Duke Finds More Doubters - TheStreet

Duke Finds More Doubters

Questions about the energy giant's merchant division won't go away.
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Wall Street isn't exactly rolling out the red carpet for

Duke's

(DUK) - Get Report

long journey back to the throne.

Mainstream analysts, who once treated Duke like royalty, now prefer to bet against the company's swift return to power. They warn of possible minefields -- particularly in the merchant energy business -- that could blow up the stock going forward. And they question why retail investors are still willing to pay a princely sum for the shares.

"Despite its ... apparent 'cultlike' following in some retail circles -- which we believe has helped support the stock -- we believe Duke has significant fundamental challenges ahead that do not warrant its shares trading at a ... premium," UBS analyst Ronald Barone wrote this week.

Barone started coverage of Duke Tuesday with a reduce recommendation and a $16 price target. At least five other analysts are pushing investors to sell their shares as well. The rest have lukewarm hold ratings on the stock. And some of them -- including two who recently upgraded the stock from sell -- even warn that Duke may have peaked already.

Following a powerful springtime rally, Duke recently topped $20 for the first time since early this year. But the stock took a hit on Barone's bearish report. Shares of Duke -- which surged more than 50% in the second quarter -- slipped 2.1%, or 41 cents, to $19.54 Tuesday afternoon.

Playing It Safe

To be sure, Wall Street has called this stock wrong before.

Before raising Duke to hold last month, both J.P. Morgan and Banc of America Securities warned investors to sell the stock while Duke's credit was still good. But the expected hit to Duke's credit profile never materialized. Instead, Moody's and Standard & Poor's opted for one-notch cuts that left Duke and its subsidiaries -- including a debt-burdened merchant finance arm -- with the all-important investment-grade ratings. And Moody's went a step further by essentially ending its review.

"Our operating assumption was always a one-notch downgrade ... but with a negative outlook," J.P. Morgan analyst Jamie Waters wrote last month. "The fact that Moody's concluded the review with a stable outlook is key to our upgrade."

Banc of America analyst Shelby Tucker, who had braced for a two-notch downgrade, expressed even greater surprise. He promptly concluded that Duke had escaped near-term hits to its stock. But he stopped short of discarding his caution with his sell recommendation.

He warned that Duke Capital, the company's struggling merchant finance division, could still drag the parent down.

"While in the near and intermediate term

Duke Capital can rely upon asset sales and additional support from the parent ... we believe that is not sustainable over time," Tucker wrote.

Barone has given Duke only a short window -- roughly six to nine months -- to turn its business around.

Possible Strikes

But Barone isn't betting on a rebound. Instead, he predicts that Duke's financial performance will continue to deteriorate through at least 2004.

And like most, he blames Duke's wholesale energy unit -- once a booming profit center -- for most of the company's problems.

Going forward, Barone expects Duke's wholesale unit to fall well short of profit forecasts this year and be operating in the red by next. All told, he believes the unit faces a $3 billion funding gap for the two years combined.

Only by selling assets and leaning on its strong utility, he says, can Duke's wholesale unit weather the industry storm. And he warns that the entire company -- and its shareholders -- could pay dearly in the process.

"Though management is 'sweating' Duke's assets hard in an attempt to generate ... cash flow," Barone wrote, "we are not convinced that the company will have the tools at its disposal -- including a favorable enough wholesale power market environment -- to succeed in this effort without requiring material concessions from equity holders down the road."

He lists possible dilution and dividend cuts as risks. He also points with caution to regulatory probes of Duke's trading division and its "crown jewel" Carolina utilities. And he hasn't ruled out a devastating credit downgrade yet.

The Final Cut?

Unlike Moody's, Standard & Poor's left the door open to cut Duke's trading unit to junk. And Barone warns of dire consequences if that happens.

The downgrade "would require roughly $400 million of incremental collateral that, in our view, Duke cannot afford to have tied up," he wrote. "Moreover, we believe a downgrade to below investment grade would significantly impede

the merchant division's ability to conduct future business."

Barone labeled Duke's credit a sensitive issue that must be closely monitored. But he also confessed that "limited disclosure," particularly from Duke's merchant unit, continues to complicate this task.

In the end, he called for investors to sell their shares and step to the sidelines until Duke's outlook improves. And he asked for management to provide the market with a much clearer picture going forward.

"We believe Duke's leadership has begun to turn the corner by being somewhat more realistic with the challenging situation at hand," he said. But "worth repeating is our view that further progress on this front -- with a clear track record of realism -- is required."