Analyzing PPL's 14% Upside, Dangers At Duke

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Includes: AEP, DUK, PPL
by: Takeover Analyst

Despite often being seen as ideal defensive plays in a challenged economy, utilities are considered a mixed bag for analysts right now. Duke Energy (NYSE:DUK) is currently rated closer to a "sell" than a "buy" (see "Bears Tackle Duke And AEP" here). As regulators continue to reject the takeover terms for Progress (PGN), investors stand to benefit from abnormally high risk-adjusted returns when the deal closes. The CEO of Progress is confident that there will be a merger, but shareholders are weary after FERC dismissed the company's approach to market power. Meanwhile, PPL Corporation (NYSE:PPL) is rated a weak "buy".

From a multiples perspective, PPL is the cheaper of the two. It trades at a respective 10.8x and 11.6x past and forward earnings while offering a dividend yield of 4.9%. Duke, however, trades at a respective 15.6x and 14x past and forward earnings while offering a dividend yield of 4.7%. This implies greater risk and less reward for the latter. Trading between these two at 12.5x past earnings is American Electric Power (NYSE:AEP), which is rated a "hold". Given industry consolidation, this utilities firm will struggle to outperform the competition and face cost pressures.

Despite bearish sentiment surrounding Duke, at the third quarter earnings call, the firm's CEO, Jim Rogers, noted several favorable developments:

"As a result of our year-to-date earnings, we are increasing our 2011 adjusted diluted per-share earnings guidance range from between $1.35 and $1.40 to $1.40 and $1.45…

That 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.

For the quarter, our nuclear fleet had a capacity factor of 99.27%. The fleet dispatched more than 15 million-megawatt hours, setting an all-time company record for best quarterly nuclear generation performance".

Latin American growth was also solid, Midwest gas operated at record levels, and fleet modernization is progressing smoothly. One problem is that the company tried to increase rates by 15% in South Carolina, but had to drop this figure to 6%. Furthermore, the Indiana clean coal plant will require $1B more capital than originally anticipated.

Consensus estimates for Duke's EPS are that it will be essentially be flat at around $1.43. Assuming the multiple holds steady and 2012 EPS turns out to be $1.43, the stock would rise nominally.

PPL Corporation, which has greater stock volatility, is more attractive. Legislation passed in Pennsylvania will allow for alternate rate-making systems and improved margins. While third quarter earnings were diluted by stock issuance and Kentucky has stagnant growth, natural gas prices are advancing towards a favorable inflection point in 2014. In addition, PPL has an advantage in its low-cost production and will benefit from the continued shift away from marketing to regulated businesses.

Consensus estimates for PPL's EPS are that it will decline by 16% to $2.63 in 2011, decline by 6.8% in 2012, and then grow by 4.1% in 2013. Of the 3 revisions to estimates, all have gone up for a net change of 0.3%. Assuming the multiple rises to 13.5x and 2012 EPS turns out to be $2.41, the intrinsic value of the stock is $32.54, implying 14.1%. However, if the multiple holds steady and 2012 EPS turns out to be 7.3% below the consensus, the stock would fall by 14%. Accordingly, the risk/reward is not incredible, especially considering that net debt of $17.1B exceeds market value.

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