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Summary

  • What are estimates for inflation/10-year bond?
  • How are the effects on inflationary pressures limiting the potential for capital appreciation?
  • For the income investor, is Duke energy's dividend growth keeping up with inflation?

For investors looking for a company with a strong history of creating shareholder value, Duke Energy (NYSE:DUK) is a dividend paying utility that currently offers a beta of 0.31 coupled with a yield of 4.50%.

According to Duke Energy's website over the past five years the company has a 5-Year Annual Dividend Growth Rate of 3.27%. So over the past 5 years the company's dividend growth has outpaced inflation, but looking forward is it reasonable to expect this out of Duke Energy in an inflationary environment?

(click to enlarge)

Chart sourced by (bond.about.com)

In an excellent article by Richard Shaw, entitled Fed Targeting 4% to 5% nominal 10-year Treasury yield and Baa Corporates approaching 7%, he describes many scenarios that could lead them to inflationary pressures over the next one to three years. In the article he states "Clearly it is time to think more about where interest rates might go". So if you have a dividend stock like Duke Energy this is a factor to consider.

Duke Energy and the 10 year Treasury Rate

As the chart below indicates there is a co-relation between Duke Energy stock price and the 10 year Treasury Rate. This is evident in the 10 year chart listed below. As the 10 year bond has set recent lows, Duke Energy's price has set record highs.

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10 Year Treasury Rate Chart

10 Year Treasury Rate data by YCharts

In 2013 Duke Energy's outperformed many other utility companies from a capital appreciation point of view. Indicated by the chart below, Southern Company (NYSE:SO), Consolidated Edison (NYSE:ED) and the and Utilities Select Sector SPDR ETF (NYSEARCA:XLU) all displayed greater sensitivity to the increase of the 10 year bond than Duke Energy.

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DUK Chart

DUK data by YCharts

Not only did the company show more resilience when faced with the anticipation of inflationary pressures but over the past five years the company has also outperformed the other companies from a capital appreciation point of view.

The CAPM approach states that the investor over the next year needs ~4.03% annualized to create value on the money one invests. So with the 10 year bond on the rise is this a realistic expectation?

As there many analysts are expecting a slow and steady increase in the 10 year bond, with estimates in the 4% range in the next three years or so, the chart above indicates that this will have a damping effect of the potential for capital appreciation over the next few years.

This co-relation is evident in analysts' most recent price targets. Currently, targets set in 2014 indicate a target range from $72.00 to $76.00. To accompany these targets analysts giving a wide range of projections ranging from Neutral to overweight. Based on these projections analysts estimate capital appreciation in 2014 from ~2.85% to ~8.57%.

As established above, one of the factors limiting the potential for capital appreciation over the next couple of years is the expected increase in the 10-year bond. So based on this information, what do future earnings look like? and what is the potential for dividend increases to outpace inflation?

If the investor is expecting limited capital appreciation over the next couple years and inflationary pressures rising this puts pressure on the company to create shareholder value in other forms. A company that does not do this will watch its shareholders real rate of return slowly begin to doctorate.

So, as there is significant speculation that the 10 year bond is on the rise, will Duke Energy's dividend be able to keep up with inflation?

Dividend

Duke Energy has a long history of dividend payments. 2014 marks the 88th consecutive year that Duke Energy has paid a quarterly cash dividend on its common stock. As stated above Duke Energy has delivered a 5-Year Annual Dividend Growth Rate of 3.27% equaling 13.04% growth. As Duke Energy has delivered an annual growth rate of 3.27% this has outpace inflation. So what about the next few years?

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DUK Dividend Chart

DUK Dividend data by YCharts

At current levels Duke Energy offers a yield of ~4.50%, which equates to a payout of $3.12.

Analysts' Estimates

Analysts at Yahoo Finance are estimating an EPS for FY 2014 at $4.56 while moderate growth is expected to continue into 2015 as EPS estimates increase to $4.75.

Bloomberg Businessweek supports this growth as it expects the company's revenues to be around $25.8 billion for FY 2014 and increase to $26.1 billion for FY 2015.

Earnings Estimates

According to Duke Energy the company has a target of increasing EPS by 4% to 6% CAGR. The company is planning a strategic review in the 2014 where these figures may be revised.

Photo sourced (DUK)

Analysts at the Nasdaq are more conservative in their projections and are estimating earnings to increase at a rate of ~3.86% CAGR over the next five years.

As the company historically has a payout ratio in the 80% range, looking at future earnings and revenue will reinforce the company's estimates for dividend growth.

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DUK Payout Ratio (NYSE:<a href='http://seekingalpha.com/symbol/ttm' title='Tata Motors Limited'>TTM</a>) Chart

DUK Payout Ratio (TTM) data by YCharts

Currently, the company and analysts estimate earnings to increase by ~3.86% year over year, over the next five years. With the company targeting a payout ratio declining to ~70% will the dividend increases be able to keep up with inflationary pressures?

Using analysts EPS estimates while calculation a payout ratio of 70% this should give dividend payout estimates until 2017.

2014 - 4.56 * .70 = $3.19 payout

2015 - 4.75 * .70 = $3.33 payout

2016 - 4.93 * .70 = $3.45 payout

2017 - 5.02 * .70 = $3.51 payout

Using the method above the 2017 dividend payout should be around $3.51. So how does this compare against the estimated increase in the 10 year bond?

In a recent publication by Donald van Deventer PH. D. the article predicts the latest implied forward rate forecast from Kamakura Corporation. Within the article, there are forecasts for the next 60 months of U.S. Treasury yield curves and a long range forecast that estimate the next 61 - 120 month forecast.

10 year bondDuke Energy estimated
YearestimateDividend Increase %
20142.652.24%
20153.074.39%
20163.463.60%
20173.771.72%

As the chart above indicates the estimated dividend increase is only expected to beat inflation a couple of times over the next few years. Having stated that, as 2015 and 2016 estimates look to be significantly stronger than inflation, dividend growth looks grow at an average of ~2.98%. Based on the chart above, the average rate of inflation over the same period of time equated to ~3.23%.

Conclusion

Currently, companies within the Utility sector has some major obstacles ahead of them. One of them is creating investor interest in the face of inflationary pressures. As pressures like the expected increase in the 10 year bond are putting a damper on the potential for capital appreciation, I believe it's important to measure the dividend to see if growth will keep up with inflation. As the company's current yield is ~4.5%, the dividend growth looks to be slightly less than inflation with growth estimated at ~2.98% with a payout ratio at 70%. If estimates for growth rise and / or the company is able to revise their payout estimates above 70% this will have a significant effect on the dividend payout. Having stated that, at current estimations, if a investor was looking to buy now and is looking for income at this point in their lives without accessing the drip program or utilizing any capital appreciation, then I believe you will earn slightly less than inflation over the next few years.

Source: Duke Energy Income Investing: Dividend Growth, Inflation And Capital Appreciation