- Impressive rate base growth will drive long-term earnings growth.
- Company’s efforts to maintain flat O&M and plans to sell Midwest assets will benefit its performance and stock valuation.
- Future dividend growth to be better than last five years’ average of 2.5%.
Duke Energy (NYSE:DUK) is positioned well to deliver steady earnings and dividend growth, as its business fundamentals stay solid. Duke has been making efforts to further increase its regulated business exposure, as it has plans to exit from unregulated generation and is conducting a strategic review of its international business. Also, Duke does not have any significant rate cases over the next few years, which is likely to improve its risk profile. As the company is de-risking its earnings, this could result in an increase in valuation premium. In the near term, Duke's earnings are likely to be driven by the realization of merger synergies and rate increases secured in 2013. Long-term growth prospects remain even more compelling, as the company intends to step-up its capital spending (CAPEX) from 2015.
Long-term growth prospects seem attractive for Duke as it plans to accelerate its growth CAPEX from 2015. As the company plans to step-up its CAPEX, it is likely to accelerate its regulated rate base growth to 6% on average in 2017-2018 and beyond, as compared to the current rate base growth of 4%. According to Duke, growth CAPEX are expected to total $16-$20 billion from 2014 through 2018, including spending on infrastructure, new generation and environmental compliance. Financial and regulatory risks attached to the planned spending remain low for Duke, as 90% of the planned spending will be directed towards regulated operations. Also, another positive in relation to the planned spending is the fact that a major part will be spent in those states, including Carolinas and Florida, where Duke has a constructive relationship with authorities.
Moreover, environmental CAPEX of $5-$6 billion over the next 10 years will also augur well for the long-term rate base growth. Almost half of the environmental CAPEX will be allocated to ash coal management. However, the final EPA regulations in December 2014 and NC legislative action in July, next month, could impact the planned environmental CAPEX. The Dan River accident and ash cleanup have created a negative image of the company; however, in my opinion, the associated costs will not have any significant impact on the company's long-term performance.
To reduce earnings uncertainty and increase regulated earnings exposure, Duke plans to divest its Midwest generation (unregulated) assets by early 2015. Despite the fact that Duke is keeping an eye on FirstEnergy's (NYSE:FE) and American Electric Power's (NYSE:AEP) initiatives to begin a long-term agreement to bring earnings stability to unregulated businesses, Duke is likely to proceed with Midwest assets sale.
The current book value of Duke's unregulated assets is almost $3.5 billion, which is believed to be higher than the fair market value, which is why the company took an impairment charge of $1.4 billion in the recent first quarter. The company is expecting to fetch almost $2.1 billion ($3.5 billion - $1.38 billion) from the sale of Midwest assets. Other than the fact that the sale of Midwest assets will provide earnings stability, Duke could use the sales proceeds to repurchase shares or reduce debt, which will augur well for future EPS growth. Furthermore, the company is undertaking a strategic review of its international operations, which consist 15% of EPS, to ensure efficient allocation of capital and cash; which is another positive step by the company.
Other than the factors discussed above that will drive earnings growth in the long term, rate increases approvals secured by Duke in 2013 are likely to fuel top and bottom line growth in the near term. The retail rate increases are expected to result in incremental revenues of $707 million and $777 million in 2014 and 2015, respectively. Other than the scheduled revenue increases, Duke's cost cut measures stay on track and the company is likely to succeed a merger synergy target of 5%-7% reduction in operational and maintenance (O&M) expenditure. These savings will allow the company to maintain flat O&M from 2011 through 2016, at $6.1 billion per year.
Duke has a solid fundamental outlook. Rate base growth for the company remains impressive, which will drive long term earnings growth. Also, efforts to maintain flat O&M and plans to sell Midwest assets to reduce earnings volatility will augur well for the company's performance and stock valuation. In addition, the company's dividend growth in upcoming years is likely to track earnings growth, which will be better than the last five years' average dividend growth of 2.5%; currently Duke offers a safe dividend yield of 4.4%. As Duke remains a high quality utility stock, valuation premium for the stock is justified.