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Progress Energy (PGN: NYSE)

By Calyon Securities ($40.53, July 17, 2008)

WE ARE RAISING OUR RATING on Progress Energy to Buy from Add and reiterating our $50 per share target price. We believe Progress Energy is an attractive defensive investment opportunity in today's volatile marketplace, with upside potential far outweighing downside risk.

Progress Energy is executing its corporate plan as laid out, and the regulatory picture in both the Carolinas and Florida remains strong.

Progress Energy shares have declined about 7% since late June, and are down 16% from its December 2007 high of $50.22. We see 23% upside potential in the equity, plus an attractive and secure 6.1% dividend yield.

Progress Energy shares are trading at a current-year price/earnings of 13.3 times versus its electric utility peers at 15.7 times, a discount we believe is unwarranted. In addition, its 6.1% dividend yield is well above its electric utility peer yield of 3.9%. The stock has traded at a peer discount over the past several years due to its corporate restructuring (it sold approximately $3.6 billion of assets over the past several years) and due to its payout ratio having exceeded 100% in 2006. These initiatives are now complete, the dividend is secure, and the payout ratio is down to 0.8 times.

We expect continuing modest dividend increases for the next two to three years, with the company sticking to its stated goal of reducing its payout ratio to approximately 75%, something we believe will occur by 2010. The company reiterated its commitment to the dividend, and there is nothing we can see that should jeopardize it.

There remains some uncertainty at Progress Energy's PEC (North Carolina/South Carolina) utility operation regarding the impact of the Clean Smokestacks legislation in North Carolina. While Progress received regulatory approval to recover the original $813 million of estimated compliance costs several years ago, the ultimate cost of compliance has increased to $1.1-$1.4 billion. A decision on the ultimate mode of recovery of this incremental cost is expected this quarter. Cost recovery for these mandated initiatives is likely, as we believe it should be.

Customer growth has slowed in Florida to 1.4% year over year, from a seven-year compound annual growth rate of 2.4%, and could slow further (but we would note that it still remains above its peer average). Importantly, customer growth in the Carolinas remains only modestly below its 2.2% seven-year CAGR level. On a positive note, investor concern over rising bad debt industry-wide has not occurred at Progress in a meaningful way. Progress noted that they have seen very little impact despite the rising cost of power generation.

Progress continues to pursue its $17 billion Levy County Nuclear buildout in Florida, including transmission, and recently received Florida Public Service Commission approval for its "determination of need" filing. Preconstruction costs for the plant could total as much as $500 million through about 2010, but all of these costs are fully recoverable in Florida via annual cost-recovery filings. Florida appears fully committed to fuel diversification away from natural gas, particularly after the impact of several hurricanes over the past few years, and given that coal plants appear to be a nonstarter at this point in Florida. While a big price tag, this should provide future earnings. The impact over the next several years, however, is minor.

-- Gordon Howald

-- Shahriar Pourreza, CFA

The companies mentioned in Hot Research are subjects of research reports issued recently by investment firms. Their opinions in no way represent those of Barron's Online or Dow Jones & Company, Inc. Share prices at the time the report was issued and the date of the report are in parentheses.

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