Struggling with a well of problems in the past few months, the once venerable Duke Energy’s quarterly earnings plunged 71% from a year ago. Huge merchant energy losses, problems in California, the deferral of several large generation projects and mounting severance costs all played a part in the losses. But Duke disclosed more bad news last week, revealing that the Securities and Exchange Commission (SEC) launched a formal investigation in mid-October of its round-trip energy trades. The SEC’s stepped up scrutiny joins two inquiries already under way by the Commodity Futures Trading Commission (CFTC) and a Houston grand jury, which subpoenaed Duke last summer (see NGI, July 15).

Less confident than in earlier conference calls, Duke’s management team spent more than an hour last week in a call with financial analysts to explain third-quarter earnings. The news was not all bad: natural gas transmission earnings were more than double from a year ago, and its franchised electric business was up slightly. However, CFO Robert Brace spent the most time discussing Duke’s $300 million-plus write-offs for the quarter, an expected $19 million or more write-off for the fourth quarter, as well as a flat-to-lower earnings outlook for all of 2003. And through 2003, Duke also said it would lay off almost 2,000 employees — 1,500 full-time workers, as well as more than 400 contract workers — to reduce operating costs. Nearly 60% of the reductions will be in energy services; 40% of the cuts will be in Duke Power.

Analysts asked few questions about Duke’s earnings following the conference call, with most of the queries centered on two paragraphs within the lengthy earnings release. “The energy industry has continued to be the focus on government investigations,” said Duke in its written release, noting that it had “received and responded” to “information requests from the Federal Energy Regulatory Commission, a request for information from the Securities & Exchange Commission, a subpoena from the Commodity Futures Trading Commission and a grand jury subpoena issued by the U.S. attorney’s office in Houston.”

Duke also disclosed in the written statement that as of “mid-October…the SEC has formalized its inquiry regarding so-called ’round- trip’ trading. All information requests and subpoenas seek documents and information related to trading activities, including ’round-trip trading. Duke Energy is continuing to cooperate with all of the respective governmental agencies.”

Several analysts appeared stunned as to why Duke had not, until Thursday, revealed that it now faced a formal investigation. However, Brace responded that the SEC investigation was “no real news really.” He said Duke had investigated more than 750,000 trades “back through Jan. 1, 1999,” and said the company had published a file available on its web site. “These are follow-up questions, and as a normal part of the investigation, they evolved into a formal investigation rather than an informal one. I don’t believe you can read anything into that. It’s a normal thing that happens. The proper way…the SEC does what they are charged to do.”

Brace said the formal investigation was part of the “standard operating procedure from SEC.” He said Duke had not yet received the “order that backs that [investigation] up, and we made the disclosure in the press release…because we didn’t consider it material.” He was unsure when asked whether the SEC had or would broaden its inquiry and investigate subsidiary Duke Power’s proposed settlement with the North Carolina Utilities Commission and the Public Service Commission of South Carolina.

The parent company also announced the agreement with state regulators last week, saying it may have to take a $19 million special charge in the fourth quarter because of it. The agreement is designed to settle charges that Duke Power officials understated utility profits by $124 million in 1998, 1999 and 2000 in order to avoid bumping up against the company’s allowed rate of return, which could have prompted a rate review. State regulators commissioned an independent audit of the company by Grant Thornton in August 2001 following a whistle blower’s charge that Duke Power had intentionally altered its books to make it appear that it earned a lower rate of return. The utility is required to earn less than a 12.25% return in South Carolina and less than 12.5% in North Carolina. Grant Thornton’s investigation found that in reaction to a 1998 Scana Corp. case, “a number of Duke mid to senior level managers met and developed a plan to identify expense and revenue items which could serve as a basis for accounting adjustments which could be made to ‘avoid reporting over-earnings to regulators.'” Duke denies any wrongdoing in the settlement (see related story this issue).

“The SEC has wide power to do whatever they think appropriate,” said Brace. “I can’t see any particular connection on the report itself. But what the SEC does is up to the SEC.” Asked if Duke would make a timely announcement if the SEC did broaden its investigation, he said, “We have made public our views on the Grant Thornton report,” adding that later this month, once it can complete its settlement with the states, Duke will “put all of this behind us.” Duke will take a $19 million charge in the fourth quarter related to the settlement.

The Duke executive said the SEC’s investigation to this point was being handled in a “friendly informal way, in that respect. Given that some people in other companies have supplied false information, we have tightened up our processes and procedures.” He said any information that was released from Duke would be “given with the Good Housekeeping Seal of Approval.”

The CFO acknowledged that Duke had “some problems” in its accounting reconciliations, particularly in operating and maintenance expenses, which have been ongoing for several quarters. He said the company was going through the numbers “in an orderly way,” reconciling its statements with all of its customers. “This is a complicated business,” he answered, when asked why the company’s accounting errors were continuing. Saying he “took issue” with the insinuation that there were ongoing problems that would not soon be corrected, Brace said, “We couldn’t do the reconciliations we would have like to have done in the past, and now we are cleaning it up.” He said it would be a “few more months before everything is final,” and admitted that there would most likely be additional changes in the future.

For the quarter, Duke recorded several write-offs, mostly related to the depressed merchant energy business. The charges, which are included in this year’s reported results but are not “ongoing in nature,” impacted Duke’s earnings by $319 million. They included canceling some turbine orders and the write-down of uninstalled turbines, $163 million; write-off of site development costs, mostly in California and Brazil, $80 million; demobilization costs for deferring three merchant power projects, $12 million; severance costs, $33 million; and partial impairment of a merchant plant because of the market outlook, $31 million. Of the $319 million, $198 million are non-cash items; Duke expects to take additional demobilization charges of $25 million in the fourth quarter related to deferring three plants in the western United States.

