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Duke Energy Is Hampered by Trading Arm's Atrophy

A nasty legal brawl with ExxonMobil gives way to credit concerns at a once-robust trading operation.

Last year,

Duke Energy

(DUK) - Get Report

won a huge legal fight -- against corporate heavyweight

ExxonMobil

(XOM) - Get Report

, no less.

But the victory is turning out to be bittersweet at best. Now Duke's prize threatens to hamstring the company as it confronts a thicket of financial challenges.

Back in 2002, the North Carolina utility, which followed

Enron

into the high-stakes game of energy trading, had just scored the legal right to buy out ExxonMobil's 40% stake in Duke Energy Trading and Marketing, which is known as DETM. But DETM wasn't the trophy it had once been. During the two-year battle for control of the venture, Enron had rocketed and collapsed and taken practically the entire industry with it.

So DETM -- a big energy trader caught in the sector meltdown -- wasn't such a great investment anymore. Duke chose to keep its precious cash instead of buying out the rest of DETM. And ExxonMobil, the more creditworthy partner in the deal, has supposedly never forgiven Duke for seeking total control of DETM in the first place.

Meanwhile, the partnership has taken some bruising hits, and its health continues to suffer. In fact, by the end of the first quarter, DETM's stand-alone financial statements -- unavailable to the general public -- reportedly showed that equity, once pegged at around $500 million, had slipped deep into the red.

"They've been trading on the basis of their financial statements and credit rating for years," said one industry expert. "Continued trading losses and recent downgrades of DETM's credit rating do not sit well with their partners."

Duke failed to supply

TheStreet.com

with DETM's financial statements; regarding the drop in equity, Duke said DETM's equity capitalization will vary based upon the level of income and collateral at the unit. Although Duke does not release these particular figures, it did say the company has been limiting the amount of outgoing collateral at DETM for many months.

Standard & Poor's confirmed the equity drop but explained it as a mere accounting issue that has since been addressed. Still, the agency -- the only one to rate DETM as a separate entity -- has slashed DETM's credit three notches to BBB-minus, its lowest investment-grade level, in less than a year. And it continues to have a negative outlook on the company.

Even so, S&P downplayed the significance of a possible cut to junk during an interview with

TheStreet.com

last week.

"As far as the company has disclosed ... there's never been any discussion about DETM posting additional collateral" because of a downgrade to junk, said S&P credit analyst Dimitri Nikas.

But Duke has at least hinted at a backlash in its own regulatory filings.

"If further downgrades were to occur and to the extent that these downgrades placed certain of the entities -- primarily DETM and

Duke Energy Field Services -- below investment grade, there could be a negative impact on that entity's working capital and terms of trade," the company's latest annual report states.

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Shaky

Certainly, Duke has startled analysts before. Just last week, in fact, the company suddenly admitted that it had built proceeds from asset sales into full-year earnings guidance -- which it shakily maintained -- of $1.35 to $1.60 a share. As the stock tanked, analysts peppered Duke with questions during a conference call later described as "disastrous" by some company employees.

"I'm a little bit surprised on the comments on the asset sale gains -- the included numbers -- because, if I recall, that was an issue we discussed in past years," said Merrill Lynch analyst Steve Fleishman, who has recommended selling Duke shares for months. "I thought, going into this year, you were not going to include those in your guidance."

Blaylock analyst Lasan Johong, also a bit stunned by the discovery, later shook his head at Duke's handling of the matter.

"They never really answered the questions until the last moment," said Johong, who rates the stock a hold. "The company has basically created a credibility issue."

Johong is less concerned about DETM's possible cut to junk. Instead, he thinks S&P will follow Moody's lead and revise Duke's credit outlook to stable. Still, he disagrees with the S&P analyst who said a DETM downgrade wouldn't hurt.

"It would accelerate the need for cash at DETM, which would have to come from Duke Capital

a subsidiary of Duke, which would have to borrow money or draw down liquidity," Johong said, concluding that the repercussions for Duke itself "would be quite severe."

Super Crunchy?

Indeed, one industry analyst speculated that a junk-rated DETM might face sudden collateral demands of up to $1 billion. And Duke, as the majority partner of DETM, would need to pony up more than half of that amount.

