By The Valuentum Team
Duke Energy (NYSE:DUK) is one of the largest utilities in the US, and its shares have caught a nice updraft as a result of Brexit while investors continue to search for income as Treasury yields remain significantly suppressed. The generally accepted view of the business models of utilities being safer than most has played a key role in the recent uptick in investor demand as well.
There is plenty to like about the business models of utilities. Regulated utilities are often monopolies in their operating regions, to which they provide an essential service. This, coupled with the fact that the returns of regulated utilities are set by a regulatory body within a defined ratemaking process causes the sector to be full of operators that boast steadily growing earnings that appear to be materially dependable. Oftentimes we warn against capital-intensive business models, a key characteristic of utilities, but the regulated aspect of the utility business model reduces a fair amount of the risk associated with such large capital outflows. In fact, it is the fixed rate of return on such hefty investment that is the driver behind regulated utility earnings expansion.
As it relates to the firm's investor-income generating abilities, Duke Energy has an impressive dividend track record, having paid a quarterly dividend for ~90 consecutive years. Moving forward, the company is targeting a dividend payout ratio of 65-70% at least through 2020. The firm's balance sheet is far from healthy (in our view), but its credit rating remains investment-grade thanks to the regulated nature of the vast majority its operations. The acquisition of Piedmont could impact the pace of dividend growth moving forward as Duke works to integrate the newly acquired operations, some of which are not of the regulated variety. Though the company boasts an already attractive dividend yield, management remains committed to growing the payout.
However, we must note that most large public utility holding companies have raw, unadjusted cash flow-derived Dividend Cushion ratios below 1, indicating that future expected free cash flows over the near term are completely absorbed by net debt obligations and future expected dividend payments (in bringing forward all debt obligations - please note that the Dividend Cushion is a measure of dividend payment risk, not a measure of liquidity). Utilities' high dividend payout ratios (dividends paid per share divided by earnings per share) and elevated capital outlays - both of which prevent the buildup of cash on the balance sheet - coupled with the ballast of hefty debt obligations, which are higher on the capital structure than any equity concerns, prevent most utilities from receiving a healthy Dividend Cushion ratio, a pure financial statement-based comprehensive assessment of the coverage of the dividend.
Duke Energy's Investment Considerations
- The merger between Duke Energy and Progress Energy created one of the largest US utilities. The firm's regulated utility operations serve 7+ million electric retail customers located in six states in the Southeast and Midwest (NC, SC, IN, OH, KY, FL), representing a population of approximately 21 million people.
- The company boasts significant scale, diversity, and expertise as its strengths. Size doesn't guarantee success, but Duke has been adapting through its 110-year history. Management continues to effectively adjust to changes in technology, fuel prices, and regulations.
- The firm's regulated utility operations represent ~85-90% of its total adjusted earnings. Management thinks long-term adjusted diluted earnings per share growth of 4-6% is achievable, and the company's investment-grade credit rating is solid.
- Duke Energy recently agreed to buy Piedmont for ~$60 per share in an all-cash transaction. The company will also assume ~$1.8 billion of Piedmont's debt, which brings the total value of the deal to approximately $6.7 billion. The deal is expected to close by year-end 2016.
- A growing dividend is central to Duke's investor value proposition. The firm continues to pursue measured dividend increases, and recently celebrated its 90th consecutive year of paying a quarterly dividend.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Duke Energy's 3-year historical return on invested capital (without goodwill) is 3.4%, which is below the estimate of its cost of capital of 7.7%. As such, we assign the firm a ValueCreation™ rating of POOR.
In the chart below, we show the probable path of ROIC in the years ahead, based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Companies that have strong economic profit spreads are often also solid free cash flow generators, which lends itself to dividend strength. Duke Energy's Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is -0.1 (anything above 1 is considered strong).
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Duke Energy's free cash flow margin has averaged about 2.7% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures, and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Duke Energy, cash flow from operations increased about 5% from levels registered two years ago, while capital expenditures expanded about 22% over the same time period.
In the first quarter of 2016, Duke reported cash from operations of more than $1.66 billion and capital expenditures of just under $1.65 billion, resulting in free cash flow generation of nearly $20 million, a decrease of 34% from the first quarter of 2015.
This is the most important portion of our analysis. Below, we outline our valuation assumptions and derive a fair value estimate for shares.
We think Duke Energy is worth $68 per share with a fair value range of $54-82. Shares are currently trading at ~$86, well above the upper bound of our fair value estimate. This indicates that we feel there is significantly more downside risk than upside potential associated with shares at the moment.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of these. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.
Our estimates for Duke Energy's top and bottom lines for 2016 and 2017 are roughly in line with consensus estimates. We're expecting steady organic revenue growth for the foreseeable future in the low-single-digit range, as the firm's ongoing investments in its regulated operations should continue to push its top line higher. Bottom line growth should outpace top line expansion, as efficiency initiatives and operational improvements are par for the course for such a competitive utility.
Our model reflects a compound annual revenue growth rate of 2.9% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 6.1%. Our model reflects a 5-year projected average operating margin of 28.4%, which is above Duke Energy's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 1.8% for the next 15 years and 3% in perpetuity. For Duke Energy, we use a 7.7% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $68 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets, as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety, or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Duke Energy. We think the firm is attractive below $54 per share (the green line), but quite expensive above $82 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Duke Energy's fair value at this point in time to be about $68 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Duke's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $80 per share in Year 3 represents our existing fair value per share of $68 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we 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.