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Although Duke draws only a minor portion of its revenue from California, its experience in the state highlights the financial hazards for energy wholesalers when deregulation goes awry.

As of the end of 2000, Duke was still owed more than $400 million for power sold in California. As a result the company set aside $110 million in reserves to cover the possibility that a portion would never be collected. Since then it has managed to obtain some of the money it's owed, and institutional investors reckon its current exposure of a couple of hundred million dollars isn't that significant for a company of Duke's size. But it's not the kind of payment wrangle any business likes.

The tense situation in California also underscores the political risks for energy companies in deregulated states. "It's great if these high profits come about, but if they're going to be short-lived, if they result in massive givebacks in terms of taxes and penalties," they won't be of much benefit to shareholders, says Dan Manion, manager of the

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Sentinel Common Stock fund, alluding to the surges in energy prices last winter that prompted federal investigations of Duke and other power producers. The fund maintains a 2.25% stake in Duke.

In March, the leading U.S. energy regulator said that unless Duke and other energy generators can justify the high prices they charged for power in the state last winter, they would have to pay millions of dollars in refunds. Duke is clearly tangled in a messy situation: This month, California newspapers revealed that it had written a

confidential letter to the state governor, requesting that the state drop its lawsuits and investigations against the company in exchange for a number of concessions, including forgiving a portion of payment due for past power sales.

The catastrophe in California bodes ill not just in the short term for energy producers, but also for the movement toward deregulation in general. The sky-high energy bills and rolling blackouts California has wrestled with have slowed the momentum toward deregulation in other states. "I think some states will point to California, rightly or wrongly, as a test case that failed," says Manion. That could hurt the prospects of power producers in other markets slated for deregulation.

Aside from the risks presented by California, there's also a possibility that energy producers -- many of whom are busy building new power plants -- could run into power gluts a few years down the road. "You're not going to see the peak margins in selling power" continue indefinitely, says Sentinel's Manion. But he adds, "On the other hand, as we continue to see deregulation, there's always profit opportunity for the most efficient producers."

For its part, Duke has been careful to suss out the prospects of individual regions to try to avoid getting stuck with excess supply. It actually sold a power plant it had built in Texas months before the plant was slated to open because of worries that the market was getting too crowded. "Is there a risk of overbuilding out there? Certainly," says Leslie Rich, manager of the

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Evergreen Utility & Telecomm fund, which owns a 1.84% stake in Duke. "Is it in each and every power pool? No." Companies like Duke that carefully scout out the prospects for individual plants can minimize that risk, she suggests.

The company also says its diversified portfolio will help it weather all kinds of energy cycles. "What you do in developing an integrated strategy is you have sectors that somewhat counterbalance the cyclicality of other sectors," says Gatewood. For example, he says, a drop in energy prices tends to boost energy consumption. When energy consumption rises, there will be more demand for Duke services like pipeline transportation or generating capacity. "That would offset perhaps the volatility of sectors in which earnings are more dependent on prices going up and down," he says.

The Management Question

One of the crucial factors in the success or failure of Duke's transformation is the company's management. While you'd think a bunch of risk-averse utility execs might lack the aggressiveness for a big growth push, so far investors give their performance a thumbs-up. "If you'd asked me three years ago, can

CEO Rick Priory transform this company, I would have said maybe, maybe not," recalls Evergreen's Rich. "Most utility execs probably aren't up to the task."

"To their credit, they've done a really good job of delivering," she adds. "Priory has pleasantly surprised me. So I think he is capable of taking Duke to where it wants to be."

Management's conservative tilt may help it avoid the problems competitors have struggled with. The stocks of several utilities have taken a clobbering over the past few years when they took too many risks in energy trading markets.

"They're very conservative in terms of the balance sheet and leverage, in terms of risk management," says Rich. And so far earnings have been steady, even as the less predictable, unregulated businesses have become a bigger part of the overall pie. Duke has exceeded its target EPS growth rate for the past seven quarters.

Sure, it's true those gains have occurred against a backdrop of solid good news for energy producers, and it's not clear how a management known for its caution would react to a downturn for the energy sector. But in fairness, it's also possible that volatility in energy prices will decrease going forward, as more generating capacity comes online. While that may mean less profit for energy producers, it may also result in more predictable returns.

Given the reigning fascination with all things energy-related, it should come as no surprise that Duke's stock has jumped about 40% from its 52-week low last June. It closed recently at about $46, and most analysts assign it a 12-month price target of $50 to $52.

As it stands, investors still tend to lump Duke in with slower growers; though it trades at a premium to regulated utilities, it generally follows their fortunes more closely than those of sexier independent power producers, or IPPs. "Duke will have trouble breaking out of their multiple, their peer group, until the Carolinas

where its regulated utility is located are deregulated," says Rich.

Given those characteristics, it's no surprise that Duke Energy doesn't leap to most people's minds as a growth stock. Manion, who runs a value fund, calls it "value with a catalyst."

But here's another measure of Duke's ambitious profile, and perhaps of its continued growth prospects: Its biggest institutional owners aren't value funds like Manion's, but some of the biggest growth-hounds around, including

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Janus Twenty and

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Janus Mercury. Though other Janus funds have been adding some defensive names, Twenty and Mercury remain heavily tilted toward growth stocks, suggesting their managers like Duke Energy for its growth potential.

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