Duke Energy Is Worth Buying After Loading And Shedding Some Assets

| About: Duke Energy (DUK)

Summary

Duke Energy will suffer higher economic losses than the initial estimates.

The company will incur an estimated cost of $1.35 billion to close eight high-risk ash impoundments.

Duke Energy will sell its international assets for a cumulative enterprise value of $2.4 billion in two separate transactions.

Hurricane Matthew was the first Category 5 Atlantic hurricane since Hurricane Felix in 2007, and it heavily damaged Florida and the Southeast United States. CoreLogic has estimated initial losses of $4 billion to $6 billion, excluding business interruption costs and additional flooding related insured losses, but total economic losses would be much higher.

Approximately 1.1 million suffered power outage in Florida where Duke Energy (NYSE:DUK) serves more than 1.7 million customers. Duke Energy Florida has restored power to all customers. In North and South Carolina, 1.2 million customers were without power and Duke Energy is working on the full restoration of its electrical system.

The climate changes and stricter environmental regulations are creating increasing challenges for electric utilities, particularly coal-dependent electricity producers. Duke Energy is almost done restoring the power, but expects potential losses to exceed the initial estimates. Duke Energy could suffer revenue loss due to power and higher-than-expected spending on rebuilding the electrical system in some service areas and repair of more than 100 damaged substations, as well as maintenance of miles of lines and broken poles could potentially squeeze the fourth-quarter operating earnings.

Duke Energy has invested approximately $2.4 billion in Florida since 2004 to harden and upgrade its system against devastating hurricanes. The company has installed grid automation system and smart grid devices to improve the reliability of the entire system and reduce the power outage duration. Duke Energy has installed new technology for 20% of all Duke Energy Florida customers. The continued investments in smart grid will enable the company to install new devices for another 15% customers by mid-2017.

The continued investments in grid modernization and micro-grids can help Duke Energy mitigate the potential losses. Natural disasters, however, are not the only environmental risks Duke Energy should worry about because the government is forcing stricter regulations.

Decarbonization

Duke Energy is one of the major coal-burning utilities, but coal as a fuel mix has dropped from 60% in 2008 to approximately 30% in 2016. Under Coal Ash Management Act, Duke Energy is required to manage 33 ash impoundments by 2029 at 14 facilities in North Carolina - depending on the risk level of each ash impoundment. To close eight high-risk ash impoundments, Duke Energy will incur an estimated cost of $1.35 billion by 2020. Coal ash management related expenses will accelerate further in the future as Duke Energy continues to retire coal-fired power plants.

Duke Energy is becoming one of the major coal-dependent utilities that is increasing investments in natural gas and renewables. In the past few years, the management has taken aggressive measures to decarbonize and comply with Clean Power Plan (CPP), which has helped significantly reduce carbon emissions from 2005 level.

Duke Energy currently has potential coal plant retirements of 1,471 MW and plans to replace the entire coal-fired generation facilities with natural gas and renewables by 2040. The target is very realistic, given the fact that Duke Energy has slashed 50% coal from its fuel mix over the past eight years. With 5% of total capacity coming from the wind and solar, Duke Energy fails to make it to the top ranked investor-owned electric utilities on clean energy deployment. However, the management plans to install and acquired 8,000 MW of the wind, solar and biomass capacity by 2020, which will be a substantial improvement over current wind and solar capacity of 2,784 MW.

Duke Energy is also strengthening its portfolio of natural gas storage, distribution, and electricity generations assets that will help it accelerate earnings growth for the long term. The company has recently completed the acquisition of Piedmont Natural Gas, which will add 1 million natural gas customers to Duke Energy's existing customer base. Duke Energy is also planning new natural gas pipeline in Ohio service territories at an estimated cost of $100 to $150 million. In addition to that, Duke Energy now holds 47% stake in Atlantic Coast Pipeline, which will start generating a new stream of cash flows in 2019.

Disposal of International Assets

Duke Energy has finally found the exit route from international markets. The company will sell its international assets for a cumulative enterprise value of $2.4 billion in two separate transactions. Duke Energy had estimated a book value of $2.4 billion to $2.5 billion for its international assets, which means the company won't be recognizing a loss on disposal.

The sale of electricity generation business in Brazil to Three Gorges Corporation of China will generate $1.2 billion in two to four months - depending on the regulatory approvals. In the second deal, Duke Energy is selling assets in Peru, Chile, Ecuador, Guatemala, El Salvador and Argentina to I Squared Capital for $1.2 billion. The transaction will close in the first half of 2017. The acquirer companies will also assume the debt attached to those assets, which will reduce some burden from Duke Energy.

The generation capacity of international assets is 4,315 MW, which means the disposal will reduce Duke Energy's total capacity to 52,382 MW, and the company will also experience some decline in revenue and income in 2017. However, the implications for the shareholders will be favorable as the elimination of risky, unregulated and poor performing assets will improve the overall profitability and predictability of future cash flows.

Amid increasing noise over interest rate hikes, it is a better idea to pay off some debt with disposal proceeds rather than returning it to shareholders. Duke Energy is one of the few large-cap electric utilities that has lowest debt level. The company is sitting on a total debt/equity ratio of 1.12 times. Due to its operating cash flows to short-term debt ratio of 69%, as compared to 42% of Dominion Resources, Duke Energy is in a comfortable position to pay off its short-term obligations and boost dividend payments.

Management is interested in paying off the debt from after-tax sales proceeds, but the debt level is likely to remain the same as the $2 billion debt from Piedmont Natural Gas will fully offset the impact.

Duke Energy Is A Bit Cheaper

Utilities were expensive a few months ago, but the steep correction of approximately 10% has brought the sector close to its long-term historical average. The electric utilities are trading at a forward price to earnings of 17x, which is in line with the S&P 500 Index valuation. Duke Energy is comparatively cheaper as it is trading at forward price to earnings and EV/EBITDA multiples of 16x and 10.5x. Moreover, Duke Energy is trading at a discount to its 5-year historical price to earnings average of 20x. In comparison, Dominion Resources (NYSE:D) and Southern Company (NYSE:SO) are trading at EV/EBITDA of approximately 14x and 12x, respectively.

Shares of Duke Energy have plunged more than 11% in the past three months and dividend yield has increased to 4.5% - well above the industry average of three-and-a-half percentage point. Duke Energy is worth buying at these valuation levels for an attractive yield with mid-single digit growth potential. The sector-wide weakness is likely to prevail in the short run as a December increase is still on the cards.

Natural gas utilities are trading at a hefty premium of approximately 24% over electric utilities, which makes sense as natural gas consumption is estimated to grow at an average increase rate of 1.3% in 2016 and 2017, according to Energy Information Administration. Another bullish aspect of Duke Energy is the potential new stream of regulated natural gas cash flows from Piedmont Natural Gas and Atlantic Coast Pipeline. These investments have created an upside for the long-term shareholders and yet the market is not pricing in potential cash flows.

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.