UK water group AWG (formerly Anglian Water Group) has attracted more than its fair share of attention from the finance community over the last year. The reason for this is not hard to fathom: in November last year the firm announced a radical restructuring of its operations which has involved splitting the group into two discrete operations. These are a ring-fenced, debt financed company which will concentrate on the regulated water business known as Anglian Water Services (AWS) and AWG, which will focus on infrastructure and management activities (see Project Finance May 2002, page 19). This move put into action what a lot of UK water utilities had been talking about for a long time ? a restructuring designed to improve profitability in a heavily regulated industry in which most operating efficiencies have already been achieved.

Details of the proposed return of capital and issue and redemption of redeemable shares associated with the restructuring were issued on 21August 2002. There is a proposed cash payment to shareholders of £1.77 per ordinary share (achieved by issuing bonus shares on October 15 this year which will be subsequently cancelled in consideration of the cash payment). This will be voted on at an EGM on September 13 with the issue of redeemable shares taking place on September 23. The capital repayment follows on from the issue of £1.76 billion ($2.68 billion) of new debt which has increased gross borrowings to £3.48 billion (including the group debt of £1.72 billion which has been transferred from the infrastructure and services businesses to AWS). AWS has retained a cash balance of £205 million of the new debt as a liquidity reserve.

With the hard work of the £2.6 billion restructuring now safely under its belt it is up to AWG to make sure that the benefits that this upheaval was implemented to achieve actually materialise. As group director of strategy, Iain Robertson is one of the key AWG executives charged with that responsibility. He is a relative newcomer to the company, having joined when AWG took over Edinburgh-based construction company Morrisons in 2000. He was previously chairman of the Scottish Highlands and Islands Enterprise agency for 10 years. Robertson sees the future for AWG as a ?network infrastructure services group? which will concentrate particularly on government and utilities business in the UK. ?Most of our growth will be in the UK and we expect double digit growth in these two areas,? he declares.

More effective and efficient utility service provision has become the holy grail of the UK utilities sector and AWG has undergone a radical transformation to this end. The Huntingdon-based company was established in 1989 ? when the Water Industry Act created 10 private companies in this sector. After a restructuring in 1999 it became the first domestic UK water company to expand into other service areas. The latest restructuring has seen a classic unbundling of asset ownership and management, with the latter activities having been reorganised into five areas within a single company. These are: utilities; government services; project management and development; property development and international services. The company claims that the restructuring ?will significantly enhance AWS' ability to finance its operations in the debt capital markets and enable the group to reduce materially the cost of capital employed in the regulated business?. What it also clearly does is shift debt from the balance sheets of the group's other businesses, freeing them up for further growth.

The driver behind this growth is the need to move into higher margin businesses. This will be achieved by the group moving further up the value chain in its targeted areas. Robertson believes that the company is ideally placed to do this as it can marry its skills in running a network to a host of different activities. ?The skills are interchangeable between the water, electricity, telecoms, rail and gas sectors,? he notes. He also adds that AWG has one significant advantage over most of its rivals in service provision. ?We are a group with service capability but with an asset as well ? water. This means that we are not reliant on revenues,? he says ? noting that the only other UK utility group that really matches AWG in this is United Utilities.

Robertson describes AWG group chief executive Chris Mellor as ?visionary? in implementing this focus for the infrastructure and services businesses. Unfortunately, Mellor has been called several other things by disgruntled shareholders following what Robertson describes as the ?key acquisition? in this strategy ? that of Morrison Construction. ?With Morrison, the group acquired huge utility services and contract services expertise which has given the group a new range of skills and a commercial sharpness,? says Robertson. ?It was a key acquisition of a lean and aggressive organisation.? At the time of the deal Mellor described Morrison (which AWG acquired for a headline cost of £262 million but in reality an all-in cost believed to be closer to £300 million) as ?cheap? and a ?quantum leap forward? for AWG. The reality two years later is that AWG has written off £100 million on the acquisition so far thanks in part to damaging cost overruns on six of Morrison's contracts. A side effect of this is that while group turnover at AWG was increased from £1.28 billion in 2001 to £1.8 billion in 2002 profits have been severely hit. The firm made £137.3 million profit before goodwill, tax and exceptionals in 2002 (down from £153.8 million in 2001) but this figure has been significantly reduced by those exceptionals. The total restructuring and refinancing costs amount to £63.9 million and, as mentioned, costs associated with Morrisons amount to roughly £100 million. This includes £60 million impairment of assets and £39.3 million from revised property valuations. The net result is that a profit is turned into a loss by exceptional costs amounting to a full £174.3 million for the year (£19.9 million in 2001). It is not surprising that some investors are seething ? although the return to shareholders of around £500 million by means of the restructuring should serve to smooth a few ruffled feathers.

