Duke Energy officials said last week that 6,200 MW, or about 63% of the company's remaining merchant generation, will go on the auction block and will be sold separately from Duke Energy North America's (DENA) energy trading book. CEO Paul Anderson said the company intends to focus only on the Midwest merchant energy market and the sale of these assets will better prepare Duke for its $9 billion merger with Cinergy.
Duke announced its plans on Tuesday, saying it would take a $1.3 billion non-cash, pretax charge ($0.88 per basic share) in the third quarter after writing down the value of the generation assets and switching the accounting of DENA's book to mark-to-market from accrual. The sales are expected to generate total net proceeds of about $500 million.
Although the company made progress over the last year reducing DENA's asset portfolio -- it sold 5,325 MW of undervalued Southeastern power generation to K Gen Partners LLC for $975 million -- and improving its trading book, it determined that achieving its prior objective of reaching break-even financial results for DENA by the end of 2006 was "not realistic without taking on an extraordinary amount of additional risk."
"Because we are not willing to increase our risk profile, we believe it is best from a shareholder value standpoint to exit the remaining business," said Anderson. "Over the year ahead, we will be exiting DENA's trading book and working to achieve the highest value for DENA's remaining assets through sale or other disposition."
DENA reported a segment loss from continuing operations of $56 million in second quarter 2005, compared to a loss of $38 million in second quarter 2004. Duke CFO David Hauser said earlier this year that the company was looking for a joint venture partnership deal for the division. He said Duke was involved in discussions about a possible transaction.
In a conference call with analysts Wednesday, Anderson said after considering several options, including retaining the DENA operations or partnering with another company, Duke management determined this was the best course of action in preparation for the merger. The sales are expected to boost 2005 earnings per share by about 5 cents to $1.65 and should be completed within 12 months.
"Although we had several parties interested in working with us on the assets and the value of the generating assets has improved substantially since 2003, we've had great difficulty finding a workable model because of the size and complexity of the long-dated legacy positions in the trading book," Anderson told analysts.
"This complexity has prevented us from being able to form a joint venture on these assets or even sell portions of the book to interested parties. This is in part due to credit requirements and accounting standards which would have either influenced the form of the transaction or how the business would have ultimately been run."
He said the greatest economic value will be captured by breaking up the business into pieces and dealing with the trading book and power generation assets separately. "By dealing with the assets unencumbered by the book, their disposition will be greatly facilitated, and we believe we can better transact the disposition of the trading book by breaking it into multiple pieces as well."
In addition to the $500 million in net profit, Duke said the sales would add about $160 million in cost savings associated with combining DENA with Cinergy.
"The projected proceeds from the sale of the assets should more than offset the projected cash outflows from terminating the DENA [trading] book, including all tax impacts," said Duke CFO David Hauser. "Specifically we expect to be net cash positive."
DENA has a massive outgoing collateral position totaling about $1.6 billion, Hauser said. As a result, Duke Capital credit risk profile will improve significantly following the sale of the trading book.
Hauser said the $1.3 billion charge in the third quarter will include a $400 million impairment on the writedown of the company's generation in the Northeast and West to fair value. It also will include a $900 million net charge associated with bringing forward the value of DENA's gas and power derivatives on its trading book.
"We have sold power at prices below today's forward market curve so we will record a loss of $2.3 billion," Hauser said. "We have bought gas at prices below today's forward market curve so we will record a gain of $1.4 billion. The net of these two is...$900 million... The final piece of the calculation is a $300 million gain associated with gas trading that will be settled over the next 12 months."
Duke said it will remain active in the merchant power sector with DENA's 3,600 MW of remaining generation in the Midwest and Cinergy's 7,055 MW of power generation. Duke also will adopt Cinergy's trading platform going forward and will concentrate on building a regional business rather than trying to become a national energy giant.
Cinergy currently is among the largest gas marketing companies in the country by volume with about 5.86 Bcf/d of physical gas sales in the first quarter of this year. However, the company announced plans in August to scale back its gas trading operations after the wrong market bias led to a commercial gas division loss of 13 cents per share in the second quarter, which contributed to a 14% drop in Cinergy's second quarter net income.
"Exiting DENA's business outside the Midwest provides us with a fresh start and allows us to fully focus on the future," Anderson said. "The merger with Cinergy provides new opportunities and allows us to focus on the consolidation of the electric utility industry and on growing our gas businesses. We continue to anticipate closing on the merger in the first half of 2006."
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