Wednesday, January 20, 2010

Update: Natural Gas Pipelines, Some Get it and Some Dont: Williams Companies (WMB) and Southern Union Company (SUG)

January 20, 2010

Related Stocks: SUG , WMB , EP

On 1/15/10 Mr. Miller issued a ground breaking and visionary buy opinion for WMB. On 1/19/10, the Board of Directors of WMB announced a complete restructuring of the company in line with Mr. Miller's analysis.

SUG is on the opposite end of the spectrum and Mr. Miller has issued a sell opinion on SUG. Mr. Miller believes the Company needs to be broken up, the assets sold off to other market participants to allow shareholders to unlock value.

SUG Board of Directors is completely entrenched, with average age of the top 7 directors approaching 77 years old, well past all corporate governance benchmarks. SUG has been subject to activist shareholder attacks already, and Mr. Miller expects more to come in short order, given current market conditions in the natural gas industry.

SUG, in Mr. Miller's opinion, is the number one pipeline break-up target for the activist investors.

Below is an exerpt of Mr. Miller's analysis.

January 15, 2010

WMB Buy Rationale:

Mr. Miller has not had a favorable opinion of WMB until recently. The public record over the past ten (10) years reflects Mr. Millers prior negative opinion about WMB management execution, or lack thereof and business strategy. After all, they almost bankrupted the company during the California Energy crisis of 2000/2001. What saved them was the ability to post their exploration and production assets as collateral for a major bailout by Warren Buffett and Lehman Brothers at that time.

However, after years of pain and suffering, WMB management and board has been overhauled, gotten its act together and put serious focus on its two core businesses; i) transporting natural gas on its mainline pipes and; ii) natural gas exploration and production, with very stated high drilling success rates. Highlights include, based on Company data:

4.3 trillion cubic feet equivalent in domestic natural gas reserves

1.2 billion cubic feet equivalent of daily production in the United States

5.4 million that's how many homes can be served by our daily production

99 percent typical drilling success rate 8,000-plus new natural gas wells developed since 2004 Mr. Miller believes that WMB offers a unique combination of expansion pipeline revenues with the substantial upside of the exploration and production business. WMB operations credentials in the pipeline and exploration area were never in question.

Their forays into non-core businesses and errant senior management led them astray in the past, which has been corrected. Finally, WMB is leveraged, which should provide a superior levered equity return versus its peer group going forward.

Mr. Miller compares WMB to Chesapeake Energy (CHK) in that he believes WMB shows the entrepreneurial traits of CHK albeit in the natural gas pipeline business; they have solid assets, core expertise, willing to take calculated risk, and are levered and positioned to provide above market the ROA and ROE.

On the Other hand, there is SUG, which is an entirely different case and one which has already brought the wrath of the activist hedge funds and other institutional investors upon the company. Despite appeasement attempts and temporary pacts to call off the wolves, Mr. Miller does not believe SUG will be around much longer in its current form. Once you are attacked by investors like SUG has been, the smell of blood is simply too irresistible to the hunters in the market if the problem has not been solved. The problems that brought the wrath of activist investors upon SUG problems have not been solved.

SUG Sell Rationale:

SUG Governance is very poor. Average age top 7 directors is 76-77yrs and getting older. Most in industry would refer to this as a "Crony Board". By way of example, El Paso Energy had a similar problem several years ago and was shaken to its core by the market and a nasty proxy fight between its largest shareholders and an entrenched Board. The net result was that senior management and the board was forced out and the company was completely rebuilt.

Sandell Asset Management and other institutional investors have already challenged the SUG Company Board structure, management credentials, and identified / targeted the extremely poor governance at SUG, including low return on assets, among other major problems.

No tangible value creation for shareholders in recent years. No identified, dependable and executable business strategy No E&P exposure or upside to boost shareholder return Director and COO Herschmann appears conflicted with SUG's law firm Kasowitz, as he is a Kasowitz Partner and also officer of SUG and most recently made director of SUG. This speaks to the poor corporate governance structure previously mentioned.

Return on assets is low. Assets are average, underutilized and leverage is high.

Company appears to be run in New York by lawyers, not in Houston by energy experts. No clear energy operations expertise at executive management level

Opinion: Rarely do you find a company the size of SUG today that cant be turned around from the inside. Unfortunately, SUG is the rare Company that is so entrenched that Assets must be sold and Board / Current Management dissolved for investors to realize any real upside.Hope is not a prudent investors ally in SUG case.

It is amazing that there has not been a major proxy battle to address these issues and sell off the pieces of SUG already. I expect the institutional investors will be back on this course of action, given the qualified buyers in the market and SUG is clearly worth more to shareholders in a breakup than in its current form. Once you take a broadside blow from an activist like Sandell or other sizable investors, blood is in the water. It is only a matter of time until the wound is re-opened.

Best case scenario: SUG Assets are bought by another market participant (s), most likely a combination of Master Limited Partnerships and other Pipeline companies, through a cash or share offer, with which provide SUG shareholders option to have exposure to an experienced management team and Board which knows how to manage optimize regulated energy assets, or cash them out of SUG exposure.

Disclosure: Mr. Miller has no position in SUG securities for reasons stated above.

Disclaimer:This column, Energy Commentary from Karl Miller, is the opinion of Karl Miller. Content found in the articles is subject to the terms found in the disclaimer and does not represent a recommendation of investment advice. Investors should seek the advice of a qualified investment professional prior to making any investment decisions.

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