Duke's Risky Spin


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

Fortnightly Magazine - February 2007

It was the most anticipated energy deal in the New Year, but not for the usual reasons. The spin-off of Duke Energy’s natural-gas business into a stand-alone company, Spectra Energy Inc., wasn’t unusually large, did not involve outsized personalities, and certainly did not involve a new strategy.

No, interest peaked because the transaction was to have marked the vindication of the so-called “pure play” electric strategy—the idea that an electric utility might maximize shareholder value by segregating returns associated with various asset classes. The deal also has captured attention because the spin-off represented a divestiture strategy that until now hasn’t been universally embraced, with gas assets still seen by some utilities as part of core operations.

The Spectra Energy spin-off (along with the Cinergy merger the year before) marks the reversal of the so-called Duke, PanEnergy transformational “convergence” merger that was to have taken advantage of opportunities in restructured electric and gas markets. This is the belief of Duke Energy CFO David L. Hauser and the observation of the Duke Energy Employee Advocate, an unaffiliated employee Web site.

For those of you who may not remember, a $7.7 billion transaction in 1997 united Duke Power’s electric business to PanEnergy’s natural-gas business—the third largest natural-gas company in North America at the time.

The merger created the energy merchant and energy services colossus that Duke Energy was during the late 1990s.

But the merchant overbuild, the Enron collapse, trading scandals, the California crisis, and the reversal of energy restructuring in the early part of this decade contributed to a period where Duke Energy, as one research analyst put it, “doubled debt, destroyed significant value, turned free cash flow negative, and substantially raised operating and financial risk.”

During the last few years, new corporate management has devoted itself to restructuring the utility’s balance sheet and returning Duke Energy to good financial health. And now Duke Energy has come full circle: It is once again a “pure play” electric utility, albeit a larger one than before.

This should be the beginning of a Hollywood ending, but it could be just the beginning of the beginning, as equity research analysts and investor research suggest Duke Energy may have been better off with its gas assets.

Following the spin-off, research analysts moved Duke Energy’s stock rating to “hold” or “sell,” or they maintained their previous neutral position.

The Value Proposition

While many utilities in the industry have been undertaking a “back-to-basics” approach over the last few years, this has not necessarily meant the disposal of natural-gas assets. In fact, over the last few years, many utilities have bolstered their growth profile through greater earnings from gas assets due to the run-up in natural-gas prices.

Take a look at almost any of the utilities in the September 2006 “Fortnightly 40,” the magazine’s financial ranking of the 40 best run energy companies, and you’ll find that diversified utilities with gas assets dominated the list. But some financial advisors have been telling utilities 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 a stand-alone company, while the average parent company outperformed by 14.4 percent in the 12 months preceding the effective date of the spinoff. But the report notes that spin-offs outperformed their sector during the first two years as a stand-alone company in every sector except energy.

The energy sector has had a mixed track record with spun-off companies. Who can forget the very public bankruptcies of Southern’s Mirant and Xcel Energy’s NRG Energy? But all indications are that the Spectra Energy spinoff is receiving a warm reception on Wall Street, and there already are rumors of buyout offers.

Duke’s Hauser explained that because Duke’s intent was to optimize shareholder value, Duke Energy shareholders were given shares in Spectra Energy. “All we did was take what was one piece of paper, and now the shareholders have two pieces of paper. The shareholders still own both companies to the degree they elect to keep both companies.”

Victory in the deal would be declared if the value of both companies goes up, he says. “But they don’t necessarily have to go up. You could have one stay pretty flat and the other one could go up dramatically, and you would still have success.”

For Duke’s sake, let’s hope the market eventually sees its parts as more like a Mercedes than a Yugo. But utility executives contemplating such strategies should be heedful of being taken for a ride.