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Planned Duke Energy-Cinergy Marriage to Likely Speed Up Consolidation

Last week's thunderclap of news that Duke Energy Corp. agreed to acquire Cincinnati, OH-based Cinergy Corp. in an all-stock deal valued at about $9 billion, following on the heels of Exelon's pending acquisition of Public Service Enterprise Group (PSEG), is a "key signpost" that the energy industry is firmly on the road to recovery and that the process of rationalizing the industry for the next stage of growth is under way, Colorado-based consultant Global Energy Decisions said last week.

"Duke's acquisition of Cinergy will likely speed the industry consolidation at the utility level and among merchant energy companies and their major suppliers, where you could see consolidation of as much as 50% of the players," said Gary Hunt, president of Global Energy Advisors, a Global Energy Decisions business unit.

The planned merger of Duke Energy and Cinergy would create a formidable utility company with 5.4 million natural gas and electric customers. Company officials also hinted the future might see Duke splitting off its natural gas assets and going forward as a pure electric play.

The new company, to retain the name of Duke Energy Corp. will have approximately $27 billion in annual revenues and $1.9 billion in annual net income, and will -- on a combined basis -- own or operate approximately 54,000 MW of electric generation domestically and internationally (35,000 MW from Duke Energy, and 19,000 MW from Cinergy). It would provide a "profitable, sustainable merchant business" for Duke Energy's generation business, Duke Energy North America (DENA), said Duke Energy Chairman Paul M. Anderson.

DENA has had sagging profits over the past years and Duke had been looking for a buyer or partner in the venture. While awaiting regulatory approval of the proposed merger, Duke Energy "[will] continue to look for options to grow DENA," such as joint ventures and "other ways to position" the generation business, Anderson noted. The company is not going to be "sitting on its thumbs."

In addition to aiding DENA, Duke Energy's long generation capacity position in the Midwest will be available to help Cinergy's short capacity position in the region, noted Cinergy Chairman James E. Rogers.

A "good portion" of the Duke Energy portfolio will not be affected by the proposed deal, including the company's natural gas pipeline, field services and international operations, the Charlotte, NC-based integrated energy company said. The combined company will have assets totaling more than $70 billion, and a market capitalization of $36 billion.

The transaction was unanimously approved by both companies' boards of directors. The transaction also will require the approval of the shareholders of both companies, as well as a number of approvals or reviews by federal and state energy authorities, including state regulators from North Carolina, South Carolina, Ohio, Kentucky and Indiana; the Federal Energy Regulatory Commission; the Nuclear Regulatory Commission; the Securities and Exchange Commission; and the Department of Justice. FERC Chairman Pat Wood indicated last week that the agency would condition its approval of the Duke Energy-Cinergy marriage on Duke Energy joining a regional transmission organization (RTO).

Duke Energy officials expect the transaction to close in the summer of 2006. The company said it plans to file with all the state agencies by June 30.

Under the merger agreement, each common share of Cinergy will be converted into 1.56 shares of Duke Energy upon closing of the merger. Cinergy investors are expected to receive 13.4% above the $40.36/share that the company's stock closed at on May 6. Duke Energy shareholders will own about 76% of the total 1.3 billion shares, while Cinergy shareholders will own approximately 24% or about 310 million shares of Duke Energy shares outstanding.

The proposed merger is expected to be accretive to earnings by about 10-15 cents/share over the 2006-07 Wall Street estimates, according to Duke Energy.

Upon completion of the transaction, Duke Energy's Anderson will be the chairman of the board of the combined company. Cinergy's Rogers will become president and CEO of the new company. The new board will include 10 members named by Duke Energy and five members named by Cinergy.

"I know a lot of you've been speculating on what type of transaction we might do next...I'm very happy to say -- this is it," Anderson said last Monday during a briefing with investors on the planned merger. "We are bringing together two premiere franchise electric utility platforms," noted Rogers.

The transaction will form a utility business with 3.7 million retail electric customers and 1.7 million retail gas customers in Ohio, Kentucky, Indiana, North Carolina, South Carolina and Ontario, Canada. The retail electric businesses will have more than 25,000 MW of generation capacity.

The combined company also will include Duke Energy's major natural gas pipeline assets (Texas Eastern Transmission, Algonquin Gas Transmission, East Tennessee Natural Gas, BC Pipeline, Maritimes & Northeast and Gulfstream), along with storage assets, about 57,000 miles of natural gas gathering pipeline and processing facilities.

Anderson indicated last Monday that the new company may split its gas and electric utility businesses in the future. "If they are separated, I would expect...the gas company would probably look to consolidate with other players in the gas industry...Duke Energy would be at that point a pure-play electric company with a fairly diverse set of assets in terms of fuel mix, in terms of geographic territory and in terms of regulatory environment. And I think that we would be in a very good position at that point to further consolidate [with the] electric industry," he said.

