Shares of Duke Energy (NYSE:DUK) rose 0.7% on Tuesday after the energy company received an upgrade from Deutsche Bank, which believes the sector is attractively valued.
While I like the current dividend yield and see upside resulting from the Progress deal, I think the current valuation is already quite high. Investors which are starving for yield in recent years have pushed up the share prices of high-dividend paying stocks too much in my opinion.
I remain on the sidelines seeing few reasons for further capital gains. I like the dividend, but a renewed spike in interest rates could trigger violent sell-offs.
Analyst Jonathan Arnold believes the energy sector is attractively valued, raising the recommendation from "hold" to "buy," while giving the company a $74 price target. This implies that shares have some 10% upside from current levels.
The bank notes that utilities have been lagging in 2013, as the sector now trades at price-earnings parity with the S&P 500. In comparison, the sector traded at a 20% premium early in 2012.
Deutsche Bank notes that shares in the utility sector are not compelling cheap. Yet the 7-8% total return which is based on 3-4% growth, and a 4% dividend yield, are compelling enough for the bank in this market.
Key risks to the downside remains the macro-environment, especially if 10-year yields make another attempt to increase towards 3%.
Duke Energy ended its second quarter with $1.85 billion in cash, equivalents and short-term investments. The company operates with $37.6 billion in total debt for a net debt position of close to $36 billion.
Revenues for the first six months of the year came in at $11.8 billion, up 63% on the year before on the back of the Progress Energy deal. Despite $386 million in impairment charges taken in the second quarter, earnings rose by 32% to $973 million.
At the time, Duke reiterated its outlook for full year adjusted earnings of $4.20 to $4.45 per share. A simple extrapolation of these numbers would result in annual revenues around the $24 billion mark.
Trading around $67 per share, the market values Duke at some $47 billion. This values equity in the firm at close to 2 times annual revenues and 15-16 times annual earnings.
The $0.78 per share in quarterly dividend provides investors with an annual dividend yield of 4.6%.
Some Historical Perspective
Shares of Duke traded as low as levels in their mid-thirties by 2009 after which they steadily recovered to current levels at $75 per share. Shareholders have been receiving fat dividends in the meantime as shares currently yield around 4.5%.
Between 2009 and 2013, Duke is set to almost double its annual revenues toward $24 billion. Earnings are set to nearly triple to $3 billion. Note that the outstanding share base increased by little over 60% in the meantime, a direct result from the share issue to finance the Progress Deal.
Duke has delivered very good returns for long-term holders. Shares have risen, supported by attractive dividends, and on the back of the acquisition of Progress Energy.
As such shareholders have seen their holdings double over the past four years. On top of that, they have seen very fat dividend yields boosting returns even more.
Back in May, when the stock traded at $73 per share, I last took a look at Duke's prospects following the release of its first quarter results. I concluded that shares were in demand as investors kept looking for yield and were optimistic as they saw the first benefits from the $32 billion acquisition of Progress, which closed in the summer of 2012.
Investors have moved on, especially after the "messy" closing of the deal as former CEO Bill Johnson of Progress surprisingly resigned after the deal. Cheaper debt financing and operational synergies were the rationale behind the deal, and Duke is on track to reap the benefits from this.
I concluded that a 17-18 times earnings ratio is quite steep for a utility company. In the meantime shares have fallen a bit from those levels while the integration continues to deliver results. The earnings multiple has now come down to 15 times earnings, but investors should be comforted by the 4.5% dividend yield and the guidance of earnings per share growth through 2015, combined with stable and high payout ratios.
From the time of writing, shares have fallen about $6 per share, the equivalent of two year's worth of dividends. At the time I thought multiples were bid up too high, and shares have come off a bit, especially after a spike in interest rates during the summer, which spooked some investors.
Indeed, a renewed spike in long term rates remains one of the biggest worries. Unlike Deutsche Bank, I don't see convincing upside from current levels. The stock is great for dividend investors who look for current yield. At the same time I don't see much upside for capital gains, and possibly even more downside depending on interest rate movements in the coming months.
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.