VERIZON COMMUNICATIONS’ (NYSE: VZ) November spinoff of its yellow pages directory unit has been a resounding success thus far. IDEARC (NYSE: IAR) shares are worth nearly 25 percent more than when they first began trading. And there are probably more gains ahead.

Utilities across the board are finding that dividing their operations can create interest in their stock and gains for shareholders. And deals completed to date have had considerably more plusses than minuses.

Most of the recent spinoffs have been simple asset sales that generate cash, cut debt and reduce operating risk. Verizon, for example, has sold several of its local phone line exchanges for cash, including a particularly profitable unloading of its Hawaiian landline division. Another of my favorites, ENTERGY (NYSE: ETR), was able to post blockbuster earnings for 2006 in large part on the strength of selling its energy trading unit.

Excitement over DUKE ENERGY’S (NYSE: DUK) spinoff of its natural gas operations as SPECTRA ENERGY (NYSE: SE) cooled somewhat and both stocks have settled back. But both of the newly separated companies are solid and based on 2006 results show every sign of becoming worth considerably more in the markets than they are now. 

Not every future breakup of a utility is going to prove so positive for investors. As an industry friend on the legal side has pointed out to me time and again, utilities tend to do things at the same time. And the herd is becoming increasingly enamored with spinoffs as a way to get investors’ attention and push up share prices.

The good news is, in contrast with many past examples of the industry’s herd-like behavior, the urge to divide is, at worst, neutral for operating risk. In the mid-1990s, the groupthink was that every utility needed its own energy trading arm. Few realized the inherent risks and most wound up big losers. The same thing happened to the pack of utilities that invested overseas a few years earlier. And it happened to the horde that invested in unrelated businesses ranging from drug stores to insurance companies in the late ’80s.

Spinning off operations, in fact, will likely reduce operating risk, by forcing management to concentrate more closely on remaining operations. Rather, the danger is that companies will sell valuable assets for too little and/or reinvest the proceeds poorly.

Virtually all major utility asset sales or spinoffs are handled by Wall Street investment bankers with every motivation to fetch the highest possible price. But a company that wants to make a big  splash in the market may not be willing to wait for it.

As for reinvesting the proceeds, the safest way to assure shareholders get the best return is to simply dish out the proceeds as a special dividend. We’ve seen several Canadian income trusts take this route over the past year, including TRANSFORCE (TSX:TIF.UN, OTC: TIFUF). In a much larger deal, British water utility KELDA GROUP (London: KEL, OTC: KELGF) is distributing the proceeds from the sale of its US water unit, Aquarion, early this year.

American companies generally have been loath to share cash spoils. Most use the proceeds from asset sales to buy back stock, pay off debt or else make more acquisitions.

Of those three choices, paying off debt has the surest result: improved credit quality and higher earnings due to lower interest expense. Unfortunately, it also has the lowest potential payoff and it can be expensive, with interest rates still at relatively low levels.

Too much debt repayment may be very tax inefficient, and regulators could also reduce returns in some states. Consequently, aside from comeback utilities like AQUILA (NYSE: ILA), CMS ENERGY (NYSE: CMS) and SIERRA PACIFIC RESOURCES (NYSE: SRP), debt reduction from asset sales is best done only in measure.

Stock buybacks have been popular on Wall Street for some years. By reducing the number of shares on the market, companies increase the amount of profits per share as well as book value per share. All else equal, that will mean a higher share price.

Most utility asset sales will probably involve buybacks to some extent. But utility stocks have been rallying for four years plus from the late 2002 lows and most are no longer particularly cheap. Management thus runs the risk of buying a richly priced stock when it could have used the money for more profitable moves.

The highest potential rewards in the long-term will come from using asset sale cash for further acquisitions. The best of these will focus on the more profitable areas of the utility’s core business. In effect, such moves are a redeployment of cash from riskier businesses less related to the ute’s core business to operations that enhance the company’s core competencies. As a result, they’ll increase long-term profitability and dividend-paying power.

The main risks are that management will buy a bad asset or pay too much for something. Either way, returns won’t measure up to expectations. The company’s earnings will lag projections and its share price will suffer. In a worst-case, the acquisition could sink the fortunes of the entire company.

