By Ryan Barnes. Edited By Douglas A. McInyre

Duke Energy Corp. (DUK) – Price $20.16; Break-up Value $29

Duke has been a company struggling for a new identity ever since its disastrous foray into retail energy in the late 1990’s.  The company is still mainly a generator and transmitter of electricity in the U.S. Southeast, and they also have operating segments in natural gas storage, international power, commercial power (wholesale energy trade), and real estate. 

Duke recently became a break-up value success story in the making by completing a split-off of its natural gas transmission system as Spectra Energy via a dividend to existing shareholders.  It was long-awaited for by investors as the value of the natural gas assets, including over 17,000 miles of pipeline, was considered undervalued when measured alongside the more stodgy electric generation assets. 

Duke is still busy integrating the Cinergy merger of 2005, which added to their generation and wholesale assets.  Duke just doesn’t seem to want to give up on the wholesale trade segment, instead choosing a “get bigger to get better” strategy that is the point of some contention among many investors and more than a few analysts. 

If Duke were to unload the wholesale generation, international, and real estate segments the stock would easily command a premium multiple to its peers.  This is because Duke has one of the largest nuclear reactor collections in the country; nuclear power has extremely high up-front costs but once complete is a much cheaper source of power than traditional coal and gas plants.  As such the core generation segment of the company sports a 22% operating margin, well above industry averages of 14-16%. 

The Crescent Resources segment, which represents the company’s real estate venture, was recently split with Morgan Stanley 50/50.  Duke’s share earned roughly $280m in 2006, and the segment could be divested for 4-5 operating earnings, bringing about $1.2 of cash into Duke Energy.

The International Power segment has been a dog for quite a while, and it just doesn’t seem to fit with the company’s strategy.  They’ve had multiple operational missteps in the past two years, causing charges that are hitting consolidated company earnings.  This segment should be sold off in one chunk or piecemeal, whichever gets the divestiture done the quickest.  The segment should go for the low end of industry multiples, adding another $2.5 billion to the company coffers.  In this scenario the most likely use of cash proceeds would be to pay down some LT debt and work the total debt/cap down to the 55-65% range, which would provide some lift to the multiple as well. 

With these 2 sales Duke would be left as a very high-margin generator & transmitter of electricity and natural gas, a strong enough operator to command the high end of industry valuations – somewhere in the range of a 17-19 P/E, or 11-12x operating earnings.  If you’ll notice we’ve left the wholesale segment with Duke at this point; selling it off is probably in shareholders’ best long-term interests, but it just wouldn’t fetch an attractive price at this point.  We’ll have to settle for letting Duke try its hand at turning it around one more time.  The segment represents less than 10% of company revenues, so it shouldn’t dampen the valuation too much unless it ceases to be at least a break-even business.  We’ll account for it by reducing Duke’s multiple post-sales to 10x operating earnings, bringing the total break-up value in our opinion to $29/share, excluding the Spectra Energy split which is already off the books. 

Ryan Barnes

Ryan Barnes has over 10 years’ experience in portfolio management and investment research, covering equities, fixed income, and derivative products. Ryan spent the past 5 years working as an institutional trader & manager for high-net worth investors, working with Merrill Lynch, Charles Schwab, Morgan Stanley, and many others.  Ryan is currently working as a writer and financial modeling consultant on hedging and capital appreciation strategies, and does not own securities in the companies being covered.

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