A Strong Pipeline and Its Cousin

09/18/2008 12:00 am EST


Paul Larson

Editor, Morningstar StockInvestor

Paul Larson, editor of Morningstar StockInvestor, and analyst Jason Stevens like two spinoffs from Duke Energy.

In 2007, Duke Energy (NYSE: DUK) split its electricity and gas businesses by spinning off Spectra Energy (NYSE: SE), one of the largest midstream companies in North America. With an initial public offering in June 2007, Spectra Energy offered about 17% of master limited partnership Spectra Energy Partners (NYSE: SEP) to investors.

Spectra Energy, a pure play on natural gas demand, is one of the largest natural gas midstream companies in North America. With large positions in gathering and processing, transportation and storage, and distribution, Spectra collects a large portion of economic rents paid to get gas to end users.

Nearly half of the firm's earnings stem from stable, long-term contracts for firm capacity across this system. Earnings fluctuate somewhat with the weather, as the primary uses for natural gas are winter heating and, increasingly, summer cooling.

Most long-haul pipelines [have] inherent "moats" because of federal regulatory oversight that prevents additional pipeline routes from being constructed without proof of need. This gives a pipeline a near-monopoly, but caps the rate of return it can earn.

However, Spectra's business mix includes unregulated businesses that add potential up side to regulated returns, and we expect the company to earn economic returns so long as demand for natural gas remains strong.

Spectra's key growth driver remains its hefty $3-billion expansion budget. However, top-line growth is not the real story; instead, our projections see operating margin expansion. Overall, we see operating income increasing at an average annual rate of 7% because of these factors.

Spectra Energy runs a tight ship and is managed by longtime industry hands. Chief executive officer and president Fred Fowler also sits on the board of directors. The board is chaired by Paul Anderson, the former chairman and CEO of Duke Energy.

Overall, we think Spectra Energy is a well-run company that, so far, looks out for the interests of its owners. We think Spectra is worth $28 per share. (It closed below $24 Wednesday-Editor.) We project an average annual revenue growth rate of 4.4% during the next five years.

Spectra Energy Partners owns a 100% interest in East Tennessee Natural Gas, a 24.5% interest in Gulfstream, and a 50% interest in Market Hub Partners. Gulfstream serves the booming Florida market, where demand for natural gas is growing at twice the national average, [while] Market Hub Partners operates two large salt dome storage facilities in Texas and Louisiana that interconnect to multiple major interstate pipelines.

As a master limited partnership, SEP affords fewer unitholder rights than shareholders of traditional companies typically receive. And because only 17% of the company's units were offered to the public, Spectra Energy calls all the shots.

We continue to think Spectra Energy Partners is worth $28 per unit. (It closed above $18 Wednesday-Editor.) We expect operating margins to continue to expand as incremental expansions add more revenue than expense.

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