Reliant Energy: Splitting Business in Two to Maximize Shareholder ,
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=09"IssueAlert" <IssueAlert@scientech.com>
=0910/12/2000 06:56 AM
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=09=09 To:=20
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=09=09 Subject: Reliant Energy: Splitting Business in Two to Maximize Share=
holder=20
Value

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SCIENTECH IssueAlert, October 12, 2000
Reliant Energy: Splitting Business in Two to Maximize Shareholder Value
By: Will McNamara, Director, Electric Industry Analysis
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Reliant Energy announced the top-level executives for the two companies=20
that will emerge from its planned separation into two stand-alone, publicly=
=20
separated companies. Steve Letbetter will serve as chairman and CEO of=20
the unregulated company. David McClanahan has been named president and=20
CEO of the regulated company, which will be created at the time of the=20
business separation. In July, Reliant Energy announced plans to separate=20
into two publicly traded companies in order to separate its unregulated=20
businesses from its regulated businesses. Following regulatory approval,=20
the company plans an initial public offering (IPO) of approximately 20=20
percent of the common stock of its unregulated operations by early 2001.

ANALYSIS: In June 1999, Texas adopted legislation to allow retail competiti=
on=20
beginning on Jan. 1, 2002, for the majority of customers within the state.=
=20
Senate Bill 7 mandated that utilities in the state construct firewalls=20
between their operating companies. In other words, Texas utilities must=20
have separate companies=01*with separate financial records=01*for energy se=
rvices,=20
distribution, generation, etc. In Texas, incumbent utilities must establish=
=20
affiliated retail units that will serve customers who do not switch, but=20
these units must be completely separate from the T&D operation of the=20
incumbent=20
utility. At first, Reliant Energy resisted this mandate and lobbied to=20
keep its operations under one company. Thus, it was somewhat of a surprise=
=20
when Reliant announced in July that not only would it be splitting into=20
two publicly traded companies, but also that it would be issuing an IPO=20
for the unregulated side of its operations. Currently, as one company with=
=20
both regulated and unregulated operations, Reliant (NYSE: REI) is trading=
=20
at about $45 13/16 (at market close on 10/11). Reliant has declined to=20
make any projections about pricing of the IPO of its unregulated businesses=
,=20
which it expects to issue in early 2001, until it submits an S1 filing=20
with the SEC later this year. Reliant expects the IPO to be followed by=20
a distribution to shareholders of the remaining stock of the unregulated=20
company (within 12 months of the IPO).

Reliant's motivations to divide itself into two companies are pretty=20
straightforward.=20
On one hand, the company is simply complying with the regulatory mandates=
=20
of Texas. Yet, more importantly, Reliant is turning the mandate into a=20
financial opportunity by establishing two public companies with dramaticall=
y=20
different risk / reward profiles. The unregulated side will include such=20
businesses as power generation, marketing and trading, telecom, and the=20
European operations. The regulated side will include the businesses related=
=20
to electricity and natural-gas distribution as well as the company's U.S.=
=20
interstate pipelines.

Reliant is a company that is seeking to maximize the opportunities that=20
deregulation is offering, both in the United States and internationally.=20
As an international energy delivery and energy services company, Reliant=20
makes about $15 billion in annual revenue and has assets totaling $30=20
billion.=20
The company's wholesale energy trading and marketing business is arguably=
=20
within the top five (definitely within the top 10) in the United States,=20
supported by its nearly 27,000 MW of power generation assets.=20

As the company continues to transform itself from a traditional utility=20
into an aggressive energy services company, it recognizes that its=20
traditional=20
investors have tended to be fairly risk averse, preferring to invest in=20
the regulated activities of a conservative utility company. As Reliant=20
attempts to penetrate new competitive markets, it intends to make itself=20
an appealing investment opportunity for investors who are more "growth=20
oriented and tolerant of risk," (as described by Letbetter). The most=20
practical=20
way to maximize shareholder interest and boost stock value is for Reliant=
=20
to bifurcate its operations, offering two options for capital investment.=
=20


It's a trend that is becoming more common in the energy industry, especiall=
y=20
with regard to high-risk ventures. For instance, Southern Company just=20
closed the IPO of its aggressive subsidiary Southern Energy (NYSE: SOE)=20
on Oct. 3. Southern Energy, a global energy company, has become one of=20
Southern Company's primary moneymakers (in the second-quarter alone, the=20
subsidiary reported $93 million in earnings). When the IPO of Southern=20
Energy closed, it brought total gross proceeds and a concurrent securities=
=20
of approximately $1.81 billion to its parent. Southern Energy's current=20
stock price is running at $29 1/8 (at market close on 10/11). The IPO price=
=20
of Southern Energy on 9/27 was $22. Another example is Northern States=20
Power (now part of Xcel Energy since it merged with New Century Energies),=
=20
which this June spun off a portion of its NRG Energy subsidiary, an=20
independent=20
power producer. (See IssueAlert from 10/2/00 for more information). In=20
addition, the trend is visible in other industries as well. AT&T recently=
=20
announced its plans to spin off its customer long-distance business to=20
shareholders.

However, even though the financial rewards of such an IPO are enticing,=20
there are possible downsides to such a move as well. Moody's raised serious=
=20
concerns about Reliant's announcement in particular. Specifically, Moody's=
=20
says that Reliant's regulated unit could be left with heavy debt loads=20
after the structural split, which would hurt its own quality and bond=20
ratings.=20
Moody's has put both Reliant Energy Inc. and at least two of its subsidiari=
es=20
on watch for possible downgrade from their Baa 1 status. Reliant remains=20
on watch for possible downgrade as of Oct. 11. Another risk is that as=20
more spin offs of non-generation units become commonplace, they may lose=20
their appeal on Wall Street. The average first-day gain for similar energy=
=20
IPOs was 43 percent in the third quarter, compared to 96.5 percent in the=
=20
first quarter, perhaps indicating that Wall Street is already becoming=20
less enamored with this strategy.

Yet, these risks aren't dissuading Reliant from moving forward with its=20
plan. As the company retains but moves beyond its traditional electricity=
=20
and natural-gas distribution businesses, Reliant's focus is to expand its=
=20
current business portfolio. By splitting its two operations in two, Reliant=
=20
can separate its vastly different regulated and unregulated cultures. The=
=20
companies require totally different management approaches, one based more=
=20
in regulatory relations and the other driven by entrepreneurial spirit.=20
The freedom Reliant gains from spinning off its operations into two separat=
e=20
businesses=01*one high risk, one low risk=01*appears to make this a smart m=
ove,=20
at least for now.
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Sincerely,

Will McNamara
Director, Electric Industry Analysis
wmcnamara@scientech.com
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