Duke Energy: 4.56% Dividend With Upside Potential

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 |  About: Duke Energy Corporation (DUK), Includes: XLU
by: Jeff Williams

Over the past month the Utility Sector (NYSEARCA:XLU) has been selling off. This has provided an excellent opportunity to investigate utilities for investment purposes. Duke Energy (NYSE:DUK) is one company utility worth considering.

There are many advantages to adding utilities to your portfolio. Two main advantages include Lower volatility and high dividends. So, if the market is getting unpredictable or "frothy," a well picked utility can add some stability to your portfolio while paying a solid dividend. As of May 30, 2013, Duke Energy has a beta of 0.31 and a yield of 4.56%.

Duke Energy is the largest electric power company in the United States, supplying and delivering energy to approximately 7 million U.S. customers. It has approximately 58,000 megawatts of electric generating capacity in the Carolinas, the Midwest, and Florida, and natural gas distribution service in Ohio and Kentucky. Its commercial and international businesses own and operate diverse power generation assets in North America and Latin America, including a portfolio of renewable energy assets.

On July 12, 2012 Duke Energy completed its merger with Progress Energy. Even though the merger elevated some risk for Duke Energy and its shareholders the company stated there were some strong advantages to the merger. The company states:

  • The strategic combination of companies will deliver future savings from streamlining corporate services and enabling better access to financial markets to mitigate rising electricity prices.
  • $650 million in guaranteed savings for customers in the Carolinas from fuel and joint dispatch.
  • Better access to financial markets for power system modernization investments will lower the total cost to customers.

It is now close to a year after the merger and using the analysis below, I will analyze some aspects of Duke Energy's performance. From this evaluation we will be able to see the implications of the merger by analyzing Duke Energy's profitability, debt and capital, and operating efficiency and free cash. Based on this information, we will look for strengths and weaknesses in the company's fundamentals. This should give us an understanding of how the company has fared over the past few years and will give us an idea of what to expect in the future.

Profitability

Profitability is a class of financial metrics used to assess a business' ability to generate earnings compared with expenses and other relevant costs incurred during a specific period of time. In this section, we will look at four tests of profitability. They are: net income, operating cash flow, return on assets, and quality of earnings. From these four metrics, we will establish if the company is making money and gauge the quality of the reported profits.

  • Net income 2010 = $1.320 billion
  • Net income 2011 = $1.706 billion
  • Net income 2012 = $1.768 billion.
  • Net income 2013 TTM = $2.107 billion.

Over the past couple of years Duke Energy's net profits have increased from $1.320 billion in 2010, to $2.107 billion in 2013 TTM. This represents a 59.62% increase.

  • Operating income 2010 = $2.461 billion.
  • Operating income 2011 = $2.769 billion.
  • Operating income 2012 = $3.110 billion.
  • Operating income 2013 TTM = $3.831 billion.

Operating income is the cash generated from the operations of a company, generally defined as revenue less all operating expenses, but calculated through a series of adjustments to net income.

Over the past four years, the company's operating income has increased from $2.461 billion to $3.831 billion. This represents an increase of 55.67%.

ROA - Return On Assets = Net Income/Total Assets

ROA is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment."

  • Net income growth

    • Net income 2010 = $1.320 billion
    • Net income 2011 = $1.706 billion
    • Net income 2012 = $1.768 billion.
    • Net income 2013 TTM = $2.107 billion.
  • Total asset growth

    • Total assets 2010 = $59.090 billion.
    • Total assets 2011 = $62.526 billion.
    • Total assets 2012 = $113.856 billion.
    • Total assets 2013 TTM = $113.666 billion.
  • ROA - Return on assets

    • Return on assets 2010 = 2.23%.
    • Return on assets 2011 = 2.73%
    • Return on assets 2012 = 1.55%.
    • Return on assets 2013 TTM = 1.85%.

Over the past four years, Duke Energy's ROA has decreased from 2.23% in 2010 to 1.85% in 2013 TTM. This indicates that the company is making slightly less on its assets than it did in 2010.

Quality Of Earnings

Quality of Earnings is the amount of earnings attributable to higher sales or lower costs rather than artificial profits created by accounting anomalies such as inflation of inventory. To ensure there are no artificial profits being processed, the operating cash flow must exceed the net income.

2010

  • Operating income 2010 = $2.461 billion.
  • Net income 2010 = $1.320 billion

2011

  • Operating income 2011 = $2.769 billion.
  • Net income 2011 = $1.706 billion

2012

  • Operating income 2012 = $3.110 billion
  • Net income 2012 = $1.768 billion.

