Melissa Davis

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Duke Saw Slowdown but Kept Mum, Critic Claims

Melissa Davis

In October of 2001, as Enron prepared to shock Wall Street with a huge earnings shortfall, rival Duke (DUK Quote) was pondering a big surprise of its own.

The North Carolina energy giant was set to report third-quarter earnings that would topple expectations. The numbers looked particularly strong in energy trading, a business pioneered by Enron and one that Wall Street continued to embrace as especially lucrative and rewarding.

Duke's "problem," if you will, was that third-quarter earnings were so high -- and beating the Street, by more than a penny or two, promised only limited rewards. Nevertheless, Duke went on to report ongoing quarterly profits of $1.02 that beat consensus estimates by 26 cents and set a company record that remains intact today.

But Duke filed that earnings report only after a telling private debate among high-level company executives, according to an internal Duke accountant who's raised concerns about the company's bookkeeping. He says that less than a week before releasing its third-quarter numbers, Duke was still weighing the idea of taking various charges -- including a big write-down that would have reflected a cooling view of the still-hot merchant energy business.

"The company would have liked to have held back some of those earnings for a rainy day," says Barron Stone, who served as a senior forecast analyst for the company at the time. "Because the storm did come. And there was information on the table that leads one to believe we saw the future then."

For its part, Duke insists it had no way of forecasting the meltdown that was coming. "It's unfair to criticize the company for not seeing [the future] in a crystal ball," said Duke spokesman Randy Wheeless.

Wheeless declined to elaborate on the matter further. But Stone's account suggests that Duke knew in 2001 that the merchant energy business looked far less rosy than the company and Wall Street were forecasting. Even so, Duke continued to boast about opportunities in the sector -- until last fall, when it became one of the last energy traders to publicly back away from its expectations.

That sudden turnabout, coupled with more recent setbacks, triggered sharp declines that have left Duke's stock trading at 12-year lows. The stock shed 9 cents to close Friday at $14.15, more than 50% below October 2001 levels.

Numbers Game

Stone's concern about Duke's accounting had been building for years. And that concern is clearly reflected in emails -- coupled with internal correspondence and forecasting documents -- that Stone shared with regulators and, more recently, TheStreet.com.

In an email dated Oct. 4, 2001 -- 12 days before Duke released third-quarter results to the public -- Stone told the Securities and Exchange Commission that Duke had identified steps to intentionally trim its third-quarter earnings from $1.11 to $1 a share. He was particularly troubled by Duke's plan to suddenly "pre-fund" three years' worth of contributions to the Duke Foundation, a charitable organization run by employees of the company itself.

"There may be a valid justification for pre-funding a charitable activity such as this from an accounting standpoint," Stone says. "But I'm not aware of what that justification would be."

Robert Lipe, KPMG Centennial Professor of Accounting at the University of Oklahoma, saw no problem with booking the big donation -- if the company had already committed to contributing that particular amount. He was more troubled by the idea of a company taking specific steps to shave its earnings in general.

"Does that sound somewhat disingenuous?" Lipe asked. "It's not exactly the way I'd like to put my accounting numbers together."

Stone apparently wasn't the last person troubled by the foundation charge. In a January follow-up to the SEC, Stone said other employees questioned the multiple-year charity funding that, in the end, was booked in the final quarter of 2001. After his colleagues allegedly mentioned possible "earnings management," Stone stepped forward and asked what Duke's outside auditors would think.

"At this point, [my boss] stated, 'Maybe I should just take these handouts up,' and seemed to get nervous over the questions being asked," Stone told the SEC.

Big Trouble

But back in October of 2001, Stone had fixated on bigger things. Duke's merchant energy division was pitching a plan to cut earnings by 15 cents a share -- or by three times more than the pre-funded donations -- using a charge that Stone felt was questionable at best.

Duke was now looking to establish a $183 million reserve to cover penalties associated with canceling turbine orders from General Electric (GE Quote). But the third quarter, when Duke hoped to take the charge, had already closed without Duke apparently even negotiating the matter with GE, Stone says.

Looking back, Stone now sees an ominous warning -- transmitted internally by his own company -- of the downturn to come.

"I don't think you talk about booking a reserve like that unless you have serious concerns about the health of that business," says Stone, who was transferred out of forecasting after going to authorities with his concerns about Duke's accounting. "But this issue never came up in public until another year later.

"And by then, Duke was already going to hell in a hand basket."

Duke told TheStreet.com that it took the turbine charge when it could "properly account for the impact." But internal emails show the company considered taking the charge nearly a full year earlier. Indeed, Duke continued to toy with the idea until the 11th hour.

"There is still some possibility that it could be booked in the third!" division CFO Kirk Michael wrote in an email five days before Duke wrapped up its third-quarter 2001 earnings report. "Stay tuned: This is going to be exciting!!"

Ultimately, the proposal landed on the desk of CEO Rick Priory, who decided against the charge right before the earnings release.

The company did, however, take smaller charges -- also related to merchant energy -- that Stone viewed as conveniently timed. Specifically, Duke established reserves to cover the future demolition of power assets the company had apparently planned to destroy since inheriting them through an acquisition three years earlier.

