Rate Case Means New Headaches for Duke - TheStreet

Rate Case Means New Headaches for Duke

Earnings could be at risk as the company faces claims it exceeded South Carolina rate caps.
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Duke Energy's

(DUK) - Get Report

strongest division may be in for another jolt.

Duke Power, already under the cloud of a criminal investigation, faces a possible rate cut in its second-largest market. Due to sizzling first-quarter profits, Duke's South Carolina utility has officially stormed past its so-called allowed rate of return.

The power division, which ranks as Duke's biggest profit center, has been accused in the past of using accounting tricks to downplay utility profits and dodge rate cuts. But a state-ordered probe, recently expanded into a sweeping federal investigation, has blown the company's books wide open.

Under intense scrutiny from the authorities, Duke recently became the first South Carolina utility in five years to report excessive profits. Gary Walsh, executive director of the Public Service Commission of South Carolina, confirmed Monday that Duke had gone "well over" its allowed rate of return during the latest reporting period.

"I've done some analysis myself," Walsh said. "But I'm going to give

Duke 30 days to respond to the commission as to what caused the excess earnings."

Duke defends its rates and says it plans to work with the commission. But with the company's earnings under pressure and its credit rating a source of constant anxiety to investors, Wall Street will be eager indeed to hear Duke's response to the commission. Duke shares fell 11 cents Monday to $18.62.

The Price of Excess

In its latest quarterly report, Duke pointed to cold weather and strong wholesale power sales for an 18% surge in electric utility profits. The company generates most of its electricity with coal or nuclear energy instead of expensive natural gas. This year, with gas prices soaring, Duke has managed to rake in extra profits by selling excess capacity into the open market. But that success could prove bittersweet.

State regulators may now step in and say that excess profits, generated by consumer-funded assets, belong to utility customers instead of shareholders.

"That would be very significant," said Blaylock analyst Lasan Johong. "Duke needs every penny it can get right now."

Stung by a meltdown in the merchant energy business -- which seemed highly profitable before


collapse -- Duke now depends on its regulated divisions for almost all of its earnings. Duke Power, dominated by electric utilities in North and South Carolina, currently generates about half of the company's total profits. So any hit to this division, described by Standard & Poor's as Duke's "largest and most stable generator of cash flow," could hurt.

S&P was fretting over regulatory risks in Duke's utility division even before South Carolina raised questions about Duke's high rate of return. And it has hinted that Duke could face another downgrade -- taking its BBB+ credit at least one notch closer to junk -- if conditions don't improve.

"The company

has little ability to absorb any further weakening in operating cash flows," S&P wrote last month. But "we believe Duke Energy's operating performance may have not reached its lowest point yet."

Moody's is a bit more optimistic. The competing ratings agency surprised Wall Street this summer by adopting a stable outlook for Duke's investment-grade rating.

To be sure, Duke Power relies on its larger utility in North Carolina -- where it's currently protected by a rate freeze -- for most of its earnings. But it still looks to South Carolina for roughly 25% of its power profits each quarter.

There, Duke recently posted a 14.25% rate of return that clearly exceeds its 12.25% limit. But Duke spokesman Terry Francisco described the 12.25% cap as little more than a "target rate." He pointed out that Duke has reported much lower returns -- under 10% through most of 2000 -- without seeking rate hikes from the South Carolina commission. And he seemed to expect similar cooperation from state regulators now that Duke has scored "unusual" profits from excess power sales.

"We have some of the lowest rates in the country -- and I think the commission is aware of that," Francisco said. But "obviously, we're going to work with them."

For now, Francisco isn't fretting over what a rate cut would do to the company's bottom line.

"I can't speculate into the future," he said simply.

Strained Relations

In its home state of North Carolina, Duke is regarded as a prominent investor-owned utility that satisfies the power needs of some 2 million customers across the Carolinas. But Duke's friendly relationship with state regulators has soured a bit in recent years.

Tipped off in 2001 by a Duke whistleblower, state regulators commissioned an independent investigation that -- in the end -- read like a scathing indictment of the company's reporting practices. The investigation, carried out by independent auditor Grant Thornton, concluded that Duke had intentionally overcharged Carolina utility customers by more than $125 million between 1998 and 2000.

Duke settled the charges for $25 million without admitting any wrongdoing. But the company, now under the watchful eyes of criminal investigators, has come forward to report excess utility profits for the first full quarter since Grant Thornton issued its report.

On average, Thornton estimated that Duke had overcharged Carolina customers by more than $40 million annually during the three-year period in question. Now, Walsh is saying that Duke earned $41 million more than allowed -- in South Carolina alone -- for the year ending March 31.

"It's amazing, when the eyes are on you, what your earnings really look like," said F. Barron Stone, the internal accountant who blew the whistle on Duke two years ago. "If the

utility earnings were reported right before, our rates would have probably been cut already."

Francisco claims otherwise. He says that, even after adopting the Thornton recommendations, Duke would have fallen under its profit limits in South Carolina. But he does admit the accounting changes would have pushed Duke's larger utility in North Carolina over target limits more than once before that state froze Duke's rates last year.

Taking the Fall

Back in 1998, South Carolina Electric & Gas (or SCANA) -- another Carolina utility -- pushed past profit caps itself. And it weathered the only South Carolina rate cut in recent history as a result.

Duke immediately took notice.

In its report to state regulators, Grant Thornton said at least one Duke executive was "shocked" by the "devastating" rate cut at neighboring SCANA. Thornton went on to report that Duke employees viewed a similar rate cut as a "risk to the company" where they worked.

Within days of the SCANA rate cut, Thornton found, Duke began taking deliberate steps to address its own "allowed return problem."

"A number of Duke mid- to senior-level managers met and developed a plan ... for accounting adjustments which could be made to 'avoid reporting overearnings to regulators,'" Thornton said, quoting company documents.

Thornton ultimately viewed most of the accounting adjustments as improper -- and some "which were completely without accounting justification under any accepted accounting standards."

Duke, backed up by its own expert accountant, views Thornton's stance as a simple difference of professional opinion. But Duke must now prove its innocence to federal investigators who could slap the company -- and even individual employees -- with criminal indictments. The company must also defend itself against a multimillion-dollar retaliation lawsuit filed by Stone under the new Sarbanes-Oxley Act.

Stone, who lost a similar case against Duke through the Labor Department, predicts the company's luck may be waning. He expects South Carolina to cut Duke's utility rates -- just as it did with SCANA -- and Duke to suffer as a result.

"If the commission doesn't take some action, they're going to have another company

SCANA that's very unhappy," Stone said. "So there's some exposure here. There's an opportunity to lose earnings, to further pressure Duke's ability to hold its credit rating -- just the whole nine yards."