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Last month, I wrote an article on Duke Energy (NYSE:DUK) entitled Duke Energy: 4.56% Dividend With Upside Potential. Within the article some issues discussed were: how the fundamentals of Duke Energy were affected by the merger with Progress Energy and how the company was going to turn around a declining trend in profitability.

As the issue of declining profitability was raised, it was established that the company's gross margin, ROA and asset turnover ratio have all been decreasing over the past few years. In an effort to turn this trend around and increase profitability while reducing costs, Duke Energy is looking to move to a more economical and environmentally friendly footprint. This footprint is "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."

Although upgrading and purchasing new assets will prove to be profitable and cost effective in the future, it will be capital intensive in the short term. Duke Energy will need to spend a large amount on CAPEX over the next few years to complete these upgrades. As an investor, it is important to look at the debt side of the company to ensure that Duke Energy's management did not "over-leverage" the company in the Progress Energy merger. By looking at the debt side of the company we can see if the company has the financial stability it needs to upgrade its assets and make the company more profitable and as a result, create shareholder value.

Debt Ratios

Total Debt = Long-Term Debt + Short-Term Debt

Total debt is the sum of long-term debt, which is debt that is due in one year or more, and short-term debt, which is any debt due within one year.

  • 2009 - $16.113 billion + $902 million = $17.015 billion
  • 2010 - $17.935 billion + $491 million = $18.426 billion
  • 2011 - $18.679 billion + $2.321 billion = $21.000 billion
  • 2012 - $36.351 billion + $4.167 billion = $40.518 billion
  • 2013 TTM - $ 36.339 billion + $ 5.009 billion = $41.344 billion

As the statistics above indicate, over the past five years, Duke Energy's total debt has increased significantly. The bulk of this increase was due to the merger between Progress Energy and Duke Energy in July of 2012. Over the past five years, the company's total debt has increased by 142.99%.

Total Liabilities

Liabilities are a company's legal debts or obligations that arise during the course of business operations, so debts are one type of liability, but not all liabilities. Total liabilities are the combination of long-term liabilities, which are the liabilities that are due in one year or more, and short-term or current liabilities, which are any liabilities due within one year.

  • 2009 - $35.290 billion
  • 2010 - $36.568 billion
  • 2011 - $39.754 billion
  • 2012 - $72.993 billion
  • 2013 TTM - $ 72.713 billion

Like the company's total debt, Duke Energy's liabilities have also significantly increased over the past few years. Duke Energy's liabilities have increased by 106.04%.

In July of 2012, Duke Energy took on a significant increase in total debt and liabilities. The increase in total debt and liabilities was due to the merger with Progress Energy. Duke Energy increased its total debt by 142.99% while they increased their total liabilities by 106.04%. The next step will reveal if the company has the ability to pay it.

Total Debt-to-Total Assets Ratio = Total Debt / Total Assets

This 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. This ratio is calculated by adding short-term and long-term debt, then dividing it by the company's total assets.

A debt ratio of greater than 1 indicates that a company has more total debt than assets. Meanwhile, a debt ratio of less than 1 indicates that a company has more assets than total debt. Used along with other measures of financial health, the total debt to total assets ratio can help investors determine a company's level of risk.

  • 2011 - $21.000 billion / $62.526 billion = .34
  • 2012 - $40.518 billion / $113.856 billion = .36
  • 2013 TTM - $41.344 billion / $113.666 billion = .36

Duke Energy currently has a total debt to total assets ratio of.36. Even though Duke Energy has significantly increased its total debt over the past couple of years, the total debt to total assets ratio indicates that Duke Energy has added slightly less assets than total debt. As the number is currently below 1, this indicates that the company has more assets than total debt. This metric indicates a low amount financial risk to the company.