Not surprisingly, Robertson glosses over the problems at Morrison, saying that AWG is now solely concerned with ?taking the business forward?. Maybe so, but rumours are rife that the company is considering suing the former owners of the company for overpayment. AWG is understood to be in the final stages of a legal investigation and will decide whether or not to press ahead in October. In the meantime, Morrisons has provided AWG with the kind of construction expertise that it is looking for in targeting its two main growth areas: government services and utility services. At first glance these types of activities are hardly the kind of high margin businesses that will keep shareholders happy but Robertson outlines other advantages that will be the key to the strategy's success. ?These are long-term contracts which play to our public and private sector skills,? he tells Project Finance. ?The government is looking for best value and wants reliable partners for the long-term. It is steady work for a good income and we are still scratching at the surface of the number of activities that could be outsourced.?

AWG achieved an operating profit on its PPP and public sector technical and facilities management activities of £7.5 million in 2002, up from £6.1 million the year before. Turnover was, however, significantly up from £47.7 million in 2001 to £71.2 million. The company has expended into local government outsourcing (it has signed facilities management outsourcing contracts with Norwich City Council and North Lanarkshire Council) where margins are extremely tight ? a fact clearly demonstrated by the slim increase in profit achieved from a 50 per cent increase in turnover. But AWG justifies the move ? saying that it delivers continuity of earnings over long contract periods of up to 10 years. It has, however, also signed four PPP contracts over the last year ? involving a £100 million wastewater contract for the North of Scotland Water Authority, a £74 million housing contract with the Ministry of Defence, a £45 million school refurbishment and rebuilding contract with West Lothian Schools and a £69 million hospital contract with Nuffield Orthopaedic NHS Trust in Oxford. The firm calculates that the MoD business generated £40 million in revenue in 2002, West Lothian Schools £27 million and Nuffield £36 million.

Robertson is optimistic about the growth potential going forward. ?Now that we have a network of our own and a construction company of our own we have the depth of resource to compete in this ? very competitive ? sector,? he says. While a lot of the services are ?at the bottom of the tree? in terms of the value chain, the aim is to cut the company's teeth in this type of activity which will provide ?more than a foot in the door? for the higher value contracts. He explains that AWG is specifically targeting these types of activities because of the growth potential they represent. ?Government and utilities services are not opportunity constrained,? he enthuses. ?They may not be exciting in margin terms but in volume terms they are very exciting.? AWG is putting its money where its mouth is and has recently acquired a utility services company, which Robertson describes as ?fulfilling a particular niche.? Details of the acquisition have yet to be publicly revealed.

But how will this growth be paid for? Clearly the restructuring has freed up considerable borrowing capacity and the firm will continue to refine its activities around its core areas. As a result its housebuilding business, Morrison Homes, was put into play in July. ?Building homes is not in our strategy,? says Robertson, while emphasising that a sale is not essential. ?It provides a good income if we hold it and a good cash windfall if we sell it.?

Beijing No 10 - end of an era?

AWG has successfully expanded internationally and its international activities contributed operating profits of £24.2 million in 2002 (£16 million in 2001) on a turnover of £212.6 million (£195.6 million). It has invested in Chile, the Czech Republic, China Ireland and Thailand. The company exited its US businesses in 2000. Two of its investments have performed particularly well: ESVAL in Chile and VAKJC and SmVAK in the Czech Republic. Esval has posted a first half profit of $11.8 million ? up 18.9 per cent on the same period last year. But in 2001 a full 87 per cent of sales were UK-sourced, with just eight percent from Europe and five percent from elsewhere. Despite two high-profile new overseas contracts in Ireland and China these percentages look unlikely to change dramatically.

?To be a global player in the water business we would need a balance sheet to rival that of RWE, Suez or Vivendi ? which we do not have,? says Iain Robertson. He therefore reiterates that the group's focus is now heavily UK-based. ?Our international business is not getting large amounts of group equity invested in it as we simply don't have the critical mass to take on the big boys,? he says. That being said, Robertson emphasises that AWG is happy with the international investments that it has and does not discount further activity. ?There is a lot you can do without involving huge slugs of equity,? he notes. ?We are monitoring the situation but are not going in for huge equity plays right now.?

Project Finance suggested that this was, perhaps, a surprising stance given the recent announcement of one of the company's largest overseas investments: together with partner Mitsubishi Corp the company is involved in the largest water project in the international water market ? known as Beijing 10. The $200 million DBO contract covers the construction and operation under a 20 year contract of a water treatment plant in Beijing. The contract also involves the construction of a 76km pipeline from the Miyun reservoir. AWG and Mitsubishi were named preferred bidders for the deal in April 2001 and it took nearly a year of negotiations before contracts were signed this April and work on the financing could begin. AWG itself is expected to put up around $30m in equity for the deal ? as will Mitsubishi. The remaining $140 million is likely to be raised with multilateral agency support. It is not clear whether AWG has cooled on its international activities since this deal was first mooted but Robertson states that ?there are unlikely to be many more Beijing-type transactions? in the near future. Maybe future business on the scale of its Irish operations is more likely. In December last year the company signed a £5 million 10-year contract with Sligo County Council for the operation of a new water treatment plant known as Foxes Den. This was the first water treatment operations contract to be awarded in the Irish Republic. AWG has also initiated a programme to halve the leakage of Dublin's sewage treatment works.