For the first 90-odd years of its nearly 100 years of existence, the company now known as

Duke Energy

(DUK) - Get Report

was a homely, hardworking utility -- massive, admirably efficient and utterly uninspiring. Light years away from being a growth play, it was the sort of stock that catered to widow-and-orphan shareholders looking for steady dividend yields.

But people who bought the stock back when it was a meek regulated utility are now holding something completely different because over the past few years, the $49 billion company has begun to transform its business.

Following in the footsteps of companies like

Reliant

(REI) - Get Report

and

Southern

(SO) - Get Report

, Duke is converting itself from a basic commodity provider to a sleeker, faster-growth company with a correspondingly fatter valuation. Following a big acquisition in 1997, it now has a stake in practically every step of energy delivery, from exploration and production to gas pipelines, power generation, trading and marketing. But its biggest push by far has been into the lucrative wholesale power market.

The difference between the regulated and unregulated world is simple, but represents vast differences in profit potential: Regulated utilities have to ask a state regulatory board for permission to raise rates, which they may or may not receive. Wholesalers, on the other hand, sell power to utilities or big companies at the best price they can get on the market.

Courtesy of its aggressive move into the wholesale business, Duke now stands betwixt and between the usual categories for energy companies, straddling the line between sleepy utilities on the one hand and racier power producers on the other.

"Our growth rates and investments are certainly skewed toward the competitive businesses, so that percentage

of the overall pie should increase," says L.B. "Buck" Gatewood, Duke Energy's senior vice president of strategic planning and development. "For our shareholder, we're looking to create an integrated energy company on an international basis, one that has good balance. And we're getting there." So far, shareholders have mostly applauded the trend, sending the stock up 51% in the past year.

High Energy
Duke's stock has gotten a nice pop in the past 12 months
as the company has moved into the unregulated-energy business

But it's worth noting that in its bid for more growth, Duke is venturing into a sector with the potential for much more volatility than its traditional business. Case in point: California -- where it's had trouble collecting on money for power sales and is also facing lawsuits and investigations alleging that it overcharged the state for power. While problems there clearly represent a worst-case scenario, they do point up the risks inherent in running an energy business in a deregulated world.

The Regulated Energy Business: Dull and Getting Duller

As regulated utilities go, Duke ranks among the best. It has earned a reputation as a highly efficient, low-cost producer of energy. But that doesn't count for much these days. In the past five or 10 years, investors have grown increasingly uninterested in dividend yields in favor of price appreciation, so even a top-notch utility isn't enough to gin up much excitement. The utility piece of Duke's business is forecast to grow at a crawl, about 3% or 4% a year.

Basically, its relatively stodgy growth prospects act as a ceiling on Duke's multiple. Because it still gets a big chunk of its earnings from its utility business, it's considered less valuable than competitors focused primarily on the wholesale market. That's why it trades at only 19 times trailing earnings, while independent power producers like

Calpine

(CPN)

and

Dynegy

(DYN)

trade at

price-to-earnings ratios of 48 and 32, respectively.

And the regulated business looks even less appealing in an environment of power shortages, given the tantalizing prospects for wholesalers to sell to the highest bidders. Thus the push away from the drowsy realm of regulated utilities and toward the more profitable wholesale market. By most accounts, Duke -- a company known for its conservatism -- has managed the transformation surprisingly well.

Wholesale Power Is Where It's At

The payoff from that shift can be seen from just a glance at the company's first-quarter results: EBIT -- earnings before interest and taxes -- in its energy services arm (which consists mostly of the domestic wholesale energy business) surged 208% from the previous year.

Largely because of this tremendous growth in its wholesale business, Duke has already achieved most of its earnings growth projected for all of 2001,

Merrill Lynch

said in an April report. The investment bank predicts earnings growth in 2001 of 17%, ahead of the company's own 10% to 15% target -- and even that may be on the low side, it noted.

During the next few years Duke's growth operations (basically everything, excluding the regulated utility) are expected to grow at a clip of more than 25% annually, according to Merrill. Those operations are contributing an increasing amount to profits, too. According to Duke, those businesses kicked in more than half of the company's earnings in 2000 -- a big jump from the 8% of earnings they contributed just three years ago.

Meanwhile, Duke is investing heavily in infrastructure to fuel more growth. The company plans to bring six new unregulated plants on line this summer in the U.S., on top of the four power plants it opened last year. Additionally, it aims to deliver 10 to 11 more plants in both 2002 and 2003.

Duke's ambitious aims on the wholesale side have given rise to the inevitable speculation that it might eventually spin off its unregulated business, as Southern did with

Mirant

(MI)

and Reliant has done with

Reliant Resources

(RRI)

.

Such offerings have been warmly received by the market: For example, Mirant, which had its

IPO last September, is up nearly 38% in the year to date and already claims a

market cap -- at $13.2 billion -- nearly equal to that of parent company Southern's $15 billion.

Duke, however, hasn't indicated yet whether it plans any similar moves.

"Like all companies, we study a number of possibilities. I won't go so far as to say we'd consider that because we have a very successful integrated strategy," says Gatewood.

In any case, the spinoff speculation raises questions about how Duke plans to crank out the most return for shareholders. In the past, investors have had good reason to be pleased with the company's performance. Duke's five-year return of 16.4% edges out that of the

S&P 500, an impressive showing given that Duke has branched out from its core utility business only in the past few years.

But it's clear that to maintain that double-digit growth, the company will have to keep taking risks on an order it never had to in the regulated world. One need look only to California to see just how complicated things can get.

To go to Part 2 of this column, click here.