Debt ratio = Total Liabilities / Total Assets

Total liabilities divided by total assets. The debt ratio shows the proportion of a company's assets that is financed through debt. If the ratio is less than 0.5, most of the company's assets are financed through equity. If the ratio is greater than 0.5, most of the company's assets are financed through debt. Companies with high debt/asset ratios are said to be "highly leveraged." A company with a high-debt ratio or that is "highly leveraged" could be in danger if creditors start to demand repayment of debt.

  • 2011 - $39.754 billion / $62.526 billion = .64
  • 2012 - $72.993 billion / $113.856 billion = .64
  • 2013 TTM - $72.713 billion / $113.666 billion = .64

Over the past three years, Duke Energy's debt ratio has remained even. The ratio has remained at 0.64. This indicates that Duke Energy has increased its liabilities at the same rate as assets.

Debt-to-Equity Ratio = Total Liabilities / Shareholders' Equity

The debt-to-equity ratio is another leverage ratio that compares a company's total liabilities with its total shareholders' equity. This is a measurement of how much suppliers, lenders, creditors and obligators have committed to the company versus what the shareholders have committed.

A high debt-to-equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in the company reporting volatile earnings. In general, a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations, and therefore is considered a riskier investment.

  • 2011 - $39.754 billion / $22.772 billion = 1.75
  • 2012 - $72.993 billion / $40.863 billion = 1.79
  • 2013 TTM - $72.713 billion / $40.953billion = 1.78

Compared with 2011, Duke Energy's debt-to-equity ratio has increased. The ratio has increased from 1.75 to 1.78. As the ratio is currently above 1, this indicates that suppliers, lenders, creditors and obligators have more invested than shareholders. 1.78 indicates a moderate amount of risk for the company. As the ratio is above 1 and considered moderate, so is the risk for the company.

Capitalization Ratio = LT Debt / LT Debt + Shareholders' Equity

(LT Debt = Long-Term Debt)

The capitalization ratio tells the investors the extent to which the company is using its equity to support operations and growth. This ratio helps in the assessment of risk. Companies with a high capitalization ratio are considered to be risky because they are at a risk of insolvency if they fail to repay their debt on time. Companies with a high capitalization ratio may also find it difficult to get more loans in the future.

  • 2011 - $18.679 billion / $41.451 billion = .45
  • 2012 - $36.351 billion / $77.214 billion = .47
  • 2013 TTM - $36.339 billion / $77.292 billion = .47

Over the past three years, Duke Energy's capitalization ratio has increased from .45 to .47. As the capitalization ratio has increased, this implies that Duke Energy has acquired more long-term debt than shareholders' equity. As this is the case, Duke Energy has less equity to support its operations and add growth. As this ratio has increased, financially this implies an increase in risk to the company.

Interest Coverage Ratio = EBIT (earnings before interest and taxes) / Interest Expenses

The interest coverage ratio is used to determine how easily a company can pay interest expenses on outstanding debt. The ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by the company's interest expenses for the same period. The lower the ratio, the more the company is burdened by debt expense. When a company's interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable.

  • 2011 - $3.324 billion / $859 million = 3.87
  • 2012 - $3.693 billion / $1.242 billion = 2.97
  • 2013 TTM - $4.400 billion / $1.385 billion = 3.18

The above ratio indicates that over the past couple of years Duke Energy's interest coverage ratio has remained strong. Even though Duke Energy took on a great deal of debt during the Progress Energy merger, the above ratio indicates that Duke Energy is not burdened by interest expenses.

Cash Flow to Total Debt Ratio = Cash Flow from Operations / Total Debt

This coverage ratio compares a company's operating cash flow with its total debt. This ratio provides an indication of a company's ability to cover total debt with its yearly cash flow from operations. The higher the percentage ratio, the better the company's ability to carry its total debt. The larger the ratio, the better a company can weather rough economic conditions.

  • 2011 - $3.672 billion / $21.000 billion = .17
  • 2012 - $5.244 billion / $40.518 billion = .13
  • 2013 TTM - $5.463 billion / $41.344 billion = .13

As the current cash flow to debt ratio is below 1, this implies that Duke Energy does not have the ability to cover its total debt with its yearly cash flow from operations.

