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Business & Money

Lehman Brothers and others say upcoming rate cases and falling unregulated earnings mean some IOUs will have less to show for their effort.
Fortnightly Magazine - July 1 2003

of so-called unregulated earnings plans of some diversified utilities.

Case in point, Duke Energy's May analyst conference in Charlotte, N.C., failed to impress Lehman Brothers. "In our opinion, [Duke] remains overvalued relative to its fundamentals," wrote Ford in another report. "Duke's earnings continue to be challenged by weak commodity markets and ongoing asset sales, its utility must borrow to cover the current dividend, and Duke Capital is still at risk for a one or two notch downgrade."

Furthermore, the Lehman analyst noted the poor contribution from Duke's unregulated arm, saying, "Comparing Duke's segment [Earnings Before Interest and Taxes] EBIT contribution with its asset composition is telling. The regulated businesses represent 47 percent of Duke Energy's total assets and are projected to generate 80 percent of its 2003 EBIT, implying strong returns. The unregulated businesses, which are expected to generate returns greater than regulated returns, are clearly under-performing. Duke Energy North America (DENA), in particular stands out with 25 percent of the company's assets but contributing only about 6 percent of total EBIT."

Ford also notes that Duke's unregulated arm will have significant hurdles to meet earnings targets: "Over the next three quarters, DENA needs to generate an incremental $832 million in gross margins to meet its full year EBIT projection of $200 million."

Between hedged generation output, its un-hedged gas requirements, he doesn't believe that target is feasible.

"If we assume the company sells all of its un-hedged output to generate the yet to be sourced gross margin, it implies a spark spread of about $11/MWh (=$362 million/55-21 MM MWh). This seems unrealistic given the current outlook for the summer spreads of approximately $7/ MWh, the declining volatility, and lack of market liquidity."

Moreover, Dan Gabaldon, senior analyst at Avalon Research Group, recently initiated coverage on Constellation Energy Group (CEG) with a sell recommendation; "Constellation Corp. promises investors 10 percent EPS growth through 2005, principally by rapidly expanding its competitive power supply business. However, we believe investors are overlooking the challenges posed by its business model, including: the difficulty of growing market share outside its home territory, low overall market growth, and its exposure to continued regulatory uncertainty."

Furthermore, much like it was pointed out with Duke Energy, Gabaldon points out that CEG's above peer-average valuation depends critically on attaining its ambitious growth targets. … Rather than returning to basics like its utility peers, CEG promises investors both attractive income and yield via a strategy of increasing its share of sales to wholesale and non-residential customers." Certainly, many experts believe that equity research analysts' skepticism of exceptional utility growth plans is warranted, given the last 18 months. We've all heard the promises before, but this time, will utilities deliver?

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