The upshot: When a utility sells an asset, there’s tremendous potential upside as well as risk. The result will depend mainly on management’s foresight and acumen, but also to a large extent on factors beyond its control--such as the economy and markets--and sometimes blind luck.

THREE DEALS

Thus far in 2007 there are three major spinoff deals worthy of comment. One has just occurred, one will probably happen in the next couple of months and the third will probably consummate at the end of the year.

Of the trio, the last holds the most reliable outcome for  shareholders: Verizon’s planned spinoff of its rural phone
operations in Maine, New Hampshire and Vermont and their subsequent merger with FAIRPOINT COMMUNICATIONS (NYSE: FRP).

The deal must win regulatory approvals in all three states, as well as on the federal level, a process that will likely take most of the year. When completed, Verizon shareholders will own 60 percent of a new Fairpoint serving 1.6 million regional customers.

These assets were an afterthought, at most, for Verizon. Even in the rural areas, copper wireline franchises are dropping customers to wireless and Internet phone service providers. Companies have offset the revenue losses by upselling customers to broadband Internet service. But the result is still slow- to no-growth operations that have depressed Verizon’s otherwise robust wireless and broadband growth, stalling its share price.

Shedding these assets will mean faster growth for Verizon. And, because it will assign debt to the spun off operations, it will strengthen the company’s balance sheet as well. The result should help its share price.

As for FairPoint, more lines means greater ability to upsell broadband service as well as boost cash flow by cutting costs. The company expects to hold its dividend through the merger. In fact, management states that the deal will shore up the current rate for some years to come.

We’ve already seen one successful deal of this type, ALLTEL’S (NYSE:AT) spinoff of its rural wireline assets and their subsequent merger with Valor Communications to form WINDSTREAM (NYSE: WIN). Both Alltel and Windstream have prospered--Alltel through growth and Windstream with its huge, well-protected dividend. The package is already worth 25 percent more than it was when the deal was consummated, and should go a lot higher given the takeover interest for Alltel.

With the FairPoint spinoff, Verizon is unloading a much smaller part of itself than Alltel did. That reduces the risk to shareholders, as well as the expected returns. But the deal should nonetheless dish out a similar kind of rewards: a fat dividend from FairPoint and faster growth and capital appreciation for Verizon.

ENTERPRISE PRODUCTS PARTNERS’ (NYSE: EPD) spinoff of its natural gas liquids business as DUNCAN ENERGY PARTNERS (NYSE: DNP) is already a done deal. Duncan began trading on January 31 at $22.50 and has already ticked up nearly a dollar a share. Enterprise itself is up a few cents a share.

Enterprise is spinning off 66 percent of the following assets to Duncan: Natural gas liquids and petrochemical storage facilities consisting of 33 salt dome caverns in Mt. Belvieu, Texas, a natural gas pipelines segment consisting of the Acadian Gas System in Louisiana, 284 miles of petrochemical pipelines and a 290 mile natural liquids pipeline segment in south Texas.

In return, Enterprise receives a 35.2 percent limited partner interest in Duncan, with rights to subsequent cash flows from the projected 40 cents per share quarterly dividend. It retains effective control of the assets--since the general partner interest is run through them--and has a right of first refusal to buy the assets back if Duncan should ever sell.

Enterprise will also receive roughly $411.2 million in cash from Duncan as compensation, consisting of proceeds from the initial public offering, as well as $200 million of a $300 million credit line taken out by Duncan. In addition, it retains contractual service agreements and other relationships as well and it’s also agreed to indemnify Duncan from environmental liability with the assets.

The assets are substantial. However, they represent only about 5 percent of giant Enterprise’s current makeup. They’re also not core to the LP’s central offshore infrastructure business.

In effect, this deal amounts to another step in Enterprise’s financing of its $1.6 billion capital spending plans over the next year or so. Coupled with already completed financing--including the issuance of a convertible security--it should limit the need for another substantial share issue later this year, when financing of limited partnerships may not be as favorable. That should allow greater predictability for cash flows and distributions, even as the LP continues to add to its base of fee-generating energy infrastructure assets.

If there is a drawback, it’s the increased complexity for Enterprise overall. Duncan’s prospectus is quite lengthy at 169 pages plus numerous attachments. Even the flow chart--which attempts to simply explain the ownership structure--has been broken into two parts, one to show the relationship between the new entity and Enterprise, and another to show Enterprise’s place in the greater firmament of its effective general partner Don Duncan. Also, as the prospectus makes clear, there are possible conflicts of interest between the various component entities.