Based on the six debt ratios listed above, we can see a small increase in financial risk when compared to December 2011. Even though there has been a large increase in debt and liabilities, the overall stability of the company from the merger regarding its debt shows that the company has not "over-leveraged" itself or made it so the company cannot pay its interest expenses. The next section will reveal how much the company is paying for its debt and its relation to shareholder value.

Cost of Debt

The cost of debt is the effective rate that a company pays on its total debt.

As a company acquires debt through various bonds, loans and other forms of debt, the cost of debt is a useful metric. It gives an idea as to the overall rate being paid by the company to use debt financing. This measure is also useful because it gives investors an idea as to the riskiness of the company compared with others. The higher the cost of debt to the company, the higher the risk.

Cost of debt (before tax) = Corporate Bond rate of company's bond rating.

Current tax rate

  • 2011 - $752 million / $2.465 billion = 30.51%
  • 2012 - $705 million / $2.451 billion = 28.76%
  • 2013 TTM - $932 million / $3.015 billion = 30.91%

2011 - 2013 TTM 3-year average = 30.06%

From 2011 - 2013 TTM Duke Energy has an average tax rate of 30.06%.

Cost of Debt (After Tax) = (Cost of Debt Before Tax) (1 - Tax Rate)

The effective rate that a company pays on its current debt, after tax.

  • .01625 x (1 - .3006) = Cost of debt after tax

The cost of debt after tax for Duke Energy is 1.14%

Cost of Equity or R Equity = Risk Free Rate + Beta Equity (Average Market Return - Risk Free Rate)

The cost of equity is the return a firm theoretically pays to its equity investors (for example, shareholders) to compensate for the risk they undertake by investing in their company.

  • Risk Free Rate = U.S. 10-year bond = 2.13% (Bloomberg)
  • Average Market Return 1950 - 2012 = 7%
  • Beta = (Google Finance) Duke Energy's Beta = 0.31

Risk Free Rate + Beta Equity (Average Market Return - Risk Free Rate)

  • 2.13 + 0.31 (7- 2.13)
  • 2.13 + 0.31 x 4.87
  • 2.13 + 1.51 = 3.64%

Currently, Duke Energy has a Cost of Equity or R Equity of 3.64%. This indicates that the investor should expect to get a return of 3.64% per-year average over the long term on their investment to compensate for the risk they undertake by investing in this company.

(Please note that this is the CAPM approach to finding the cost of equity. Inherently, there are some flaws with this approach and that the numbers are very "general." This approach is based off of the S&P average return from 1950 - 2012 at 7%, the U.S. 10-year bond for the risk-free rate, which is susceptible to daily change and Google Finance beta.)

Weighted Average Cost of Capital or WACC

The WACC calculation is a calculation of a company's cost of capital in which each category of capital is equally weighted. All capital sources such as common stock, preferred stock, bonds and all other long-term debt are included in this calculation.

As the WACC of a firm increases, and the beta and rate of return on equity increases, this is an indicator of a decrease in valuation and subsequently, higher risk. By taking the weighted average, we can see how much interest the company has to pay for every dollar it finances. For this calculation, you will need to know the following listed below:

Tax Rate = 30.06%

Cost of Debt (before tax) or R debt = 1.625%

Cost of Equity or R equity = 3.64%

Debt (Total Liabilities) for 2012 or D = $72.713 billion

Stock Price = $67.64 (June 17th, 2013)

Outstanding Shares = 706.00 million

Equity = Stock price x Outstanding Shares or E = $47.753 billion

Debt + Equity or D+E = $120.466 billion

WACC = R = (1 - Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 - Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 - .3006) x .01625 x ($72.713 /$120.466) + .0364 ($47.753 /$120.466)

.6994 x .01625 x .6036 + .0364 x .3964

.0069 + .0144

= 2.13%

Based on the calculations above, we can conclude that Duke Energy pays 2.13% on every dollar that it finances, or 2.13 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0213 plus the cost of the investment for the investment to be feasible for the company.

