By Heesun Wee
On May 17, Duke Energy (DUK ), based in Charlotte, N.C., said a review of trading activity from 1999 to 2001 found no energy trades that pumped up trading volumes or revenues. In contrast, rival firms, including Reliant Resources (RRI ) and CMS Energy (CMS ) have disclosed that so-called round-trip, or "wash trades" -- now the target of federal investigators -- may have inflated trading revenues by millions of dollars.
Duke Energy isn't entirely in the clear, however. The company also disclosed that about one-tenth of 1% of the trading and marketing revenues for the 3-year period -- roughly $120 million of $100 billion -- stemmed from trades "which may have some of the characteristics" of round-trips. The revelation disturbed some investors, and shares of Duke Energy slipped nearly 3% on May 17, to finish around $33.
Despite the admissions, the stock is proving resilient. It has since recovered to around $34 a share. Granted, the stock has a ways to go to return to the 52-week high of $47 reached in May, 2001. But investors who are sticking by Duke may be on the right track -- even though energy prices are in the down part of the cycle. Duke hasn't changed its earnings-per-share guidance for 2002, keeping it at $2.54-$2.78. Last year, the company's EPS was $2.64, and it had operating revenues of $59.5 billion and earnings of $4.2 billion before interest and taxes.
Roughly half of the analysts who cover the company still have a positive rating on Duke, including Justin McCann, an electric-utilities analyst for Standard & Poor's. "Duke is a premier company, assuming everything is legit here," says McCann, who has a 4-STAR (out of 5) accumulate recommendation on the stock.
David Schanzer, an analyst who follows Duke for Janney Montgomery Scott, agrees. "The company probably was in a certain trading milieu out in California, where those trades seemed to become commonplace," he explains. "So while they probably are sorry they did them, they probably did fewer relative to a lot of other companies. It's really not an end-of-the-world scenario." Schanzer has an accumulate rating on Duke shares. Agrees Jeff Price, an energy-industry analyst for consultancy Frost & Sullivan: "What has been disclosed so far [about trading] probably is not a major setback for them." (Also see BW Online, 5/30/02, "A Final Word with Dynegy's Chuck Watson")
Many analysts say there's a lot to like about Duke, citing diverse businesses, which include an old-fashioned electric utility business that offers a stable source of income. They also point to the company's portfolio of physical assets, including power plants and pipelines, plus a solid balance sheet. "They have a balanced approach and want to have a mix of energy businesses," says David Burks, an analyst who follows Duke Energy for Hilliard Lyons.
"We've not been slaves to the current fashion or whatever the current fad is," says Robert Brace, Duke Energy's chief financial officer. "We've got a more balanced portfolio."
Diverse businesses buffer the outfit from wild swings of commodity trading and prices. In 2001, about 33% of earnings before interest and taxes came from Duke's wholesale energy business, which includes trading operations, notes S&P's McCann. But 40% of earnings for the same year stemmed from Duke Power, the company's utility that serves the two Carolinas. The company also generates profits from its natural-gas transmission business and a field-services unit, which includes operations like natural-gas gathering and storage.
Duke's large stable of physical assets stand in sharp contrast to the situation at failed energy giant Enron, which relied largely on trading. Duke Energy has 33,000 megawatts of generating capacity online globally -- enough juice to power roughly 33 million homes for an hour. More than half that capacity, 19,000 megawatts, comes from Duke Power, with the remaining capacity sprinkled throughout the U.S., Central and South America, and Australia. Duke Energy plans to soon bring online an additional 6,700 megawatts of generating capacity from new power plants fired by natural gas.
In addition to power plants, Duke Energy operates a 12,000-mile pipeline system and is among the top U.S. natural-gas gatherers and producers of liquified natural gas. In March, Duke completed an $8 billion acquisition of Canada-based Westcoast Energy, one of the largest natural-gas companies in North America. Duke CFO Brace says as natural gas continues to be the fuel of choice among Americans, more of it will come from Canada. In 10 years, Duke will carry roughly 30% to 35% of the natural gas flowing between the two countries, he projects.
Aside from hard assets, fans of the company point to Duke's sound finances. Its credit is rated high by the debt-rating agencies, and Duke's debt-to-capital ratio is just under 50%, which is below the industry average of roughly 54%, notes Burks of Hilliard Lyons. "They have a stronger balance sheet than the average utility."
Some observers are taking a measured approach in the current environment, however. Roughly half of the analysts who follow Duke have a hold rating on the stock. They want more earnings growth, which may be difficult given that energy prices are now in the down part of the cycle. There's too much supply and demand remains reduced in an economy struggling to gain momentum. Duke counters that it is on track to grow earnings 10% to 15% annually on average.
And just because analysts believe Duke is a solid company overall doesn't mean the recent revelations about trading aren't serious. Duke's comments come as U.S. energy regulators have ordered about 150 energy companies to file sworn statements disclosing whether they used controversial trading tactics similar to those employed at Enron under code names like "Death Star" and "Fat Boy."
Among the trading strategies in question are round-trip trades. In general, they work like this: An energy company sells electric power to a trading partner, while buying the same amount from the same partner at the same time, thus canceling out the transaction. According to the current rules, such trades aren't illegal. But some energy-market observers argue round-trip trades are at least unethical because they make companies look busier than they are by jacking up trading volume.
Duke Energy maintains it hasn't broken any laws. And CFO Brace adds the 1% of trades in question include transactions with brokers and those using an automated trading system, which means Duke couldn't know who its trading partners were on the other end. Meanwhile, federal regulators continue to gather evidence from Duke Energy and others about possible sham trades. And Matthew Wright, manager of the First Investors Utilities Income Fund, which currently has no position in Duke Energy, says he's avoiding the "headline risks" in the energy group.
CONFOUNDING THE CRITICS.
Still, at a time when some energy companies have disclosed that they erroneously padded revenues by many millions, Duke Energy looks like it may be a reasonable investment given a multiple in the low teens, based on 2002 EPS estimates. A.C. Moore, chief investment officer at Dunvegan Associates, who has a current position in Duke, remembers when Duke looked like the underachiever in the sector.
"Duke was a relative lackluster performer. It just didn't have the market luster than Enron had," he recalls. But just look at who's still standing.
Wee covers financial markets for BusinessWeek Online in New York
Edited by Beth Belton