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Duke Launches Divide and Prosper Strategy

With its natural gas and power businesses unbound from each other through a tax-free spin-off, Duke Energy management last week predicted 5-7% per share compound annual growth for the gas business and 4-6% for the power business, the new Duke Energy, over the next several years. Driving the growth will be an abundance of new-build and expansion opportunities in both gas and power.

In a widely expected but still bold move last week, Duke said it would spin off its gas business just one day after it told of plans to sell its newly acquired gas and power marketing unit (see related story). The move will put Duke just about back in the pure power and utility business, circa 1997, before its foray into the natural gas and high risk commodities trading arenas.

Duke said shareholders will own 100% of the equity in both Duke Energy and a new gas company. Duke officials had hinted they might spin off the gas business at the time they announced plans for their $9 billion stock deal to acquire Cinergy Corp. (see NGI, May 16, 2005), an acquisition completed just three months ago. Last Tuesday's divestiture was the sale of Cinergy's trading unit to the European merchant banking firm Fortis for $415 million. Duke, burned in the energy marketer collapse several years back, already had eased out of its own trading business.

If Duke gets the spin-off done by Jan. 1, 2007 as it plans, the separation of the gas business will come almost 10 years after the 1997 merger that united Duke Power and PanEnergy. The spin-off will mark one more step away from the gas-power double-bill strategy so popular around the turn of the century. It doesn't seem all that long ago when pure-play merchant generator Dynegy was called Natural Gas Clearinghouse and El Paso touted itself with the tagline "pipelines and power." Plans change.

"The picture's become increasingly clear that at this time the market places more value on pure-plays than on an energy super store," said Duke Chairman Paul M. Anderson during a conference call last week. "That's clear with 20-20 hindsight. It wasn't so clear in 1997 when PanEnergy and Duke Power combined to create Duke Energy in the heyday of deregulation. As you know, deregulation didn't happen as planned. You know the story. A few states saw limited success while most are still trying to find a workable model or trying to undo what they started. The anticipated electric and gas synergies failed to materialize and the rules changed in the process, prohibiting our affiliated businesses from interacting in ways that could have brought real value to both shareholders and customers."

But Duke isn't looking back. Instead, the new Duke Energy will be concentrating on opportunities to come from the nation's next power generation build-out. And once the gas business has a name there will be a panoply of new-build and expansion projects from the wellhead to the citygate in which the midstream sector leader might participate, executives said.

"This decision has been our top strategic priority in recent months and we expect to deliver significant long-term value to our shareholders by pursuing this transaction," said CEO James E. Rogers, who was Cinergy chairman prior to its merger with Duke. "As stand-alone companies, our electric and gas businesses will be extremely well positioned to meet the energy challenges facing our country and the growing needs of our customers, as well as to provide strong growth for shareholders."

Lehman analyst Daniel Ford upgraded Duke Energy to overweight from equal weight on the news of the spin-off. He said the separation move will expose the full value of both the gas and power businesses. Ford said the new gas company should trade on par with similar pipeline operators and predicted 20% upside from the current share price for Duke Energy.

Charlotte, NC-based Duke's board approved the deal last week and authorized management to create two publicly traded companies. The new gas company will consist of the Duke Energy Gas Transmission (DEGT) business unit, which includes Union Gas, and Duke Energy's 50% ownership interest in Duke Energy Field Services (DEFS). Fred Fowler, currently group executive and president of DEGT, will serve as president and CEO of the new gas company.

According to Fowler, there is plenty of work to be done in the midstream gas industry.

"Many of the largest pipeline infrastructure players actually spent very little time on pipeline expansion over the last five years," Fowler said. "They were focused instead on fixing their balance sheets after forays into merchant power and marketing and trading. The problem was that during this same period we did see North American gas consumption increase, but production did not keep pace. And then we saw a fly-up in commodity prices, and as they increased we saw a lot of drilling in unconventional formations become profitable. And we're also seeing new LNG [liquefied natural gas] that has begun to find its way to our shores."

Connecting new and developing supply basins and providing the processing and long-haul transmission necessary to make LNG-based supplies a reality are what the new gas company will be doing in the months and years ahead.

"Also, our customers and regulators have awakened to the need for additional [gas] supplies coming from more diverse sources," Fowler said "As they lived through what has to be called a white-knuckle period after two years of unprecedented back-to-back hurricane damage to offshore facilities, which reduced critical supplies from the Gulf of Mexico."

Taking a page from Kinder Morgan Energy Partners and other master limited partnerships (MLPs), Duke executives last week said some of the gas company's pipeline assets could wind up in an MLP themselves. Coincidentally, also predicted to strengthen the value of the gas business on Wall Street is the pending privatization of Kinder Morgan Inc. (KMI) through its management-led buyout now under way (see NGI, June 5). KMI's exit from the Street will mean one less natural gas play with which Duke's gas business will have to compete for investors, executives explained.