"That's cash they would not be able to use to pay down debt, which would put pressure on their own ratings," he said. "I'm not suggesting a meltdown, but it would present a difficult situation for Duke."

Most experts agree that Duke -- with cash of $1.5 billion and borrowing capacity that's twice that amount -- could satisfy new DETM collateral calls and escape a real liquidity crisis. But Duke has recently stressed, in correspondence with its own employees, that it has little extra cash to spare.

"There remains considerable concern about Duke Energy and many other companies in our sector, primarily around ongoing cash flow, cash flow from operations and coverage ratios associated with that cash flow," Duke CEO Richard Priory said during a July address to company employees. "We must do whatever we can to enhance cash flow."

But the company, known for a sunny outlook that's burned investors before, isn't really expecting business to get better any time soon.

"We do not see an upturn in the market for at least 18 months -- and it is likely to be much longer," Priory said in the same internal speech. "It is clearly very difficult for any of our companies to grow while we are in this marketplace eclipse. The bottom line is that we have to make our own breaks."

In the meantime, Duke is a shrinking company -- selling off profitable assets to pay down debt -- that must shower investors with lavish dividends just to keep many of them around. Despite a clear need for cash, Duke will shell out nearly $1 billion this year to pay dividends with a 6.6% yield that far exceeds the 5.5% utility average. By bringing the dividend in-line with its peers, Duke could free up more than $400 million in precious cash flow. But so far, management has been fiercely protective of the rich dividend that helps support the company's high-teens stock price.

Duke shares dropped 16 cents Friday to close at $17.39.

"The implied stock price support at peer average yields would be $11.45, and management is highly unlikely to take that risk," Prudential analyst Carol Coale wrote last week. So "it may come down to a forced decision by the rating agencies."

Payout Payback

Although Coale believes Duke would not voluntarily cut its dividend until at least next year, she suspects that the generous payout -- coupled with recent one-time gains in earnings -- "may send an alarm" to the credit rating firms before then. And her recent comments came even after rumors were already swirling about an alleged meeting between Duke and S&P last week.

Some industry experts believe that DETM's credit is highly vulnerable to a cut right now. In the meantime, they're concerned by what DETM's first-quarter deficit might imply. Duke reportedly blamed most of the equity plunge on a timing issue, saying the two partners simply hadn't made routine funding contributions that would be forthcoming. But some experts were startled -- and deeply troubled -- to learn that money seems to pass right through DETM.

"Rather than being a separately capitalized company, DETM appears to rely almost entirely on affiliate support," one said. "To rely on the company's financials, you have to believe the partners will still be ready to fund DETM on a tough day."

For some reason, the partners didn't fund DETM by the end of the first quarter -- and the division's credit rating has tumbled since that time. Although S&P indicated that the situation has been remedied, some industry insiders see fresh risk that DETM could fall short on funding again.

Duke Energy North America, or DENA -- the unregulated division that includes DETM -- continues to drag its parent down with disappointing earnings. As

TheStreet.com

projected in early February, DENA is already struggling to hit its aggressive earnings targets for the year. Quite simply, the division has been unable to generate the extra profits -- beyond locked-in contracts -- it was banking on when issuing its optimistic guidance.

"So far this year, DENA is running about 50% behind its goal in generating the alternate source of gross margin, and we see little reason for conditions to improve in 2004," wrote Coale, who rates the stock a hold. We "assume that the challenges for DENA to deliver earnings from other sources of gross margins may have been underestimated."

Meanwhile, some energy traders are starting to speculate that Duke's trading partnership with ExxonMobil -- whose triple-A credit lends support to DETM's rating -- could be at risk. Rumors are swirling that Duke may set up an entirely new trading shop and attempt to go it alone. And ExxonMobil, which accused Duke in heated litigation of "looting" the partnership, has expressed clear dissatisfaction with the business relationship already.

"There are enough outstanding issues right now that it wouldn't surprise me if DETM got downgraded," said one industry analyst. "There's a lot of pressure on Duke -- and there may well be additional pressure to come."