2013 TTM

  • Operating income 2013 TTM = $3.831 billion
  • Net income 2013 TTM = $2.107 billion.

Over the past four years, the operating income has been higher than the net income in all years. This indicates that Duke Energy is not artificially creating profits by accounting anomalies such as inflation of inventory

Debt And Capital

The Debt and Capital section establishes if the company is sinking into debt or digging its way out. It will also determine if the company is growing organically or raising cash by selling off stock.

Total Liabilities To Total Assets, Or TL/A ratio

TL/A ratio is a metric used to measure a company's financial risk by determining how much of the company's assets have been financed by debt.

  • Total assets

    • Total assets 2010 = $59.090 billion.
    • Total assets 2011 = $62.526 billion.
    • Total assets 2012 = $113.856 billion.
    • Total assets 2013 TTM = $113.666 billion.
    • Equals and increase of $54.576 billion
  • Total liabilities

    • Total liabilities 2010 = $36.568 billion.
    • Total liabilities 2011 = $39.754 billion.
    • Total liabilities 2012 = $72.993 billion.
    • Total liabilities 2013 TTM = $72.713 billion.
    • Equals and increase of $36.145 billion

Over the past four years, the company's total assets increased by $54.576 billion, while the total liabilities have increased by $36.145 billion. This indicates that the company's assets are increasing more than the liabilities thus adding shareholder value.

Working Capital

Working Capital is a general and quick measure of liquidity of a firm. It represents the margin of safety or cushion available to the creditors. It is an index of the firm's financial stability. It is also an index of technical solvency and an index of the strength of working capital.

Current Ratio = Current assets / Current liabilities

  • Current assets

    • Current assets 2010 = $6.223 billion.
    • Current assets 2011 = $6.880 billion.
    • Current assets 2012 = $10.122 billion.
    • Current assets 2013 TTM = $9.549 billion.
  • Current liabilities

    • Current liabilities 2010 = $3.897 billion.
    • Current liabilities 2011 = $5.528 billion
    • Current liabilities 2012 = $10.029 billion.
    • Current liabilities 2013 TTM = $9.965 billion.
  • Current ratio 2009 = 1.60
  • Current ratio 2010 = 1.24
  • Current ratio 2011 = 1.01.
  • Current ratio 2012 = 0.96.

Over the past four years, Duke Energy's current ratio has been declining. As the ratio is currently under 1, this indicates that the company would not be able to pay off its obligations if they came due at this point.

Operating Efficiency

Operating Efficiency is a market condition that exists when participants can execute transactions and receive services at a price that equates fairly to the actual costs required to provide them. An operationally efficient market allows investors to make transactions that move the market further toward the overall goal of prudent capital allocation without being chiseled down by excessive frictional costs, which would reduce the risk/reward profile of the transaction.

Gross Margin: Gross Income/Sales

The Gross Profit Margin is a measurement of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue/sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors and industry is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).

  • Gross margin 2010 = $9.347 billion / $14.272 billion = 65.49%.
  • Gross margin 2011 = $9.384 billion / $14.529 billion = 64.59%.
  • Gross margin 2012 = $12.056 billion / $19.624 billion = 61.45%.
  • Gross margin 2013 TTM = $13.390 billion / $21.892 billion = 61.16%.

Over the past four years, Duke Energy's gross margin has declined. The ratio has decreased from 65.49% in 2010 to 61.16% in 2013 TTM. As the margin has decreased, this indicates that Duke Energy overall has been less efficient.

Asset Turnover

The formula for the asset turnover ratio evaluates how well a company is utilizing its assets to produce revenue. The numerator of the asset turnover ratio formula shows revenue found on a company's income statement and the denominator shows total assets, which are found on a company's balance sheet. Total assets should be averaged over the period of time that is being evaluated.

  • Revenue growth

    • Revenue 2010 = $14.272 billion.
    • Revenue 2011 = $14.529 billion.
    • Revenue 2012 = $19.624 billion.
    • Revenue 2013 TTM = $21.892 billion.
    • Equals an increase of 53.39%.
  • Total Asset growth

    • Total assets 2010 = $59.090 billion.
    • Total assets 2011 = $62.526 billion.
    • Total assets 2012 = $113.856 billion.
    • Total assets 2013 TTM = $113.666 billion.
    • Equals an increase of 92.36%.

