Sunshine Fades as Duke Rolls Out Convertible

Duke ( DUK) saved the bad news for last.

Ending a two-month rally that had just culminated with a strong earnings report, Duke surprised the market Thursday with plans for a new securities offering. The North Carolina energy giant said it will issue up to $770 million worth of convertible bonds after the market closes Thursday, to raise money for corporate expenses and short-term debt obligations.

News of the offering, coupled with a downgrade warning shareholders of dilution, sent Duke's soaring shares into reverse. The stock sank 5.3% to $16.65 Thursday morning, halting a steady rise that had left the shares with a 44% gain since early March.

Still, Banc of America analyst Shelby Tucker sees even more dilution coming. He cut Duke from hold to sell on Thursday, primarily because he expects rating agencies to cut the credit of subsidiary Duke Capital to junk. To lessen that blow, he says, Duke must issue roughly $1.25 billion worth of common stock by the end of the year.

But even after issuing that stock, Tucker says, Duke will probably still have to cut the dividend it has so fiercely protected.

"Despite the significant recurring detriment to liquidity, management has ardently opposed the dividend's reduction," Tucker wrote Thursday. But "we believe the current dividend rate is hard to justify."

Dividend Watch

Still, Tucker believes Duke will postpone cutting the dividend until it has no other choice -- something he believes will finally come to pass in a year or so. Duke says that its "current business plans for 2003 fully support the dividend at this level." In the meantime, Tucker expects new stock offerings to shave 2003 and 2004 earnings by 7 cents and 14 cents, respectively.

Duke stock in 2003

The company, which topped expectations Wednesday with first-quarter profits of 43 cents, has promised to deliver full-year earnings of $1.35 to $1.60 a share.

For now, Tucker believes Duke can hit that target, though he's bearish on the company overall. Tucker penned his recent downgrade just before Duke announced plans for its convertible offering, which one short-seller labeled inadequate and even "absurd."

The short-seller pointed out that Duke is essentially issuing new debt "with very little equity" because the senior notes cannot convert to stock unless Duke shares jump to $24 -- a level unseen since last August. He says Duke is using new debt to refinance old debt and fund operations so free cash flow can pay the dividend and prop up Duke Capital.

But in the end, he says, Duke's dividend is vulnerable -- and Duke Capital's credit rating is even more so. Tucker agrees. He sees no justification for Duke Capital's investment-grade rating and points out that a downgrade to junk will hurt the parent company as well. He warns that potential credit downgrades -- which he views as likely -- will reduce the company's access to short-term debt by roughly $800 million and trigger another $400 million worth of collateral calls.

"We believe these issues are not reflected in Duke's current stock price," Tucker wrote. "We see little upside at this point and a lot more downside."

Tucker views Duke as clearly overvalued and expects the stock to head back down to $14 a share. In the meantime, he's found some bones to pick with the quarterly results that helped push Duke higher. And he is not alone.

Fog Rolls In

Wall Street, in general, recognized that Duke handily beat estimates with help from cold weather and a recent acquisition. But investors and analysts nevertheless view Duke's regulated businesses as sound, and they save much of their fretting for the company's troubled merchant energy unit.

Prudential analyst Carol Coale, who rates the stock a hold, never even figured out just how well -- or poorly -- the unit's closely watched trading business performed.

"Because of ... Duke's complex financial reporting, we found it virtually impossible to use the financial statements to reach meaningful conclusions related to trading profits and losses," Coale wrote Thursday.

Shelby made his own stab at deciphering the segment results -- and didn't like what he saw.

"While we had forecasted zero contribution from the segment for 2003, we are somewhat surprised that the unit was not able to capitalize on the same opportunities ... as some of its competitors," Shelby wrote. "We consider the merchant results lackluster."

Hard to See

The unit is clearly weighing down on Duke's overall performance. Contrasting sharply with big jumps in regulated income, quarterly profits in the merchant business continue to fall, dropping from $54 million a year ago to $35 million in the fourth quarter to $23 million in the period just ended.

Because of that slide, analysts have grown increasingly skeptical that the segment can still hit its $200 million profit target for the year. In the meantime, they are venting some new frustration about Duke's complicated financial statements.

Shelby, for example, complained that Duke has suddenly decided to expand its "other" division. By doing so, Duke has made it virtually impossible to determine how much real estate sales -- viewed by some as nonrecurring -- are contributing to the bottom line.

"It has become more difficult to assess the performance of this business at a time when more disclosure is needed," Shelby said. "We find this concerning."

Short-sellers were more blunt.

"There's a whole list of things these guys are not telling people," one said.

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