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Duke's Risky Spin

Lackluster interest in Duke post spin-off bodes ill for the “pure play” electric utility.

Fortnightly Magazine - February 2007

that investors who want a low-risk, low-growth electric utility are not the same investors who want a high-growth, high-risk gas company. Those advisors say that “paring down” the utility and making each business more transparent to investors will create more shareholder value.

Kenneth Marks, managing director, Morgan Stanley, in our January issue, said: “Such spinoffs will be driven by the need to enhance shareholder value for the parent company, as well as improve the prospects for the spun-off venture.”

(Editor’s Note: Lehman Brothers advised Spectra Energy and Morgan Stanley and Merrill Lynch advised Duke Energy on the spin-off).

The spin-off strategy assumes that the parts when added up will prove more valuable than the unified whole (like stolen cars headed for the chop shop). Furthermore, according to one analyst who asked to remain anonymous, spin-offs can be one of the riskiest strategies because you don’t know until long after the spin-off whether you have succeeded. There is always a danger that the spin-off takes out of the business that which was “sexy” or appealing to investors, leaving the parent without a growth story. This seems to be the fate of Duke, although the judgement is based only on early reactions from analysts.

Merrill Lynch sell-side equity research analyst Jonathan Arnold did not seem impressed with Duke Energy after its move. In a Jan. 4, 2007, report, he lowered Duke Energy’s rating from “buy” to “neutral.” Arnold wrote that Duke Energy now represented a “modest total return opportunity.” As though confirming the gas business was a major source of value for Duke Energy, the Merrill analyst said, “Unlocking the value from Duke’s gas business had always been the main premise for our ‘buy’ rating on Duke, and with this done we now see the ongoing company as trading close to fair value.”

When questioned about Merrill’s position, Duke Energy’s Hauser pointed out that the research analyst has a 10 percent total return threshold to warrant a “buy” rating. Merrill’s Arnold predicts Duke Energy will have a total return in the 9 percent range. “First of all the difference between nine and 10 on a projection is a really small difference. Secondly, we have laid out that we expect our earnings to grow 4 to 6 percent and our dividend to grow in parallel with that. So, if you were at the bottom of that range, at the 4 percent, you’d be at less than a 10 percent total, and if you are at the top of that range you’d be above a 10 percent total,” he says.

That may come to be true, as Hauser predicts, and perhaps Arnold’s threshold is too exacting. But how to explain that, at press time, Thomson Financial equity research analyst consensus estimates showed only one “strong buy” with four regular “buy” and 14 “hold” recommendations on Duke Energy, post spin-off?

By the Numbers

Some analysis suggests that spin-offs can be lucrative. According to Lehman Brothers, since 1990, the average spin-off from the investment bank’s sample outperformed the S&P 500 by 13.3 percent in its first year as