a strong following in the City for its relentless drive to cut costs and deliver shareholder value.

Most of its success is down to former chief executive Jim Forbes, who retired in October. Nicknamed "The Jockweiler", he left the company with a strong balance sheet and five million customers.

A recent report by Credit Suisse First Boston (CSFB) rated Scottish & Southern as one of Europe's most efficiently run utilities. The investment bank esti- mates that only £50m of costs could potentially be stripped out of the business, through a relatively small redundancy programme. This has posed a problem for new chief Ian Marchant, at 41 one of the youngest FTSE 100 bosses. With Scottish & Southern already so lean, where's growth going to come from?

His first response was to bid for TXU's European supply business, which was eventually snapped up by Powergen last month. Scottish & Southern is now in the running for Midlands Electricity.

And missing out on TXU has done Mr Marchant no harm. Martin Brough, an analyst at Dresdner Kleinwort Wasserstein, says: "The fact that Scottish & Southern ... lost out to Powergen should be encouraging to investors in the sense that the prudence and financial discipline that [the company] had a reputation for under Jim Forbes appears to have been continued by Ian Marchant."

Scottish & Southern's pleasure, though, has been Scottish Power's pain.

In October 2000 both shares were trading at over 500p. Today, Scottish Power's shares are worth 354.5p to Scottish & Southern's 637.5p.

CSFB believes Scottish Power isn't as efficient as its rival and £585m could be stripped out in costs. The bank sees "significant upside potential" for Scottish Power, which has 3.5 million customers.

The other reason for Scottish Power's fall is the US. After paying £3.8bn for American utility PacifiCorp in 1998, it had to admit last September that the business would take a $300m (£192m) charge after misjudging electricity prices in western America. As shares tumbled so did the reputation of Scottish Power's 49-year-old chief, Ian Russell.

There are now signs that PacifiCorp is turning the corner, which is expected to be reflected in Scottish Power's second-quarter results on Tuesday.

Unlike Scottish & Southern, Scottish Power did not bid for TXU. And despite the speculation, it is not planning to bid for Midlands Electricity. Instead, the company sees its growth story in the US and in streamlining its own business.

So here are two companies: Scottish & Southern, with a strong balance sheet but searching for growth; and Scottish Power, with growth prospects but in need of cash.

On paper, the urge to merge should be strong. On top of this, a union would create a company with 8.5 million customers. Mike Duggan, of utility consultant AMT-Sybex, says this would promote the pair "from the First Division into the Premier League of UK energy companies", rubbing shoulders with EdF and E.ON. More customers brings greater opportunities to sell higher-margin products and services, adds Mr Duggan.

However, there are two huge obstacles in the way of a merger. The first is the personalities of the two chief executives.

Mr Russell has a reputation as a slick operator. Some find him a little too slick, however. "You have to read between the lines with him," says one analyst.

Mr Marchant, on the other hand, is described as "earthy and straightforward". Some, however, feel he lacks experience.

There are two schools of thought on who should get what job. Some believe Mr Marchant should be chief executive while Mr Russell should become non-executive chairman. Others argue that because of his greater experience, Mr Russell should take the top job and Mr Marchant should become finance director – a position he held at Scottish & Southern before being promoted.

In reality, neither man would be prepared to take a subordinate role. For a deal to happen, one of them would probably have to go.

The second issue is competition. While the likes of RWE, EdF and E.ON have been allowed to build up powerful positions in UK utilities, none owns four distribution businesses. A merger between Scottish & Southern and Scottish Power would therefore be automatically referred to the Competition Commission.

What's more, the Scottish Office holds "golden shares" in both companies. This opens the possibility of political influence over any deal, as the Office would have the power to veto a merger.

Despite these obstructions, the pressure on the pair to explore a merger is increasing. If they don't, they could find themselves subject to a less friendly approach from a hungry continental rival.