I’m always a skeptic when it comes to complexity. The good news here is all of the assets are solid and are generating strong cash flows. And, since they represent only a small part of Enterprise overall, even in a worst-case the distribution won’t be impacted. In fact, by selling assets and thereby limiting its need to access capital markets--likely well into 2008--it reduces near-term business risk for the LP overall. Enterprise’s 6.3 percent dividend increase last month and solid 2006 and fourth quarter earnings report are further reasons to have confidence in the LP’s long-run prospects.

The third major utility spinoff/asset sale now in the works is potentially far more significant to the key player, DOMINION RESOURCES (NYSE: D). The Virginia-based integrated energy company is currently taking bids for the bulk of its natural gas and oil production assets and expects to announce winners later this month.

The assets have an expected price tag of $15 billion to $20 billion, either as a package or in pieces. That’s an amount roughly equal to Dominion’s entire debt load and over half its current market capitalization. And it doesn’t include the company’s Appalachian oil and gas properties, which account for around 15 percent of the total.

For Dominion, there are several motivating factors for this deal. Obviously, the projected after-tax takeaway of $13 billion to $15 billion creates a lot of options for management to reduce business risk, strengthen the balance sheet and broaden its platform for future growth in more reliable businesses.

The oil and gas assets were primarily acquired with the Consolidated Natural Gas merger earlier this decade. Since then, the company has been extremely successful building both reserves and production, particularly in the Gulf of Mexico, and the division has steadily grown.

Earnings, however, have been extremely erratic. In 2005, with hurricanes Katrina and Rita wreaking havoc in the Gulf, production suffered but profits boomed, with higher oil and gas prices contributing 55 percent of Dominion’s overall earnings. That figure fell to only about 35 percent this year, as falling energy prices depressed margins.

That kind of volatility is in sharp contrast to the rest of Dominion’s operations, which have been a study in strong and steady growth. The company’s Virginia electric utility is on the verge of becoming a fully regulated monopoly again, as the state abandons its experiment with deregulation. Its pipeline and gas storage operations are extremely profitable. So is the company’s unregulated power plant portfolio, which in recent years has taken a decided tilt towards nuclear and wind.

Shedding the bulk of the oil and gas production operation will dramatically improve earnings visibility and smooth out volatility from quarter to quarter. That, in turn, will give analysts greater confidence in forecasts and will likely earn the company a higher market valuation. The utility is also likely to earn a credit rating upgrade, reducing borrowing costs.  And the deal will allow management to focus on growth of its more stable businesses from both an oversight and capital spending perspective.

Selling the assets does present management with a significant challenge: It must redeploy the money wisely and swiftly in order to avoid a drop in shareholder value.

One option would be to pay a large special dividend to shareholders. That would be most welcome. More likely, we’ll see some combination of acquisitions, debt reduction and a large share buyback. The ongoing speculation on Wall Street is for a buyback of roughly $3 billion.

Management has also announced it wants to reduce debt substantially, with the goal of achieving a funds from operations-to-debt interest ratio of 4.2, a debt-to-capital ratio of 50 percent and funds from operations-to-total debt ratio of 20 percent. That will almost surely earn the company a credit rating boost from is current BBB.

The proceeds from this deal would also be enough to buy out the majority of Dominion’s utility neighbors in virtually all-cash deals. That’s unlikely. Rather, the company will have the cash and improved financial position to buy and/or build strategic assets in its core power and pipelines businesses, and possibly some oil and gas production as well in key areas.

The more simplified Dominion would also be more attractive as a takeover target itself, though regulatory approvals would be time consuming. Also, there’s the theoretical possibility of a further spinoff or limited partnership for some of the natural gas assets, though nothing has been said to date on the issue.

Until there’s a definite selling price and management announces its plans in detail, there will be some uncertainty with Dominion shares. But given management’s demonstrated skill in building the oil and gas assets and its conservative bent, the likely outcomes here are all good for shareholders.

That may not be the case with all such deals to come down the pike in the next several years. History shows the longer a trend like this persists, the slimmer the pickings for investors, and the greater the hype as well. Dominion, Enterprise and Verizon appear to be doing the right thing for shareholders.

And that’s good news for all three going forward.