Some partners turn to the quick sale to raise capital and dress up performance.
Analysts cite several reasons why energy companies might wish to execute a spin-off:
* To cover a failed merger,
* To raise cheap capital, or
* To boost valuation of a diversified company.
In fact, many newly merged energy companies will fit into this last category. No longer just power companies, they now own merchant generation, transmission, pipelines and telecommunications assets.
Also, the energy industry lately has pursued equity carve-outs, a type of spin-off to help the parent raise capital, clarify focus and highlight the subsidiary's independence.
A carve-out lets analysts follow a previously obscured business more accurately, says Jeffrey R. Holzschuh, managing director at investment bank Morgan Stanley Dean Witter. The higher valuations of the carve-out typically are reflected in the parent company's stock, he adds.
Enron's Azurix Spin-Off
Enron recently carved out its water assets in Azurix, says Joe Cornell, president at SPIN-OFF Advisors L.L.C., but retained a 69 percent stake.
"They did a partial spin-off for no other reason than it is cheap access to capital. [Furthermore], they might not do the full spin," he says.
Azurix was formed by Enron to acquire, manage and develop water and wastewater businesses around the world. With deregulation sweeping through the water industry, Azurix plans to acquire water companies formerly owned by the government.
In its first major purchase, Azurix bought Wessex Water in the UK for $2.4 billion, according to Spin-Off Research, an investment advisory firm. Later it acquired water businesses in Argentina, Brazil, Canada and Mexico.
Duke's Gas Gathering Spin-Off
In mid-December 1999, Duke Energy and Phillips Petroleum agreed to carve out Duke Energy's gas gathering and processing businesses and Phillips Petroleum's Gas Processing and Marketing to form a mid-stream company called Duke Energy Field Services, according to Duke Energy. DEFS will become the nation's largest mid-stream natural gas liquids business, according to Morgan Stanley's Holzschuh, which represented Duke Energy in the deal.
"They were the No. 1 and No. 2 competitors in that sector. We are combining them to create an entity that is three times larger than its next-closest competitor," he says.
"That business, we believe, ought to trade in the public markets at a substantially higher valuation than it now trades underneath the Duke hood," adds Holzschuh.
Assuming the new company's value ranges between $5 billion and $6 billion, Duke Energy's equity ownership in DEFS following the initial public offering will range between 55 percent and 57 percent, and Phillips Petroleum's post-IPO ownership would range between 23 percent and 25 percent, according to Duke Energy. Approximately 20 percent of the new company's equity will be offered in its IPO, which is expected in the first quarter.
Holzschuh describes what this type of deal might mean for the energy industry:
"It means you are going to see people separate their generation from their transmission and distribution. It means you are going to see people potentially separate their midstream from their downstream, separate non-regulated businesses from their regulated businesses."
He adds, "You are going to see more of what we call pure plays. More and more companies will sell stocks based on one segment of the business."
Holzschuh explains that the investor with an appetite for a pure natural gas liquids company is not the same investor that wants to own the transmission and distribution business.
"[T&D] is a dividend-paying, low-risk, slow-growth [business] vs. a commodity-driven, much higher paying [niche] that is natural gas liquids," he says.
"[Furthermore], that may be another way the company divides itself to, in effect, have the same company they had before, but have different characteristics of each of those shares results in a much higher combined valuation."
Subsidiaries With Separate Valuations
There are three ways to create a subsidiary valued separately by the market, according to a McKinsey Quarterly Report.
1) Tracking Stocks. Also known as targeted stocks. A class of parent company stock that tracks the earnings of a division or subsidiary. Typically distributed as a dividend to shareholders in the parent company, these shares also can take the form of an IPO.
2) IPO Equity Carve-Out. An initial public offering of a stake in a subsidiary. The parent usually keeps majority ownership.
3) Dividend Spin-Off. The entire ownership of a subsidiary is divested as a dividend to shareholders.
A Spin-Off At Williams?
Joe Cornell of SPIN-OFF Advisors says that Williams Communications will have to be spun-off from its parent company so that it may increase the parent's earnings per share.
"Last year Williams, a Tulsa-based energy company, carved out Williams Communications Group, their fiber-optic group," he says. "They sold less than 20 percent to the public and they retained more than 80 percent of the shares. They still have the bulk of the control of that company."
What is interesting about Williams, says Cornell, is that now that both pieces are trading, it is easy to calculate the value of the spin-off.
"If [you] back-out their ownership stake in the [partial] spin-off, you are valuing the energy pipeline at about $3 per share. We think that the Williams Energy pipeline assets are worth about $20 a share," he says.
Cornell predicts that the parent will spin off the rest of its ownership to shareholders of Williams in the not too distant future. He explains his valuation this way:
"Since you know that Williams Communications, whose minority stake is trading in the public, you can take the shares outstanding and multiply that by the market price and come up with a market capitalization of the communication assets and multiply that by how much Williams still owns."
Williams Communications, trading under WCG, was carved out as an IPO on Aug. 11 and raised $680 million and was priced at $23, according to Cornell.
"At the end of December it was trading around $29 a share, so it was up 25 percent," he says, adding that the parent still owned 83 percent of the company. "There seems to be some inefficiency here. For whatever reasons, the telecommunication assets are getting a large valuation relative to Williams.
"We think that people like us and the financial community will say there is a mismatch in the valuations that can be easily cleaned up if Williams spins off the rest of Williams Communications as a stand-alone business, and the market will be forced to value both pieces separately. That should generate shareholder value," Cornell expounds.
How Investment Can Mask Value
It seems counter-intuitive to sell a business unit that initially raised the stock value of the parent company, such as Montana Power, Enron and Williams, which all have pursued a telecommunications strategy. But in the end, says Cornell, the diversification into telecommunications can mask the true value of the company.
"I am sure when they did this deal for Williams Communications, when they raised $600-plus million, some of that money was dividend back to the parent company. By doing that, I am sure they got some access to some capital at a more attractive rate than if they were to try to do a secondary offering on a stodgy old energy company," he explains.
"Sometimes you see these things where the parent really isn't getting the full value for their ownership in a partial spin-off. So they will go the full route and give the 80 percent to their Williams' shareholders in the form of a tax-free dividend," he says.
Moreover, Cornell believes that companies such as Enron and Montana Power may pursue a similar strategy of completely spinning off their telecommunications subsidiaries to better value each business unit.
In the case of Montana Power, Cornell says the market perceives it as a power company and in spinning off the telecommunications assets, its stocks probably will get a much higher multiple.
It appears that from electric deregulation to mergers and consolidation, a new trend may be emerging in energy - fragmentation.
Richard Stavros is senior editor at Public Utilities Fortnightly.
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