"What makes establishing these reserves viable now?" Stone asked in an email to the SEC a week before the charges were booked. "Are we doing all this simply because it is to our benefit from an earnings standpoint now vs. other times?"

Lipe also saw problems with this particular charge, since the demolition work had apparently not even begun. The company itself adamantly insists that it did nothing to manage earnings.

"We do not manage earnings," Wheeless said. "That's just not how we do business here at Duke Energy."

Wheeless went on to say that Duke has never been contacted by the SEC about the earnings report in question. As a matter of policy, the SEC doesn't comment on any dealings with companies.

Disappearing Act

Duke itself didn't stay focused on the turbine issue for long. Talk of turbine cancellations -- so hot just days earlier -- abruptly ended when the company filed its third-quarter 2001 report. After that, Stone says, Duke set out to erase even leftover traces of the debate.

"My fellow forecasting teammates and I were told verbally to discard any of the information/scenarios that discussed the GE turbine initiative," Stone said. "It was like an issue that was talked about and then totally vanished."

But Duke had already laid out clear, if unexecuted, plans to cancel turbines ordered for the construction of power plants. And Stone had to wonder: Why would Duke be willing to pay a steep penalty to cancel the turbines unless not canceling them looked even more expensive in the end?

Going forward, Duke itself portrayed none of Stone's uneasiness. Even as industry experts began to rumble about "overbuilding" in the power sector, Duke insisted that opportunities were ripe and its own strategy was quite sound. In February 2002, for example, the company told local North Carolina media that its cautious risk-management strategy would make Duke immune to any fallout from gluts in supply. Two months later -- after reporting disappointing results for the first quarter -- Duke reiterated its plan to build more power plants and even predicted that new generation would significantly boost earnings by the third quarter and allow the company to deliver on its promise of up to 15% in annual profit growth for 2002.

But information inside the company, available more than half a year earlier, did not support those claims. Stone said as much in an Oct. 25, 2001, email to the SEC, when Duke was in the midst of developing budgets and forecasts for the following three years.

"The initial cut of what got turned in doesn't support what Mr. Priory has told analysts," Stone told the SEC. "As a matter of fact, there is no growth for 2002 over 2001 or 2003 over 2002."

Those internal forecasts, unavailable to the general public, proved to be correct. On Sept. 20, 2002 -- nearly a year after Duke first considered halting its turbine orders -- the company suddenly announced that business had taken a turn for the worse. The company formalized plans to halt construction of three power plants, warning of a hefty third-quarter charge as a result, and slashed earnings guidance for both 2002 and 2003.

"Up until the third quarter, we really didn't see the drastic downturn," Duke spokesman Terry Francisco insisted this month. "The very young merchant energy sector ... really became depressed in 2002 unlike anything many people expected."

Stone's comments, of course, counter Duke's professed surprise. Meanwhile, Duke is clearly trying hard to talk about anything but its merchant business.

In recent discussions with the investment community, Duke has repeatedly stressed that 80% of its future earnings will come from regulated, rather than riskier unregulated, businesses. But formal documents show that these "safer" earnings can be manipulated as well.

Power Point

It was in late 1998 -- just after South Carolina regulators determined that another utility was earning too much profit -? when Stone first began to grow uneasy. Duke had authorized a special project aimed at cutting the profits its own utilities reported to North and South Carolina regulators but leaving the company's overall bottom line unchanged. And the project, which relied heavily on accounting maneuvers, was a clear priority.

During a staff meeting on the matter, Duke executives in fact stressed that there was "a risk to the company" if the project failed. Such comments are documented in a state-ordered investigation triggered by Stone's tips to regulators. After raising futile protests internally, Stone said he felt ethically obligated -- as a certified accountant -- to blow the whistle on his employer.

"By 2001, it had become apparent to me that the two state commissions weren't going to catch it -- because it had been reported that way for three years -- and that management wasn't going to change it," Stone said. "And I just thought it was wrong."

Stone is convinced that his decision to step forward cost him his position in forecasting, although Duke denies this and continues to employ Stone in an equal-paying job. Nevertheless, Stone has gained some vindication.

On Friday, Duke fielded a grand jury subpoena for documents related to its Carolina utility profits. This new investigation comes less than four months after the state-ordered outside">audit conducted last year by Grant Thornton, determined that Duke had intentionally underreported utility profits by nearly $124 million between 1999 and 2001. Duke has publicly disputed some of Thornton's accounting judgments as mere "differences of opinion." But Carolina regulators have sided with Thornton, as have utility customers. Unhappy with a modest $25 million in promised refunds, some of Duke's largest customers have renewed their calls for a full-scale investigation of the company's rate strategy since the release of Thornton's report.

In the meantime, Stone remains concerned that Duke may be less than forthright with the public. He says the company knows better than to tinker with earnings -- and that it even sent executives to an "earnings management" seminar, warning against the practice, just a week before the questionable turbine charge first came up.

"The seminar addressed how to deal with earnings management," Stone recalled. "And it essentially said, 'You don't do it -- up or down.'"