Fat Prophets take profits

We originally recommended Pittsburgh based Duquesne Light Holdings (NYSE, DQE) in July 2005 (FAT92). Key attractions were management's resolute commitment to the core electricity business and solid financial foundations, which in our view would underpin future earnings growth. In addition, within the consolidating US electricity industry, Duquesne was an attractive takeover target. In the end, this has proven to be the case following the July agreement by a consortium led by Macquarie, an Australian securities firm, to purchase the company.

Duquesne Light is the group's core operation. Throughout the region, the division provides for the electrical needs of nearly 600,000 customers. Duquesne also operates a non-regulated electricity business, an energy facilities management company, landfill gas systems and a fibre optic network.

Last month Duquesne announced mediocre second quarter results. Although adjusted earnings of US$44.2 million were up a modest 4 percent in first six months, reported profits fell substantially. The decline from US$56.2 million to US$25.7 million was due largely to unfavourable weather, the impact of phasing out tax credits and fair value changes in derivative contracts. Looking ahead however, we still believe the pursuit of several earnings-enhancing projects will provide gains.

Leading the way is Duquesne's ambitious multi year investment programme in infrastructure. Last year the group spent US$154 million whilst this year's budget is around US$200 million, with US$150-200 million earmarked for 2007. We believe the resultant improvements in service and reliability will underpin earnings. This is particularly true in the de-regulated US market where consumers can chose their provider.

The investment programme will also strengthen Duquesne's rate case submission to the Pennsylvania public utility commission (PUC). Including another US$19 million transmission increase from federal regulators, the total rate request is for US$163 million. We are optimistic the PUC will approve the submission and the rate increases will be put in effect from January 2007.

Overshadowing this view of Duquesne's short and medium term earnings prospects is the impending takeover by the 'Macquarie' consortium. Completion of the US$20 per share all cash offer looks likely in the first quarter of 2007.

After gaining approval from Duquesne management and the consortium, the deal is now awaiting the go ahead from shareholders along with state and federal regulators. We believe shareholders will approve the acquisition given the generous 21.7 percent premium the purchase represents on the share price immediately prior to the offer. In addition, competition issues should not pose a problem for the regulators.

Rival bids are a possibility as larger providers seek the additional market share and increased revenues small regional producers offer. However, we believe termination fees of up to US$50 million payable by Duquesne and US$80 million by 'Macquarie' will ensure both work diligently to a successful takeover. The long lead time required for regulatory approval also should have flushed out rival bids by now in our opinion.

An equity placement equal to nearly 10 percent of Duquesne's share capital with two members of the consortium has deepened the relationship further. We believe this will put off other bidders and make the eventual sale to 'Macquarie' even more likely.

Dividends from the company cannot increase as a condition of the merger. With the share price 'capped', and our investment showing a profit, we believe it is prudent to sell our position at this time and invest the funds elsewhere. Accordingly, Fat Prophets recommend Members with a holding in Duquesne sell around US$19.60.