Even nobility carries few privileges in the energy-trading business nowadays.

The acknowledged royalty in the sector is North Carolina's Duke Energy ( DUK), which despite a sharp fall in its stock this year continues to boast a solid balance sheet and a market value of around $20 billion. The company's shares have actually risen in recent weeks following a strong second-quarter earnings report.

That puts Duke in sharp contrast with cash-strapped rivals such as Williams ( WMB) and Dynegy ( DYN), which have seen their shares drop into the low single digits as the companies succumbed to raising cash by selling their crown jewels -- their highly profitable pipeline businesses.

But some investors and analysts are increasingly wondering whether Duke deserves the red carpet treatment after all. Though the company beat second-quarter earnings estimates, some critics say it did so only by counting proceeds from asset sales and a gain on how Duke values its mark-to-market trading portfolio -- gains the company can hardly count on recognizing every period.

Moreover, these people say that even in a post- Enron market obsessed with disclosure, Duke doesn't give investors enough information to truly justify a premium valuation. Others note the company is poised to issue stock in a market that's been very jittery about the very viability of the energy trading business.

Duke defends its earnings and disclosure practices, saying that the earnings boost came after an internal reorganizaion of its modeling practices. But with questions about earnings quality hovering, analysts at several firms have turned gloomy about the prospect that the stock will regain its highs of this spring.

Behind the Numbers

Earnings quality is perhaps the biggest question for many watchers of Duke. Almost without exception after last month's second-quarter earnings report, analysts immediately noted that Duke needed padding from one-time gains to meet its targets.

But some were harsher than others. Particularly bearish were two J.P. Morgan analysts, who labeled their post earnings-conference report "Missed Opportunity." They chided Duke for fueling, rather than addressing, nagging issues that could affect the company's share price. They singled out Duke's new mark-to-market assumptions, which resulted in a $46 million gain.

"Comments by management on the 2Q conference call and actions taken during the quarter have raised additional concerns and, in fact, confirmed some of our fears about what might be lurking in 'left field,'" wrote analysts Jim von Riesemann and Jamie Waters, who rate the stock a market performer. "We would highly discount any 'earnings' associated with these changes in model assumptions, similar to our view of earnings from asset sales."

They weren't alone. Analysts at Merrill Lynch joined the chorus, questioning a second-quarter accounting gain that comes even as many peers are reducing their trading expectations.

"While this does not sound unreasonable per se," they wrote, "it is worth noting that the Q2 changes come on top of $36 million of similar gains included in the Q1 results. While we recognize that the process of improving valuation assumptions may have taken some time, it would certainly be preferable not to have further significant gains at this line in coming quarters." Merrill Lynch rates the stock near-term neutral and long-term strong buy; both Merrill and J.P. Morgan have underwritten for Duke.

Duke spokesman Terry Francisco said much of the mark-to-market gain came after the company streamlined separate models used at its two domestic trading headquarters. "We have a very extensive Western trading operation headquartered in Salt Lake City and an Eastern trading operation headquartered in Houston," Francisco said. "We changed our modeling technique to report both East and West together."

Quality and Earnings

Unlike most companies, Duke has always included one-time gains -- and, to be fair, one-time charges -- in its regular reported earnings. The company considers buying and selling assets, such as power plants, a routine part of its business.

"It fits into our portfolio management strategy," Francisco said. "It's analogous to real estate. Everything's for sale at the right price."


Rebounding
Duke bouncing back


But some critics have scoffed at the practice, saying a company can sell only so many assets before it eventually runs out. Therefore, they added, proceeds from asset sales should not be mixed with the steady stream of earnings that flows from ongoing operations.

In Duke's second quarter, that mixture proved instrumental to hitting earnings targets. The company racked up a net gain of 4 cents a share through asset sales and a one-time construction fee. Mark-to-market "improvements" added another 3 cents a share, allowing Duke to post second-quarter earnings of 56 cents a share -- topping analyst expectations by a nickel instead of missing by 2 cents.

Even the company's operational income, particularly from trading, can be difficult to evaluate. Unlike some of its peers, Duke withholds specific information about the gross margins it earns from power and gas trading.

"In today's environment, we look hard at what we disclose and what we don't disclose," Francisco explained. "We choose not to disclose that for competitive reasons."

Revising Downward

Duke also refuses to break down its capital expenditures by segment, citing the need for spending flexibility. But overall, the company has slashed its 2003 capital spending budget from a previous high of $8 billion to as little as half that amount.

Even Duke admits it cannot entirely avoid the industrywide meltdown that has spared it for so long. After delivering on second-quarter earnings promises, the company backed off its guidance for the full year, blaming turmoil in the merchant energy sector.

Duke now expects 2002 earnings of $2.45 to $2.55 a share, below the low end of its previous guidance of $2.54 to $2.78. The company described its new expectations as "conservative," but admitted they could go lower.

"The downside risk," Francisco said, "is what's happening in the energy services market."

Fire in the Belly

Last week, Duke suddenly fired two employees linked to round-trip energy trades that artificially boosted the company's trading volume and revenue.

Duke discovered the 66 questionable transactions while gathering information for an industrywide investigation by the Securities and Exchange Commission. The company had already uncovered 23 other wash trades, transactions previously tied to more beleaguered energy merchants like CMS Energy ( CMS).

All told, the wash trades boosted Duke's revenue by $217 million during the past two-and-a-half years. Standard & Poor's viewed the transactions as "marginally negative" and, despite their immaterial financial impact, said it will continue to examine Duke's treasured A+ credit rating for possible downward revision.

In addition to inquiries by the SEC, Duke also faces subpoenas from both the U.S. Commodity Futures Trading Commission and the Houston office of the U.S. attorney. Many analysts rank regulatory investigations as one of the biggest threats to Duke's current share price.

But others are dwelling on a separate matter that's almost certain to hurt reported earnings.

The Dilution Solution

Before the end of the year, Duke will issue $1 billion worth of new securities in an effort to bolster its financial strength and satisfy increasingly merciless credit rating agencies.

Given the unfavorable bond market, many believe Duke will issue equity -- including a major slug of common stock -- at a time when its share price is trading around near-decade lows. Analysts have already revised their future guidance downward in anticipation of dilution, while warning they may not be finished yet.

J.P. Morgan, for example, has dropped its 2003 earnings estimate from $2.85 to $2.60 a share and predicted that earnings could take a hit from dilution well before that time.

"We believe recent comments by the rating agencies mean the issue could come sooner rather than later and reflect a greater portion of common equity than is reflected in our current estimates," J.P. Morgan analysts said.

Merrill Lynch offered a similar opinion.

"While we are already assuming earnings at the lower end of Duke's range, we continue to see more downside risks than upside," analysts wrote.

Others describe Duke's stock as "oversold" and predict significant appreciation in Duke's share price. But many have issued target prices in the low $20s and teens, below the stock's $24.26 close Friday.

Even some who recommend the stock have expressed disappointment at Duke's weakened outlook and surprise at the company's new vulnerability to merchant energy woes.

"The new outlook is well below our previously revised 2002 EPS estimate," wrote Vestigo Associates, the independent research arm of Fidelity Capital Markets.

"We had previously scaled back our expectations for energy trading but obviously not enough."

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