Breaking up is easy to do when you unlock shareholder value. That's the animating notion behind Duke Energy's pending spinoff of its natural-gas-distribution assets into a new company, Spectra. Why the sum of the parts is worth more than the whole.
UNDAUNTED BY THIS YEAR'S MEGA-MERGER WITH fellow power producer Cinergy, Duke Energy already is plotting another transformative transaction: the spinoff in early January of its natural-gas opera tions into a new, publicly traded entity called Spectra Energy. Next week Duke executives are expected to hit the road to talk up the plan, and investors ought to listen.
Designed tounlockvalue, the spinoff is likely to render both companies worth more-in time, perhaps, much more than the consolidated whole. Based on valuations of similar utilities and pipe line concerns, Nathan ,Judge, an analyst at Atlantic Research in London, wagers it could produce about $37 a share of value,. some 17% above Duke's current share price of 31.50. "There are catalysts to release this value," he says. "Gas and field-transmission assets will be revalued upward as they deliver accelerated growth."
Judge Jigures Charlotte, N.C.-based Duke (ticker: DUK), one of the country's five largest electrics, could command a price of $23.60 a share as a standalone company, assuming it trades at a peer groupaverage of8.4 times Ebitda (earnings before inter est, taxes, depreciation. and amortization.) Spectra (SE), one ofthe nation's largest pipeline utilities, could trade for
$16.45, he says.
Viewed another way, investors who own Duke at to day's price theoretically will get stock in Spectra for only $8 or so per share. Duke holders are expected to receive one Spectra share for every two shares of Duke common.
John Bartlett, a utilities analyst with w.H. Reaves in Jersey City, N.J., calls an investment in Duke's stock "an excellent way to capitalize on both the need for new en ergy infrastructure and the potential for a higher valua tion as the market recognizes the strength of the underly ingutility business." Reaves Utility Income Fund (UTG) owned 1.95 million of Duke's 1.25 billion shares out..'ltand ing as of July 31.
This year, Duke is expected to earn $2 billion, or $1.81 a share, on revenue of$15.4 billion. In 2007, Bartlett expects the utility to earn $1.20 a share, and Spectra $1.45. Com bined, the companies will continue to payout $1.28 a share, for a yield of 4.10% based on Duke's current price.
The Duke/Spectra spinoff is the brainchild of Duke Chairman Paul Anderson, 61, a no-nonsense executive and motorcycle enthusiast who joined the company through its merger with PanEnergy in 1997. He left to help resuscitate Australian natm'al-resources giant BHP Billiton, only to return in 2003, at Duke's darkest hour, when the company was reeling from an ill-starred foray into merchant power. Hailed at the time for refusing to cut the dividend, he calls Duke's makeover a "labor of love."
For the past year or so, Duke has traded for 16-17 times 2006 estimates, roughly in line with other utilities. Ander son, who will become non-executive chairman of Spectra, believes the utility wasn't getting "fuil value" for its gas as sets, which include 17,500 miles of pipeline. "The market places more value on pm'e plays than on energy super stores," he says. "Pure-play businesses create a kind of gTanularity that increases management's focus, and are easier for investors to understand."
In addition, the two businesses trade differently, gas companies for multiples of cash flow and electrics for multi. pIes of earnings. Gas concerns command richer valua tions, in part because they make use of master limited part nerships, which allow them to pass through cash to inves tors on a tax-free basis. The average pipeline company trades for 10.9 times 2007 Ebitda, well above the 7 times Atlantic's Judge assigns to Spectra.
Spectra has underappreciated assets it could shel ter in MLPs, and fewer regulatory hurdles than elec tric utilities. (Pipeline outfits are regulated by Washing ton, but not by state and local governments.) With a spin-off, says Fred Fowler, 60, head of Duke's gas prop erties and the future CEO of Spectra, "you end up with an investor base that understands and appreciates such vehicles better than the typical utility investor."
Fowler also sees "an unusual number of expansion op portunities" for Spectra, due to underinvestment in pipe lines and storage, and rising demand. In the Northeast, for example, gas usage until recently was highly seasonal and consumer-driven. Soon, utilities will demand a steadier supply, owing to renewed gas-fired generation.
To be sure, the success of Duke's spinoff will depend as much on the continued growth of its electric arm, run by former Cinergy CEO James E. Rogers, 59. The utility, which primarily serves five states, should continue to en joy good relations with its customer base, and see high-sin gle-digit earnings gains.
Rogers has 2.2 million reasons for making the deal work, while Anderson has 1.4 million an&Fowler 1.2 mil . lion. That's the number of Duke shares owned by each. If all goes according to plan, the value of their holdings and all Duke investors'-will surge. _
