The secret behind the numbers at
is starting to come out.
Last week, Duke revealed new information about the true health -- and earnings power -- of its merchant energy business. The picture, while clearer, isn't exactly pretty.
In a nutshell, Duke can generate a whole lot more electricity than it can sell. It needs to hunt down additional buyers -- in an oversupplied market -- just to hit 2003 earnings targets. And in this regard it faces an uphill battle, as capacity grows and power prices decline, through at least 2004. That surprising fact has some observers reassessing just how strong Duke, the hardiest of the companies that once earned riches in the energy-trading business, really is.
"While we applaud more transparent disclosures, they also appear to illustrate a longer and more severe wholesale downturn than we previously anticipated," Raymond Niles, an analyst at Salomon Smith Barney, wrote last week. "Duke's disclosures paint, in our opinion, a rather stark outlook for their wholesale generation operations for the next few years and will continue to pressure Duke's valuation."
Niles is among a crowd of analysts currently recommending that investors hold, or even sell, Duke's stock. They look at Duke, once a Wall Street darling, as a risky investment going forward. Meanwhile, short-sellers -- who sniffed trouble ahead of the curve -- are citing new evidence that Duke was riskier than it seemed all along.
For its part, Duke blamed Wall Street's dim view of the company on "extreme conditions" in the merchant energy sector, while stressing that it remains generally healthy overall. But investors' newfound understanding of the bets the company is making will mean Duke remains under the microscope in an economy where uncertainty is becoming the rule. The company's stock, which is hovering near a 52-week low set last October, fell 29 cents to $16.50 Thursday.
Recipe for Earnings
If all goes as promised, Duke will deliver 2003 earnings of $1.35 to $1.60 a share -- at least some of it from Duke Energy North America, the company's troubled wholesale unit.
Duke's expectations for DENA have clearly fallen. At its peak in 2001, DENA generated $1.5 billion in EBIT (earnings before interest and taxes) -- more than every other division, except franchised electric, combined. This year, DENA must cough up only $200 million, matching last year's contribution from Duke's real estate division, to meet its earnings goal.
Even so, analysts are skeptical.
"This would seem to be a demanding target, given the current market conditions," said Steve Fleishman, an analyst at Merrill Lynch who rates the stock a sell.
Despite analysts' doubts, Duke spokesman Terry Francisco said the company remains "pretty confident" in its guidance for DENA.
For 2003, DENA has locked in contracts worth about $600 million -- or $250 million less than it needs just to break even. The company is, therefore, counting on $450 million worth of extra merchant energy business to hit its earnings target.
"They're making a bet," one short-seller said. "It's like setting up a hot dog stand and hoping people will buy."
If nobody at all bites -- an unlikely worst-case scenario -- up to 25% of Duke's projected full-year earnings could fall through. And from there, the company's new disclosures indicate, things may only get worse.
This year, Duke will generate 28 million megawatts of electricity -- or about one-third of the amount it's capable of producing. The company has contracts to sell all of that power, and even a little extra, at an average price of $51 a megawatt/hour.
But going forward, Duke's guaranteed power sales decline. For 2004, Duke has locked in contracts for 79% of its estimated production at an average price of $44/MWh. For 2005, Duke has hedged only 64% of its production at an even lower $39/MWh.
Francisco described the decline in hedges, and even prices, as typical. But Niles for one is troubled by that trend.
Francisco described the decline in hedges, if not prices, as typical. But Niles for one is troubled by the overall trend.
"For 2005, EBIT for DENA could drop ... to around zero in our estimate unless there is a meaningful improvement in market conditions," Niles wrote last week.
Armed with fresh disclosures -- and burned by past surprises -- analysts are relying less on Duke's management than their own calculators to estimate the company's earnings. Niles expects Duke to fall short of even the low end of its 2003 guidance. Meanwhile, short-sellers continue to rumble about an alleged lack of disclosure that they say makes Duke's forecasts murky at best.
This isn't the first year Duke has built extra -- and uncertain -- trading profits into its earnings targets.
The company has issued similar guidance, with the same vulnerabilities, in the past. Wall Street just didn't know it.
Last year, Duke told investors that extra trading profits could push the company's earnings to the high end of its guidance. But Duke's new disclosures now indicate an even heavier dependence on trading than most people realized. Without those extra profits, it appears that DENA -- a turbo-charged profit machine in 2001 -- could have become a sudden money loser in 2002.
Duke said Thursday that it has always assumed "a minimal level of performance in trading" when figuring even the low end of its guidance. But short-sellers recall a far different story.
"Duke always said the way to get to the upper end (of guidance) was trading," said a utility fund analyst. "But in fact, to even get positive EBIT, it was trading."
That safety net has disappeared along with the trading boom. So critics warn that Duke must exploit other opportunities -- at a particularly inopportune time -- in an effort to bounce back.
Duke is best known, and rightly so, as an energy company.
But it's also in the real estate business. Last year, Duke Ventures -- dominated by the Crescent Resources real estate division -- generated more money than either international energy or field services. This year, Ventures could easily surpass DENA with contributions to the bottom line.
Indeed, that almost has to happen for any upside earnings surprise.
the numbers through our model would suggest that the real estate business will likely need to deliver higher earnings than in 2002 if Duke is to earn at the higher end of its stated range," Fleishman wrote in a recent report.
But critics are already challenging the quality of those earnings, calling them one-time gains rather than recurring income. Duke claims otherwise, comparing Crescent Resources to any other real estate business that counts real estate investments as expenses and -- in turn -- real estate sales as income.
"Crescent develops buildings and sells them," CFO Robert Brace said during a recent conference call. "So we don't consider them to be one-time gains at all."
But some people doubt that Duke can afford to keep buying real estate while money grows tight. And if Duke stops buying, these people insist, then Crescent's profits start looking more like one-time gains than ever.
"If you're not investing and you're just selling," one short-seller said, "then that income's not ongoing."
To date, Duke has yet to disclose how much of its 2003 earnings guidance hinges on real estate sales. It simply says it expects the real estate division to turn in a consistent performance this year.
Basket of Risks
Duke's guidance isn't the only -- or necessarily the largest -- concern for analysts right now.
Niles sees a potential threat to Duke's dividend, although the company says it's "very confident" in plans to fully fund the dividend this year. Analysts also worry about the deteriorating credit quality at Duke Capital, which could result in costly downgrades and -- even worse -- the need to issue additional stock.
Duke says it has no plans to issue equity in 2003. But analysts remain wary.
"Management did not disclose updated Duke Capital credit ratios on the conference call," Fleishman said. "But we suspect that the already stretched metrics have deteriorated further following the additional balance sheet writedowns seen in Q4."
Meanwhile, short-sellers warn of more -- potentially crippling -- writedowns to come. They support their claim by pointing to dwindling cash flows from power assets whose reported values have remained unchanged.
"They cannot afford to take those kinds of writedowns now because they might blow through their covenants and their ratings measures," one critic said. "But they've got to take them sometime."
So far, Duke has announced charges limited only to accounting changes. But the company admitted Thursday that it's "hard to say" whether major writedowns are coming.