Despite Appearances, Duke Energy May Not Be Safe

Dec.31.12 | About: Duke Energy (DUK)

When we started analyzing Duke Energy (NYSE:DUK), we thought it was a safe bet during volatile times. However, as we went deeper into the company's business model and performance, we found that DUK has some big risks as well.

Introduction

Duke Energy has become the largest electric utility in the USA, with 67 GW of power capacity through its merger with Progress Energy. The company is a typical utility with low stock price volatility, high dividend yield and low beta. The company's domestic operations are concentrated in the Southeast and Midwest part of USA, while its international operations are mostly centered on Latin America. DUK has been slow to build renewable energy assets unlike other utilities like NRG Energy (NYSE:NRG) and Exelon (NYSE:EXC). The company recently acquired a couple of solar energy power plants from Sharp's subsidiary Recurrent Energy. The company was involved in controversial merger with Progress Energy in the first half of 2012. Duke Energy has a mix of coal, natural gas and nuclear power plants with coal dominating, with almost 50% share of its energy portfolio.

What we like about Duke Energy

  1. US based assets - Most of Duke's power capacity is based in the USA which is world's most powerful country. The company's regulated utility segment allows it to get a fixed ROE on its investment. This makes the company's operating cash flow quite safe.
  2. Diversified Fuel Capacity - A mix of different fossil fuels implies that the company does not face any major fuel centric supply or price issues. The company's power plants use coal, nuclear energy, hydroelectricity and natural gas. This makes the company immune to a sharp fall in coal prices or a sharp escalation in NG prices.
  3. Settlement with North Carolina Utilities Commission - Duke has been at loggerheads with North Caroline's electricity regulator after its big bang $32 bb merger with Progress Energy. The regulator had problems with the top management tenure of the combined utility. However, a deal has been reached recently, with CEO Rogers accepting retirement at the end of 2013.
  4. Merger Synergies - The Duke and Progress Energy merger is supposed to bring multiple benefits in term of cutting costs and manpower. Some of these benefits are: i) Pumped Hydro Storage will be used at a greater capacity using Progress power, ii) Decrease in 5-7% of non-fuel operating expenses and iii) 1,100 employees have taken the voluntary severance.
  5. Increasing Margins - DUK has managed to consistently increase their gross and operating margins in the last decade. From 40.3% GM in 2004, Duke's GM has increased to 64.6% in 2011. Their Operating Margin too has increased from 13.5% to 19.1% during the same period.
  6. Rate Increases in core S.C. market - DUK has recently completed a $9 billion program to shut down its older less efficient, more polluting coal power plants. The company has applied to the regulator for rate increases for recovering the investment. If the regulator approves, DUK will make an additional $359 million per year.
  7. Lower Fuel Costs - The shale gas revolution in the US has not only lowered the natural gas costs, but also the coal costs quite dramatically. With fuel being a major cost component for a utility, DUK has benefited from lower natural gas and coal prices. It does not look like the natural gas and coal prices are going to increase dramatically in the near term.

Risks

  1. Uncertainty related to Crystal River Nuclear Power Project - The Company has not decided what to do with its nuclear plant in Florida which developed cracks in 2009. DUK has not made a decision whether to repair or retire this plant. The insurance coverage for the plant has not been recovered by Duke till date.
  2. Nuclear Power - The Company is one of the largest nuclear power suppliers in the US with 11 GW of capacity. The biggest disadvantage of nuclear power is the tail risk associated with a nuclear accident. Many top nuclear power countries such as Japan and Germany, have decided to exit nuclear power. A major accident in USA might result in the same anti-nuclear movement here as well. This could result in major losses for Duke, which has got almost 11 GW of nuclear energy capacity and is planning to build more nuclear reactors in South Carolina and Florida. German utilities have been hurt badly by Germany's decision to exit nuclear energy.
  3. Growth in Distributed Rooftop Solar Energy - The recent crash in solar panel prices has made solar power competitive with fossil power in a number of places. While this is not an immediate problem for Duke Energy, utilities around the world are getting negatively affected due to this phenomenon. Some of the utilities are losing their captive markets as their customers generate energy on their own.
  4. Slow Growth - US Electricity Demand has slowed dramatically after the 2008 crisis and is not expected to grow too strongly. If we factor in the 2% economic growth and energy efficiency, then you have a subpar energy demand growth.
  5. Regulatory Risks - The Company has not quantified the hit to earnings due to a 20% reduction in Brazilian electricity prices in 2013. The company does not operate in a true free market and is subject to oversight by electricity regulators. Its recent tiff with the South Carolina regulator shows that the company can be badly affected by fighting the regulators.

Stock Performance

DUK's stock shows very less volatility which is typical for utility stocks. The stock hit a low of $36 as S&P crashed to 666 during March 2009. The stock hit a high of ~$70 in June, 2012 and is not trading around 10% below its peak value. The stock has outperformed the S&P 500 by 8% in the last 5 years; however it has underperformed by 15% during the last year.

Valuation

Duke trades at a low P/B of 1.1x, which is lower than the industry average, while the P/S of 1.9x is higher. The company has a low debt equity ratio of below 1x. The company is going through a transition period, as it consolidates the acquisition of Progress Energy.

One of the best metrics to judge a utility stock is by its dividend yield. DUK gives a 4.8% yield, which is in line with the industry average of 4.2%.

Summary

The trillions of dollar of central bank liquidity have led to an unwanted exuberance in the stock markets, which is not reflected by the global economic malaise. Most of the bears have gone into hibernation, as repeated bailouts and liquidity injections by governments / Central Banks has prevented the stock markets from falling over a cliff. However, the fact remains that the current economic scenario is full of potential dangers. Having some safe, low beta, high yielding stocks in your portfolio might be wise. DUK's merger with Progress Energy has made it a more formidable competitor, with a monopoly like position in one of the most recession proof industries. However, we are concerned about DUK's large nuclear energy portfolio and the potential of huge unappreciated tail risks. The natural gas and coal prices will also not remain low forever. The company's management is not the best, given the fiasco during the Progress merger and the controversy with large amounts of management compensation. We are not really sure whether DUK is a safe bet during tumultuous times even though it gives the appearance of one.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.