Bears At Duke Energy Wrong

Nov. 7.11 | About: Duke Energy (DUK)

While Duke Energy (NYSE:DUK) may not be undervalued at the present moment, the near "sell" rating on the Street is, in my view, wrong. The utilities firm's nearing merger with Progress Energy (PGN) will result in a giant cash-generator that can be easily scaled as the macroeconomy improves. And the respective managements are meanwhile taking the necessary steps to cut costs that will optimize scale opportunities.

The main reason why I am more bullish than the Street is that I am impressed with the cost cutting initiatives and the commitment that Duke and its target has for returning free cash flow to shareholders. While Duke operates in an industry known for high dividend distributions, its yield of 4.84% is at a premium to the median. Likewise for Progress. A beta of 0.37 also makes it an incredibly safe stock for a challenging economy. Over the last 12 months, shareholder value has gone up by 11.6% for Duke and 17.3% for Progress.

At the recent third quarter earnings call, Duke's CEO, Jim Rogers, noted:

"[W]e reported third quarter adjusted diluted earnings per share of $0.50. This compared to $0.51 in the prior year. Our year-to-date results due to third quarter were flat to the prior year. However, when we take into account the significant weather that favorably impacted our results last year, this performance is outstanding.

The U.S. Franchised Electric and Gas, our largest business segment, this strong operational performance in our generation investments helped offset less favorable weather and higher planned O&M cost.

At international, we saw strong results from our Latin American operations, as well as increased earnings from our stake in National Methanol Company."

These results were challenged by a tough regulatory environment, storm damages to supply chain, and commodity volatility. As a value investor, however, I am much more concerned with how the fundamentals are improved to limit WACC and boost ROIC. Duke proved successful in this area with stellar progress in fleet modernization that will help drive long-term value creation. In particular, a nuclear fleet capacity of 99.7% was achieved while the Midwest gas fleet is operating at record levels. Volumes are up by 40% from the last quarter in Midwest gas - representing a catalyst that will offset shortcomings elsewhere. In addition, I believe that the base rate increases will have only a limited impact on volumes. In the long-term, margins need to be improved in order to maximize the benefits from increased scale following a merger with Progress.

The utilities firm recently finalized a stipulation with the Ohio Electric Security Plan that will see rates based on competitive auctions starting next year. An approval by PUCO is, in my view, inevitable. I calculate that this will cut into 2012 EPS by as much as 7 cents. The agreement was roughly what most commentators expected. Another concern is how the firm will restructure its balance sheet, as net debt currently stands at 64.1% of market value. Note, however, that utilities tend to hold a substantial amount of debt, as is the case for CenterPoint (NYSE:CNP) and SCANA (NYSE:SCG).

Consensus estimates for EPS are that it will decline by 2.8% to $1.39 and then increase by an average of 2.5% in the following two years. Assuming an optimistic multiple of 16x - a premium to most peers - and the realization of consensus 2012 EPS, $1.42, the rough intrinsic value of the stock is $22.72. This offers only a slight margin of safety, which suggests that the stock is fairly priced. The stock currently trades at 16.6x and 12x past and forward earnings, respectively. With a high dividend yield and low beta, the stock is nevertheless safe and has tremendous upside following a merger with Progress. Better than expected transmission in the Carolinas coupled with improving technology will help fuel any growth in the years ahead. In conclusion, while I would hold out until the cost synergies can be better ascertained, I do not believe that Duke is in any way a short.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.