Duke’s full-year 2002 earnings forecast is between $1.95 and $2.05 per share, but Brace added that the company expects its results to fall in the “low end of the range.” For 2003, Duke’s earnings outlook is flat, but could be lower than this year unless there is a “modest improvement in the current extremely depressed merchant energy market.” Earnings before interest and taxes (EBIT) were $668 million in third quarter 2002, compared with $1.53 billion in third quarter 2001.

Duke has revised the way it reports energy trading revenue to comply with changes to the Generally Accepted Accounting Principles (GAAP). Beginning with third-quarter 2002 earnings, Duke plans to report trading revenue on a net basis, and said it would revise the revenue reported for comparative periods. Using the new GAAP changes, third-quarter trading revenue was $4.21 billion, compared with $4.78 billion a year ago. Year-to-date 2002 revenue was $11.5 billion, compared with $14.88 billion during the same period in 2001.

Duke Energy North America, which includes Duke Energy’s 60% share in Duke Energy Trading & Marketing, reported a loss of $107 million for the third quarter, compared to earnings of $654 million for the same period a year ago. Brace said the business was negatively impacted by the slow economic recovery, continued low price volatility in the merchant energy sector, low spark spreads and decreased trading market liquidity. “The market also continues to suffer from the credit weakness of many industry participants and regulatory uncertainty.”

Although there will be cutbacks within DENA, Brace noted that Duke will not pull out of energy trading. He said it was a positive sign that UBS Warburg and Bank of America had entered the energy trading marketplace, and said he expects that eventually, the trading business will return for Duke.

Brace took time to explain Duke Energy’s metrics within its trading and marketing operations. Daily earnings at risk (DER), a measure of the likely one-day favorable or unfavorable movements in commodity prices and their corresponding effects on earnings within Duke Energy’s trading portfolio, averaged $12 million in third quarter, compared with a year ago’s earnings of $16 million. DENA’s merchant generation portfolio, or “accrual book,” which includes merchant generation facilities and hedging contracts held for power and natural gas, crude oil and petroleum products, had forecasted gross margins totaling $5.3 billion as of Sept. 30, 2002.

On a cumulative basis, approximately 3% of the margin is expected to be realized by the end of 2002, 14% through 2003, 23% through 2004 and the remainder in 2005 and beyond. The reduction in the accrual book valuation is a result of changes in correlations and volatility. The expected DENA North American merchant generation economic output hedged for 2003 is 94%; for 2004, 64%; and for 2005, 65%.

The value of Duke Energy’s mark-to-market (MTM) trading portfolio was $0.7 billion, said Brace. On a cumulative basis, approximately 17% of the fair value of these contracts is expected to be realized by the end of 2002; 35% through 2003; 50% through 2004; and the remainder in 2005 and beyond. The unrealized MTM loss for third quarter was $161 million, compared with a gain of $103 million for second quarter 2002.

The “good news,” said Brace, is that the units that made money in the third quarter are “relatively traditional businesses with good cash flows that are not impacted by the merchant energy market.” In its Natural Gas Transmission segment, earnings doubled, partly because of its Westcoast Energy acquisition, as well as increased earnings overall.

Transmission’s third-quarter earnings were $287 million, a 100% increase over the $143 million in third quarter 2001. Results included the second full quarter of earnings from the recently acquired Westcoast Energy natural gas transmission and distribution assets, which contributed $92 million to third quarter earnings. Other key drivers were reduced operating and maintenance expenses, as well as an $18 million gain on the sale of limited partnership units in its Northern Border partnership.

The franchised electric segment posted quarterly earnings of $585 million, compared to $607 million for third quarter 2001. Included in third quarter 2002 results was a charge of $21 million for severance costs related to workforce reductions. It gained from “solid nuclear operations and increased revenues due to favorable weather, offset by lower industrial sales and increased costs for a scheduled nuclear outage. ” There also was a charge in last year’s third quarter of $33 million due to the reclassification of nuclear insurance distributions from income to a balance sheet suspense account, which was ordered by the North Carolina Utilities Commission.

The Field Services business segment, which represents Duke Energy’s majority interest in Duke Energy Field Services (DEFS), reported third quarter earnings of $23 million, compared with $75 million in third quarter 2001. The decline, said the company, was mostly related to higher operating and administrative costs, an increase in its provision for gas imbalances with customers and suppliers and other charges related to its ongoing internal review and reconciliations of balance sheet accounts. The Duke Ventures business segment, comprised of Crescent Resources, DukeNet Communications and Duke Capital Partners, reported earnings of $21 million for the quarter, compared with $51 million a year ago.

With the value of its equities investments diminished by the market, as of Sept. 30 and based on actuarial estimates, Duke’s pension plan obligation exceeded the value of the plan assets by $439 million. Because of the erosion, Duke also recorded a pension liability of $772 million, which is a combination of the $439 million excess obligation and $333 million in pre-paid pension assets. Duke said the liability was offset in other comprehensive income, net of deferred income taxes. The liability will change in the future, as the market value of the assets changes, said Duke.

Duke’s consolidated capital structure as of Sept. 30, including short-term debt, was 56% debt, 35% common equity, 5% minority interests and 4% preferred securities. The company had $473 million in cash and cash equivalents as of Sept. 30.

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