(FORTUNE Magazine) – Just when it looked as if energy companies were moving past Enron, along came "Project Alpha." In early April, after the sector had managed a decent recovery, the Wall Street Journal reported that power producer Dynegy had been using a complex transaction--dubbed Project Alpha--to close a gap between its cash flow and the estimated value of long-term contracts. Gulp. Not another Byzantine financial scheme to keep us up at night! And yes: The auditor who okayed the arrangement was Arthur Andersen. Dynegy's stock nose-dived.

Investors aren't over the crooked "E"--not by a long shot. Concerns over accounting practices remain at the forefront of investors' minds. But that doesn't mean all energy stocks are Enrons-in-waiting or even close. There are plenty out there that still have spark--strong earnings and juicy dividends--and aren't in danger of a meltdown.

The bad news first. Nearly all companies in the power game--whether they're creating energy, distributing it, or trading it--face tough challenges. For one, natural gas and electricity prices have collapsed. A warm winter and a slow economy have sliced profit margins and earnings. Second, the industry built way too many power plants. Now there's a glut of capacity.

In the rush to construct new plants, electric companies themselves created the third and most dangerous problem--debt. Calpine's debt levels surged from $4.8 billion to $12.7 billion in 2001 alone. Its debt-to-equity ratio now stands at 79%, and Mirant's at 62%. The credit rating agencies suggest that a more appropriate ratio for such independent power producers is 50%. Furthermore, many have been struggling to raise short-term cash and stay liquid. And if the Federal Reserve starts to raise interest rates later this year, these companies could face even higher borrowing costs. "If there's any upward move in interest rates, it's going to put significant pressure on the sector," warns John Escario, manager of the Rydex Utilities Fund.

The cash crunch is forcing some power companies to hold fire sales. The waves of consolidation that many pundits expected to hit the industry haven't--largely because of those gigantic debt loads. A company could pick up Mirant for $5 billion, for example, but it would also have to take on its $8.4 billion debt. Instead, power companies and utilities with decent balance sheets are cherry picking assets. (See "Finding Balance-Sheet Beauties," below.)

All this has divided the sector into two distinct camps, the sound and the scary. Investors--at least those who want to hold on to their stocks for more than a day--should steer clear of firms like Calpine, Mirant, and Reliant that make the bulk of their money by selling power on the open market and trading energy contracts. Besides hefty debt loads, cyclical pricing pressures, and volatile trading operations, these firms still face questions over how they account for long-term contracts. Their shares react instantaneously to rating agency moves and news headlines. "These stocks are moving 10% in a day or 30% in a week. You can make a lot of money and lose a lot of money quickly," warns Kit Konolige, an electric-power analyst at Morgan Stanley. "They demand constant attention. You've got to be ready to buy them today and sell them Monday."

But there are power companies out there worth investing in. Take Duke Energy (DUK, $39). (See "The Un-Enron" in the April 15 issue.) Duke operates a regulated utility in the Carolinas, a higher-profit, unregulated energy-generation group, and a large natural gas pipeline business. It's also building up its trading business, which, in contrast to Enron, centers around selling its own power rather than just betting on the direction of energy prices.

Duke, says Konolige, should be able to increase earnings 12% annually for the next five years. It also pays an attractive 2.9% dividend. Duke's credit standing is good, and its debt-to-equity ratio of 59% is "respectable," says Konolige. That's partly why it sells for a P/E of 13 times 2002 earnings, vs. the industry average of 11.8. But that premium--10%--is actually below its historical level; the stock usually sells for 20% to 25% more than its peers, the analyst notes. "We believe Duke should be trading at an even higher premium," Konolige says. "If there is value to be created in this industry, Duke is going to do it."

Another company analysts recommend for its diversity is Dominion Resources (D, $67). Like Duke, Dominion has the security of steady earnings from its regulated electric utility business in Virginia, plus the higher profit potential from selling electricity in the wholesale market. What's more, says Jeffrey Gildersleeve of Argus Research, the company has a natural gas pipeline business along with an oil exploration and production group.

The company's debt load is reasonable for the industry--Dominion issued stock in March, lowering its debt-to-equity ratio to 55%. The stock has bounced recently: It's up 11% this year, giving it (like Duke) a P/E of 13 times 2002 earnings. But for that, Gildersleeve contends, investors are getting double-digit earnings growth and a 3.9% dividend yield.

Incumbent power producers in states that are deregulating offer another way to get steady growth and nice yields. Companies typically keep the majority of their customers after deregulation, while their potential to lower costs and enhance profits improves sharply. After Texas deregulated in January, for example, 97% of households stuck with the name they knew--TXU Corp. (TXU; $55). TXU's presence goes beyond Texas' borders: It has a significant customer base in the U.K. and Australia. Asset sales have produced almost $6 billion in cash or debt reduction, and its debt-to-equity ratio is nearing 55%. "This company has a good balance sheet, should be able to grow earnings at 7% a year, and has a dividend yield of about 4.5%," says Judy Saryan, manager of the Eaton Vance Utilities fund. TXU also plans to use its strong free cash flow to make several acquisitions.

Deregulation is also bringing greater earnings growth potential to New Jersey's Public Service Enterprise Group (PEG; $45). Profits for the company's unregulated unit, PSEG Power, which makes up about 50% of the company's overall earnings, should see strong margin enhancement, Konolige predicts. "This is a classic example of what can be achieved in a deregulated environment and how value can be created for investors," he says. "You've taken the caps off earnings and given these companies some opportunity to control their own fates, their own margins and profits."

PSEG doesn't come without risk. Through various units the company has investment exposure to Argentina, which some analysts say it may have to write off. Still, it pays a hefty 4.9% dividend and is expected to increase earnings by 7% a year. Those may not be the enormous growth rates that Enron and company delivered in the late 1990s, but at least this time they're real.

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