Following the merger, the combined company will be a registered holding company with corporate headquarters in Charlotte, NC. The local headquarters of the operating utilities will remain unchanged by the merger: Cincinnati Gas & Electric and Union Light, Heat & Power will remain in Cincinnati; PSI Energy will stay in Plainfield, IN; and Duke Power will continue to be headquartered in Charlotte. Duke Energy Gas Transmission and certain commercial operations will remain in Houston, TX. Duke Energy Field Services will remain headquartered in Denver, CO, and Crescent Resources will continue to be located in Charlotte.

Duke Energy estimates the transaction will result in about $400 million in annual pre-tax savings by the third year from the elimination of duplicate spending and overlapping functions, improved sourcing strategies, avoidance of planned expenditures and the consolidation of non-regulated business unit operations. The combined companies currently employ about 29,350 workers, and are expected to see a reduction of approximately 1,500 employees, primarily through attrition, early retirements and other severance programs. Employees in the natural gas, nuclear and international operations won't be affected by the reductions, according to Duke Energy.

Along with the merger announcement, Duke Energy's board of directors said it intends to increase the company's dividend by 12.7%, or 14 cents a year, for an annual dividend of $1.24. The dividend increase will be voted on during the board's June meeting, and would be effective with the September disbursement, Duke Energy said.

Meanwhile, two of the three major ratings agencies last Tuesday offered their initial reactions to the mega-merger news. Standard & Poor's Ratings Services (S&P) placed its "BBB/A-2" corporate credit ratings on Duke Energy and its subsidiaries on CreditWatch with negative implications. At the same time, S&P placed its "BBB+/A-2" corporate credit ratings on Cinergy and its subsidiaries on CreditWatch with negative implications.

S&P said that the CreditWatch listing on Duke reflects several factors. These factors include Duke's indication that it may pursue various strategic options after the merger is completed, including the potential separation of the regulated utility and pipeline operations; the possible expansion of higher-risk nonregulated activities; the challenge the company faces in achieving the estimated cost savings; and some uncertainty as to the final corporate structure of the merged entity.

"Standard & Poor's expects that the ratings on Duke Energy, post merger, are more likely to remain at current levels than be lowered, assuming no material increase in business risk or weakening in the consolidated financial profile," said S&P credit analyst Dimitri Nikas.

"Nevertheless, the nonregulated operations, particularly electricity and gas trading and marketing, could become a significant user of liquidity, including cash on hand and available credit facilities, under certain adverse market and credit conditions," said Nikas.

Furthermore, the merged companies could be challenged to fully exploit the targeted synergies among the merchant generation assets in the Midwest, S&P added.

For its part, Moody's Investors Service affirmed the ratings of Cinergy (Baa2 senior unsecured) and its subsidiaries Cincinnati Gas & Electric (Baa1 senior unsecured); PSI Energy (Baa1 senior unsecured); and Union Light Heat & Power (Baa1 senior unsecured). The rating outlook is stable.

The affirmation and stable outlook reflects Moody's expectation that Cinergy and its regulated utilities will become subsidiaries of a newly created holding company, although the ultimate legal and organizational structure of the new company still is being finalized. Moody's anticipates that no incremental debt will be issued by Cinergy or its utility subsidiaries beyond current expectations.

The merger is expected to offer modest opportunities for cost savings and economies of scale, and Cinergy could realize some benefits from being part of the much larger Duke Energy organization, Moody's added. "The merger also represents an opportunity for Cinergy to meet future capacity needs in its service territory with some of Duke's excess unregulated generating assets located in the Midwest. The merger will also diversify Cinergy's predominantly coal-fired generating assets with nuclear, gas, and hydro generating assets."

Moody's affirmed the ratings of Duke Energy (Baa1 senior unsecured) and Duke Capital LLC (Baa3 senior unsecured), and revised the rating outlook to developing for Duke Energy, Duke Capital, PanEnergy, and Texas Eastern Transmission.

The ratings agency said the developing outlook "reflects uncertainty regarding the ultimate placement of assets and liabilities within the different legal entities that would be part of the combined company that would result from the proposed acquisition" of Cinergy.

"This uncertainty reflects unresolved strategic issues for the company as well as the potential that regulatory approval may require changes in the transaction that could affect the financial and business risk profile of the merged entity and its subsidiaries. From a consolidated pro-forma perspective, we consider the acquisition by Duke of Cinergy to be largely ratings neutral, due to the 100% stock financing plan and Cinergy's relatively stable earnings and cash flow that are predominantly derived from its regulated utility business."

Moody's said the rating affirmation "reflects the steady cash flow profile of the combined entity's electric utility and gas pipeline operations, balanced against the more unpredictable real estate and international businesses, and the poorly performing U.S. merchant power business that currently is part of DENA."

With regard to Duke Capital, Moody's also considers the new holding company structure. "As a holding company, Duke Capital's new parent is expected to be a weaker entity than the existing owner, which is primarily a utility operating company. The Duke Capital rating continues to incorporate concerns about DENA, which continues to perform poorly and has a trading book that subjects it to volatility risks and potential calls on liquidity."

Moody's said it would readdress the developing outlook when there is more clarity on the placement of assets and liabilities by legal entity within the new organization.

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