As the revenue growth has increased by 53.39% while the assets have increased by 92.36%, this indicates that the company from a percentage point of view has been generating less cash with more assets, effectively becoming less efficient at creating revenues.

Free Cash Flow = Operating Cash Flow - Capital Expenditure

Over the past four years we can see that the company has posted positive free cash each year except 2009. In a business that is looking to spend a lot of cash in upgrades to increase efficiency and keep up with increasing environmental standards this is a positive. This indicates that the company is growing at a pace that it can support, without adding additional risk to the company and ultimately the shareholder.

  • 2010 - $4.511 billion - $4.817 billion = $(306)million
  • 2011 - $3.672 billion - $4.372 billion = $(700) million
  • 2012 - $5.244 billion - $5.501 billion = $(257) million
  • 2013 TTM - $5.463 billion - $5.888 billion = $(425) million

Even though the company's fundamentals are very strong the analysis above indicates a degradation on the efficiency of the company's profitability. This statement is supported by the decline in the company's gross margin, ROA and asset turnover ratio. Having stated this the other ratios are indicating strength in the company.

Forward Looking

To increase profitability while reducing costs, Duke energy is looking to move to a more economical and environmentally friendly footprint. Duke Energy is moving toward "a more balanced fuel mix". "By 2015, we anticipate a regulated fleet using much less coal and much more cleaner-burning natural gas. And this does not even count the growing portfolio of wind and solar generation in our commercial businesses."

Click to enlarge

As the diagram indicates above you can see the transformation from coal based power to natural gas based power.

Even though natural gas plants are more expensive to run than coal powered plants government incentives and regulations will even out the playing field. An excellent article by Tim Lucas explains the cost advantages and disadvantages of focusing on natural gas for power creation. He states, "The stricter regulations on sulfur dioxide, particulate matter, nitrogen oxide and mercury may make nearly two-thirds of the nation's coal-fired power plants as expensive to run as plants powered by natural gas". The article also states, "A transition to natural gas for electricity generation will require the construction of a much larger network of pipelines and other infrastructure to transport and store the gas, assuring power plants of a reliable supply."

To support its more economical and environmentally friendly footprint, Duke Energy brought three new, state-of-the-art fossil units on line in late 2012, marking significant milestones in the company's multi-year effort to transition to higher-efficiency, cleaner generating sources.

The three units are:

  • Cliffside Steam Station: This high efficiency station means it burns less coal per unit of electricity generated than most other coal units in the nation.
  • H.F. Lee Plant: The 920-MW H.F. Lee Plant near Goldsboro, N.C., features a highly efficient natural gas combined-cycle design.
  • Dan River Combined Cycle Plant: The Dan River Combined Cycle Plant in Eden, N.C., has 620 MW of natural gas-fueled generation.

Throughout 2013, Duke Energy is planning on bringing on a natural gas combined-cycle facility near Wilmington, N.C and start-up testing is underway in Indiana for a Integrated Gasification Combined Cycle station.

All of these new plants are designed to increase power, stay within environmental regulations while reducing costs and increasing profitability. The results of these upgrades are displayed within the analysts estimates.

Analysts' Estimates

Analysts at MSN Money are estimating an EPS for FY 2013 at $4.34 while moderate growth is expected to continue into 2014 as EPS estimates increase to $4.58. Bloomberg Businessweek supports this idea as it expects the company's revenues to be around $24.7 billion for FY 2013 and increase to $26.0 billion for FY 2014.

Price Targets

  • Finviz has a price target for Duke Energy at $74.82
  • Recently, Deutsche Bank gave the company a "hold" rating with a target of $74.
  • On April 16, RBC Capital Mkts gave the company an "outperform" rating with a target of $78.

Over the past five of years, the average P/E ratio for Duke Energy has been 17.80. As the company has averaged a P/E of 17.80 and is expected to have an EPS in 2014 of approximately $4.58, this would give the stock a price target of around $81.52.

Over the past month or so the utility sector has been showing weakness compared with the market. The above analysis reveals that Duke Energy is a fundamentally sound utility. The company's focus on improving efficiency while maintaining environmental standards will prove to be profitable in the future. Analysts at MSN Money and Bloomberg predict growth for the company over the next couple of years. Analysts predict a stock target price between $74.00 and $78.00 over next year. Currently, Duke Energy has a very attractive yield of 4.54%. As the stock price has declined over the past month this has proven to be an attractive point to look at the utility sector. If patience is used and price begins to form a bottom and ultimately break to the upside, it could prove to be an excellent opportunity to invest in Duke Energy.

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.