On the power side, the businesses remaining in Duke Energy will be the U.S. Franchised Electric & Gas utility business unit, the Commercial Power business unit, the International business unit and Crescent Resources.

The transaction is expected to qualify for tax-free treatment for U.S. federal income tax purposes to both Duke Energy and its shareholders. Duke shares ended the week at $29.39, near the top of a 52-week range of $25.06 to $30.55.

When the spin-off is completed, Anderson will be going back to where he came from, sort of. The Duke board said he will be named non executive chairman of the gas company's board of directors. Anderson was CEO of PanEnergy at the time of the Duke Power-PanEnergy merger. He then served as president and COO of Duke Energy. He left Duke Energy in 1998 to become managing director and CEO of BHP Ltd., which later merged with Billiton PLC to create BHP Billiton, the world's largest diversified natural resources group, which Anderson led until retiring in 2002. Then in October 2003, it was announced that Anderson would return and take over for Duke Energy's retiring Chairman Richard B. Priory as chairman and CEO (see NGI, Oct. 13, 2003). At the time of the hard-fought Cinergy merger it was decided that Rogers would lead the company as CEO and Anderson would be chairman.

Last week the Duke board also announced that Greg Ebel, currently president of Union Gas, will be chief financial officer (CFO); Alan Harris, currently group vice president and CFO of DEGT, will serve as chief development officer; Bill Garner, currently group vice president for corporate development at DEGT, will be general counsel; Martha Wyrsch, currently president of DEGT, will serve as president and CEO of the new gas company's transmission business, which will include natural gas transmission, storage, the Western Canadian gathering, processing and natural gas liquids operations, and Union Gas; and Bill Easter will continue as president and CEO of DEFS, reporting to the DEFS board of directors.

Upon completion of the gas company spin-off, Anderson will resign from the Duke Energy board and Rogers will be appointed chairman. Rogers will also continue in his role as president and CEO. David Hauser, currently group executive and CFO, will also continue in his role.

Duke Energy currently ranks 117th in the 2006 Fortune 500 ranking of America's largest companies. As stand-alone entities, it is anticipated that both Duke Energy and the new gas company would continue to be Fortune 500 companies.

The gas company will be one of the largest gas transmission, storage, gathering, processing and distribution businesses in North America, with more than 18,500 miles of natural gas transmission pipeline, 250 Bcf of gas storage capacity and 1.3 million retail gas customers in Ontario, Canada. Through its 50-50 joint venture with ConocoPhillips, it will also be the largest producer of natural gas liquids in the United States. Duke Energy expects the gas company, which will be headquartered in Houston, to have ongoing earnings per share (EPS) growth on average in the range of 5% to 7% annually over the next five years.

Upon completion of the spin-off, Duke Energy will be one of the five largest electric utilities in the United States, consisting of the U.S. Franchised Electric & Gas business unit, operating as Duke Energy Carolinas, Duke Energy Indiana, Duke Energy Ohio and Duke Energy Kentucky. These utility businesses will continue to rely on approximately 28,000 MW of nuclear, coal, natural gas and hydroelectric power generation to serve 3.8 million retail electric customers in five states across 47,000 square miles of service area. The company will also continue to serve 500,000 retail gas customers in Ohio and Kentucky.

The Duke Energy portfolio will also include Duke Energy's International business unit, with operations in eight Latin American countries; Duke Energy's Commercial Power business unit, with approximately 8,700 MW of nonregulated electric generation primarily in the Midwest; and Crescent Resources, a real estate company.

Duke Energy expects that after completion of the spin-off, Duke Energy's ongoing EPS will grow on average by 4% to 6% annually over the next five years. The company will continue to be headquartered in Charlotte.

Duke Energy and the new gas company will be capitalized to provide financial flexibility to take advantage of growth opportunities. After completion of the spin-off, both companies are expected to have financial policies, balance sheets and credit metrics commensurate with solid investment-grade credit ratings. At the time of the separation, the sum of the two companies' dividends will be equal to the current Duke Energy dividend. The specific dividend allocation between the two companies will be determined closer to the date of the spin-off.

The final terms of the spin-off transaction are subject to subsequent approval of the Duke Energy board of directors. Consummation of the proposed transaction is subject to certain conditions, including final approval of the Duke Energy board, receipt of confirmation of the tax-free treatment of the spin-off, receipt of certain regulatory approvals, and the filing with the Securities and Exchange Commission (SEC) and the effectiveness of a registration statement on Form 10. The registration statement on Form 10 is expected to be filed with SEC in third quarter 2006. Shareholder approval is not required.

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