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Analysts Expect Southern Union to Eye LNG, LDC Spin-Offs

Southern Union shares slipped slightly Thursday but remained near a 52-week high after its largest stockholder, Sandell Asset Management Corp., on Tuesday reiterated its demands for strategic changes or an outright sale of the company and vowed to wage a proxy battle to seek the election of three candidates to Southern Union's board.

Observers said Southern Union's management may share Sandell's concerns and may already by considering some of the suggested actions. "We believe [Sandell's] latest overtures may spark more management action," said analyst Craig Shere of Calyon Securities. "We now believe that some of [Sandell's] recommendations could begin to be implemented in the coming year.

"The first value creation step may be a [master limited partnership (MLP) initial public offering] of SUG's LNG terminal (with proceeds possibly used for share repurchases)," said Shere.

In the letter to Southern Union CEO George Lindemann on Tuesday, Thomas E. Sandell, whose fund owns about 9.8% of the company's common stock, said up to $12 per share of value could be created through a three-step restructuring of the company. "Specifically, our plan calls for 1) a sale of the remaining LDC assets [in Missouri and New England] as soon as practicable; 2) the creation of an MLP with the Trunkline LNG terminal; and 3) an increase in annual dividends to $1.00 per share.

"Based on our calculations, the first two steps would be both accretive to earnings (2008E) and deleveraging, giving Southern Union the necessary flexibility to increase the dividend to a level consistent with its public company peers as well as to fund increased share repurchases," Sandell said.

In a previous letter to the board on June 27 outlining strategic alternatives, Sandell said the company could "narrow the very significant gap between the SUG stock price (then $26.26) and what we believe is its intrinsic value of $35 per share. Furthermore, we illustrated how the company could be worth in the $36-$41 per share range through the creation of a MLP and increasing annual dividends to $1.00 per share.

"Five months have elapsed and there has been a lack of constructive response to our position." Sandell said if the board is unwilling to restructure it should put the company up for sale. SUG shares were down nearly 3% Thursday afternoon to $28.94.

Sandell also announced that Castlerigg Master Investments Ltd., an affiliated investment fund, has notified Southern Union of its intention to nominate three independent candidates for election to the board of directors at the 2007 annual meeting.

Castlerigg also has filed a lawsuit against the company charging that the director nomination provision of Southern Union's bylaws is invalid. The lawsuit alleges that the challenged bylaw provision is an entrenchment device that purports to strip stockholders of their right under Delaware law to nominate director candidates by providing that candidates must be approved by a hand-picked committee of incumbent directors.

"We will continue to make every effort to work constructively with the board and management in our efforts to focus them on delivering maximum value for the benefit of all stockholders," said Sandell. "We each have a significant vested interest in seeing the company's valuation improved."

"We'll have to see where this goes," said another analyst, "but the Lindemann family owns a lot more of the company than Sandell does, and I doubt any buyer would be too interested if Lindemann isn't on board with a transaction.

"I think the Sandell letter at its core is correct," the analyst added. "I think management is reasonably onboard with the idea that their stock is undervalued and that they have some opportunities, some of which were mentioned in the Sandell letter. They probably are pursuing some of those already."

Shere said he expects the LNG MLP to be the most attractive near-term opportunity. The recently constructed and pending upgrades to the terminal "have aggregate [earnings before interest, taxes, depreciation and amortization] of $110 million off a $415 million capex investment," he said. "These recently constructed, fully contracted LNG-related projects would be prime assets for a yield-oriented tax-deferred MLP...

"We expect any meaningful dividend increase may be more of a late 2007 or early 2008 phenomenon...." He noted that SUG is likely to be "cash flow negative in 2007" but should see that reverse in 2008. The company's longer-term growth investment plans have been reduced because of the recent swap of Transwestern pipeline assets for Florida Gas Transmission interests.

In Shere's view, the least likely value driver is the sale of SUG's gas utility operations in Missouri and New England. Although a sale might garner $1 billion, the tax hit would be about $400 million, he said. "If SUG were to consider selling remaining LDC properties, in our opinion it would be after they secured a pending Missouri regulatory rate increase and after an acquisition had been identified for a tax-free like-for-like exchange."

The other analyst, who asked not to be identified, agreed that an LDC asset sale would only occur only if SUG found another pipeline or midstream asset to buy.

Houston-based Southern Union owns and operates the nation's second largest natural gas pipeline system with more than 20,000 miles of gathering and transportation pipelines and North America's largest LNG import terminal. Through its LDCs, Missouri Gas Energy and New England Gas Co., Southern Union also serves half a million natural gas end-users in Missouri and Massachusetts.

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