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December 19, 2001 



Reliant Energy Proceeds with Corporate Restructuring, Bucking Turnaround of Industry Trend 



By Will McNamara
Director, Electric Industry Analysis



[News item from PRNewswire] Reliant Energy (NYSE: REI) shareholders approved on Dec. 17 a major step in a corporate restructuring that will ultimately divide the company into a regulated energy-delivery company named CenterPoint Energy and a competitive energy services provider called Reliant Resources. 

Analysis: It is somewhat surprising that Reliant Energy is proceeding with its massive restructuring, which it acknowledges is being done to maximize shareholder value, considering how dramatically the market has changed since the company first announced its plans about 17 months ago. In July 2000, Reliant's plans to bifurcate its operations were just the latest in a string of similar restructuring initiatives from companies such as Southern Co. and Xcel Energy, both of which spun off high-growth, unregulated subsidiaries into stand-alone companies in very successful IPOs. Fast forward a year later and the splitting of regulated operations from unregulated operations into two stand-alone companies no longer appears to be a sure-fire business decision. For example, companies such as Constellation Energy and Allegheny Energy, which announced plans to engage in this kind of restructuring activity after Reliant's announcements, now have backpedaled and put such plans on hold. The details among the companies may be different, but the end result is pretty much the same: splintering an integrated company into two operations to attract two sets of investors. At the onset of the plans, the real appeal was to put unregulated power generation into a separately traded company and sell lots of stock. That sounded like a great idea last year when the independent power producer (IPP) market was going gangbusters. Now, demand and prices have dropped, and the merchant energy industry is shrouded in uncertainty. Into these rocky waters, Reliant Energy is about the only company that still believes a major restructuring is presently a wise move. 

As noted, Reliant's restructuring plans have been in motion for over a year, so in fairness to the company, it may be making the decision to proceed with the risky initiative in hopes that investors will still be receptive. The IPO of subsidiary Reliant Resources, held in May 2001, raised about $1.56 billion and was considered one of the most successful offerings this year. Reliant Energy presently owns a little more than 80 percent of Reliant Resources, whose business model is focused primarily on wholesale power marketing, maintaining generating and trading assets, and selling retail energy. Quite naturally, Reliant is hoping for a repeat of that success when the spin-off is completed in the first quarter of 2002.

Let's be clear about what Reliant is doing with this restructuring plan. What shareholders approved this week was the formation of a new holding company called CenterPoint Energy, which will include both the company's regulated energy-delivery business and Reliant Resources. The creation of a new holding company and accompanying name change are being characterized as interim steps that Reliant is taking toward the ultimate separation of the unregulated and regulated businesses. After receiving regulatory approvals from the IRS and SEC, shares of Reliant Energy will be automatically converted into shares of CenterPoint Energy, which will trade under the symbol CEP on the New York and Chicago Stock Exchanges. Trading for Reliant Energy, under the symbol REI, will be discontinued at that point. 

As the next step in the restructuring, pending an additional round of regulatory approvals, CenterPoint Energy will spin off the regulated company by distributing its shares of Reliant Resources to its shareholders, creating two separately owned public companies. Ultimately, CenterPoint Energy will own only the regulated side of the business, including electricity transmission and distribution, natural-gas distribution, pipelines, and any power generation facilities that remain regulated. 

Reliant's motivations to divide itself into two companies are pretty straightforward. On one hand, the company is simply complying with the regulatory mandates of Texas, which require that state utilities establish firewalls between their operating companies and create separate businesses for generation, energy services, distribution, etc. Yet, more importantly, Reliant is turning the mandate into a potential financial opportunity by establishing two public companies with dramatically different risk / reward profiles. The unregulated side will include such businesses as power generation, marketing and trading, and the European operations. The regulated side will include the businesses related to electricity and natural-gas distribution as well as the company's U.S. interstate pipelines. Note that the company previously indicated plans to sell its communications unit, which has struggled amid a larger market downturn in this sector. Thus, once the restructuring is completed, CenterPoint will be aimed at the traditional type of utility investor, which expects steady returns and reliable dividend income, while Reliant Resources will be more geared toward investors with a high tolerance for risk that want to take advantage of competitive opportunities in the deregulating wholesale market. 

Reliant Energy's CEO Steve Letbetter recently said he expects CenterPoint's dividend payout to be comparable to other regulated utilities, suggesting a payout greater than 50 percent of earnings per share. The company had already projected that CenterPoint's earnings per share for 2002 will fall in the range of $1.17 to $1.22. 

