Duke Energy is probably best known as a utility company offering electricity services to nearly 5.5 million customers across the Carolinas, Ohio, Kentucky and Indiana.

But Duke is a good deal more than just a utility company. Duke also owns more than 17,500 miles of natural gas and natural gas liquids pipelines, as well as storage and gas processing facilities. In fact, Duke is one of the largest midstream gas players--pipelines, storage and processing--in the US. 

During the past few months, Duke has announced plans to separate its business into two parts: the mainly regulated utility operations as Duke Energy and its midstream gas business to be called Spectra. Duke Energy expects to continue trading on the New York Stock Exchange under the symbol "DUK", while Spectra will be spun off in January and trade under the symbol "SE". Under current plans, every DUK shareholder will receive one share of Spectra for every two shares of Duke owned.

Both companies will continue to pay impressive dividends. In the company's most-recent conference call, management clarified the dividend situation for current Duke shareholders. Owners of 100 current Duke shares will have 100 shares in Duke Energy (DUK) paying an annualized distribution of 84 cents per share and 50 shares of Spectra paying 88 cents per share.

That's total dividends of $128 annualized on 100 Duke shares, or about a 4.1 percent yield, based on the company’s current price. But the potential of the deal goes far beyond immediate dividend income.

The benefit of the split is simple: Pure-play businesses are easier to value than conglomerates of businesses in different fields. Duke believes it can highlight the growth prospects of its various divisions more effectively by splitting into parts.

In addition, the Spectra business will become rather unique in the industry.
With Kinder Morgan soon going private, Spectra will be one of the only major publicly traded pipeline owners in the country, at least of its size.

In addition to the extensive pipeline network that Spectra already owns, the company has plans for at least two dozen major pipeline expansion projects in the next three years. With US gas and storage infrastructure woefully inadequate to handle the coming wave of demand, these assets will be extremely valuable. And with many of its pipelines regulated by the government, Spectra receives a stable return on capital invested in pipeline infrastructure.

Meanwhile, Duke Energy is attractive in its own right. Duke has been investing big time in scrubbers for its coal plants and in new clean coal technologies.

One power plant technology that bears careful watching is known as integrated gasification combined cycle (IGCC). In this plant design, coal is converted into a synthetic gas known as syngas. Because this conversion takes place in an enclosed space, it's easier to remove sulfur and other pollutants.

The gas is then burned to fire a turbine. In addition, the heat produced during the process of producing syngas is used to produce steam and run another turbine. A few small-scale IGCC plants have been built, and results are positive. Big companies such as Siemens and GE are currently leaders in IGCC plant construction. Among the utilities, Duke Energy has been at the vanguard of testing IGCC and other advanced clean power plant technologies.

This will vastly reduce the company's emissions of pollutants such as sulphur and nitrous oxides. Given the US’ increasingly stringent environmental regulations, Duke's extensive investments in these environmentally friendly technologies are a big positive.

In addition, Duke has been one of the leaders in filing for permits to build new nuclear facilities. As an experienced operator of nuclear facilities, it's a logical player in any new building. I see Duke as an early mover in the nuclear industry, another advantage.

Finally, the company's core market in the Carolinas is attractive. The utility industry is a regulated business, and regulators in these states tend to be quite friendly to Duke. They've traditionally allowed the company a fair return on its investment.

Here's where this deal gets a bit more complex. Spectra is planning to spin off some of its pipelines into a third company in the first half of 2007. This company will be listed as an MLP.

This is a huge advantage for Spectra because it has very attractive cash-generating assets to place in an MLP. The MLP's high-income structure makes it relatively easy and cheap to raise capital for further expansion.

And from an investors' standpoint, Duke has a great track record when it comes to MLP spin-offs. DCP Midstream Partners was part of a Duke-ConocoPhillips joint venture that was spun off in December of last year (see chart below). Since that spin-off, DCP Midstream has returned a whopping 60 percent to shareholders.


Source: StockCharts.com

Here's the trade. Duke plans to spin off Spectra in January 2007. The company has offered a few tantalizing glimpses into what Spectra will look like once that spin-off is complete, but it's now getting ready to sell this idea and the new company to shareholders in what's known as a "road show." That road show is coming up in December and will likely go on for much of the month.

This Duke marketing campaign should be a key catalyst for the stock and help to drum up interest from institutional investors. After Duke has sold the deal, it will release more details to the public; this will get investors fired up about the spin-off plan.

Although we still have a few weeks to go before the road show, I'd suggest buying Duke for a trade. My plan would be to hold Duke and accept the spin-off of Spectra in January, followed by the spin-off of an MLP in the first half of 2007. My take: The sum of these three parts will be worth significantly more than Duke is today.

Elliott H. Gue is editor of The Energy Letter.

© 2006 Elliott H. Gue
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