Debt Side Summary

All indications above reveal that Duke Energy has increased its debt and therefore its financial risk over the past couple of years. Having stated that, the ratios indicate that Duke Energy is financially stable from a debt point of view. Even though they carry a very large amount of debt, the CAPM supports the stability of the company by stating that an investor needs an average of 3.64% over the long-term to get good value on his or her money. As the current divided is 4.52%, this implies that if buy and hold strategy is employed at these levels, an investor will get good value on his/her money even if there is some short-term volatility ahead.

Return on capital employed = EBIT / (Total Assets - Current Liabilities)

This ratio indicates the efficiency and profitability of a company's capital investments. The higher the percentage the better.

ROCE should always be higher than the rate at which the company borrows otherwise any increase in borrowing will reduce shareholders' earnings, and vice-versa. A good ROCE is one that is greater than the rate at which the company borrows.

  • 2011 - $3.324 billion / $56.998 billion = 5.83%
  • 2012 - $3.693 billion / $103.827 billion = 3.56%
  • 2013 TTM - $4.400 billion / $103.701 billion = 4.24%

Even though the ROCE has diminished over the past few years due to the merger, it is still at 4.24%. When comparing the ROCE to the WACC, we can see that Duke Energy needs 2.13% return on its investments for the investments to be feasible for the company. The current ROCE of 4.24% indicates that the company is meeting that goal.

If a buy and hold strategy is employed at this point, this would be a key statistic to watch. If the ROCE percentage drops, or the WACC increases significantly to the point where the WACC is higher than the ROCE, in my opinion this would indicate a sell point. It would indicate a sell as this would imply that Duke Energy is borrowing at a higher rate than it is earning.

Rate increase?

On June 12, 2013 the North Carolina Utilities Commission's Public Staff and Duke Energy came to a consensus regarding a rate increase. According to Bloomberg Businessweek the deal states: a "$205 million rate increase each of the first two years, increasing to $235 million after the third year. The deal would allow a rate increase that includes a 10.2 percent return on equity, a measure of profit." The final approval must be met by the utilities commission, which has scheduled to meet on July 8th.

Even though Duke Energy is not going to get the rate increase they want, if the rate increase goes through, this will help the bottom line for the company.

(click to enlarge)

Chart sourced by (FINVIZ)

Summary

The above analysis reveals that Duke Energy is a solid company on the debt side. Duke has significantly increased its debt levels over the past couple of years but all of the ratios imply that the company is not "over-leveraged" or in financial distress. Currently, they have a couple of forces working against them. These forces are: the fear of rising interest rates and future capital expenditures. Duke Energy is going to need to continue spending large amounts of capital over the next few years to continue upgrading and modernizing its assets. They must do this carefully, as the company already has a large amount of debt. Even a small increase in interest rates could have a large effect on the company's bottom line.

On the positive side, the ratios above state Duke Energy is in good shape financially. Duke Energy has a very low WACC ratio implying that the company can borrow money at very low rates. As well, the ROCE is higher than the WACC showing that Duke Energy is creating profits on the money it has borrowed - thus improving shareholder value.

According to the summary above, the current CAPM for Duke Energy is 3.64%. This indicates at these current rates, in this market an investor should expect to get 3.64% over the long-term on their investment. As the current divided is 4.52%, this shows that if buy and hold strategy is employed, at these levels an investor will get good value on their money even if there is some short-term volatility ahead.

Based on the chart above, we can see that the stock price is currently at a key point. The stock is in a strong uptrend when compared to December, but if the price breaks support here it could fall drastically. Based on the evaluation above, even if the price falls from this point, an investor will still get excellent value for money over the long-term, as Duke Energy pays a divided of 4.52% to buy and hold.

Source: Duke Energy: Buy And Hold Trumps Short-Term Volatility