As I mentioned, however, economic conditions in the energy industry have changed considerably since Reliant announced its restructuring plans over a year ago, and the new industry climate may make the company's decisions to proceed with its plans a risky move. Again, I will point to the examples of Constellation and Allegheny, which really seemed to be caught in the crossfire of the restructuring trend and are still sorting through residual fallout. At the time of their original restructuring announcements, both Constellation and Allegheny had grounds to be fairly confident of their plans, considering how high the valuations for independent generating companies were running at that time. 

Yet, in a fast-changing market, those valuations have dropped considerably and the shares of both companies received some major hits related to this decline. Constellation shares were trading at about $50 in May 2001, but presently are priced at half that figure. Allegheny is down about 39 percent from its high of $55 a share to $33. While the drop in share price that these two companies have faced cannot be totally attributed to their restructuring plans, the important point is that companies that planned to restructure have done so to put more emphasis on their unregulated trading operations, a sector that has been undervalued. This point can be supported by looking at companies that have completed their restructuring processes (such as NRG Energy and Mirant), which are trading at 40 to 50 percent below their 52-week highs. Clearly, investor confidence in such companies has been eroded. By the same token, shares of Reliant Energy are trading at about $24, down from a 52-week high of $50, while shares of Reliant Resources are trading at about $15, down from a high of $37.50. This could be related to investors' concerns about the company's plans to proceed with restructuring in the current market climate. 

Moreover, a year ago the concept of utility restructuring to separate regulated operations from unregulated businesses seemed like a quick way for companies to cash in on the opportunities created by deregulated energy markets. In fact, it was the expectation of companies involved in the restructuring to gain a 20-plus P/E ratio for the unregulated company once it had been split off from the regulated business. However, the actual process of restructuring, which can take a year or more, is taking place under less-than-conducive market conditions, including a drop in energy prices, reduced demand and warnings of an energy glut. The original purpose of the restructuring plans (that is, to give shareholders increased value) is no longer a guaranteed result for companies that proceed with the separation plan, as Constellation and Allegheny clearly found. Only time will tell if Reliant's completed restructuring plan will prove to be another success or another failure in the energy industry, but it is a fairly safe bet that Reliant is one of the last companies that will be riding the restructuring trend any time soon. 

Ironically, one company that routinely has been praised for its strategy this year is Duke Energy (NYSE: DUK), which made a pointed decision to ignore the restructuring trend and remain an integrated company. In addition to recently being named Energy Company of the Year at the 2001 Financial Times Global Energy Awards, Duke's financials remain quite strong. For the third quarter 2001, Duke reported a 46-percent increase in ongoing earnings per share, or $1.02 per share. Year-to-date earnings per share from ongoing operations as of Sept. 30 were $2.30 compared to $1.63 for the same period last year. For year-end 2001, Duke remains committed to delivering earnings growth within a stated guidance of 10- to 15-percent compound annual growth in earnings per share from a base of $2.10 in 2000. Looking ahead to 2002, Duke expects to earn toward the high end of the 10- to 15-percent range. When asked to establish reasons for the company's success, Duke Energy CEO Richard Priory mentioned the decision to remain an integrated company against a trend of other companies splintering apart. 


Other Reliant Resources News:
Shareholders of Orion Power Holdings (NYSE: ORN) overwhelmingly approved the merger agreement between Orion and Reliant Resources, which was announced last September. Under the agreement, Reliant is buying Orion for $26.80 per share in a cash transaction valued at approximately $2.9 billion. Reliant Resources will also assume approximately $1.8 billion of Orion Power's net debt. The companies anticipate that the transaction will be completed in early 2002, at which time Orion Power's business will be combined with Reliant Resources' domestic wholesale group. 

When previously discussing this acquisition (please see the 9/28/01 IssueAlert available at www.scientech.com <http://secure.scientech.com/rci>), I established five reasons why Reliant is buying Orion, which also support the assessment that it is a strategic purchase. These reasons are as follows: 1) Reliant Resources gains Orion's generating assets, which support its own expanding wholesale business; 2) Orion's assets are primarily located in the Northeast, particularly in New York, which (unlike Reliant's core territory) offers a fully functional deregulated wholesale market; 3) Facing economic downturns and the possible softening of demand, Reliant Resources' acquisition of Orion is expected to immediately keep earnings solid, while other competitors are lowering their own earnings expectations; 4) The purchase illustrates the spate of consolidation efforts that are taking place in the independent power producing market; and 5) The purchase supports Reliant Resources' intentions to focus exclusively on North America and divest its European assets. 
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