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With major utility players consolidating, the industry will make winners and losers. While I am optimistic about Duke's (DUK) merger with Progress Energy (PGN), I still do not believe the company's likely growth justifies stock out performance. Accordingly, the company has underperformed the S&P 500 (SPY) by 1,582 basis points over the last six months.

In this article, I will run you through my DCF model on Duke and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared with PPL (PPL) and Xcel Energy (XEL). I find, again, that the company is not likely to outperform broader indexes.

First, let's start with an assumption about the top line. Duke finished FY2011 with $14.5B in revenue, which represented a 1.8% gain off of the preceding year. I model growth occurring at 4% annually over the next half decade or so. Frankly, I think this is more on the bullish side than anything else. But, for the sake of proving my point, I accept the projection.

Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures and taxes. I model operating expenses generously as 80% of revenue and capital expenditures as 32% of revenue. Taxes are estimated at 29% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model).

We then need to subtract out net increases in working capital. I estimate that this will hover around -1% of revenue over the projected time period.

Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 6.6% yields a fair value figure of $19.51, implying 5.3% downside. 6.6% is a low WACC for companies, but the low beta of 0.34 offers some justification for the input. If the WACC was 7%, however, the stock would be worth only $16.23 for more than 20% downside. Given the low WACC and high growth / low cost assumptions, I find that this mandates holding out from Duke.

All of this falls within the context of decent performance:

From a financial perspective, we grew earnings, ending the year with adjusted diluted earnings per share of $1.46, which is $0.03 higher than our 2010 results. Considering that extremely favorable weather contributed about $0.13 to the prior year, our 2011 performance is truly exceptional. These results exceeded both our original and revised guidance range. For the year, earnings from our ongoing modernization programs and strong performance from our international business helped offset less favorable weather, significant storm restoration costs and the annualized effect of customers switching in Ohio. Continuing our commitment to increase the dividend, we grew our quarterly dividend by about 2%. Our dividend is supported by a strong, regulated earnings base and we target a long-term payout ratio of 65% to 70% of adjusted diluted earnings per share.

From a multiples perspective, the company is still not worth the risk. It trades at a respective 16.1x and 13.9x past and forward earnings versus 10.2x and 11.4x for PPL and 15.3x and 14x for Xcel. Assuming a multiple of 15x and a conservative 2013 EPS of $1.43, Duke's stock would hit $21.45.

Consensus estimates for Xcel's EPS forecast that it will grow by 3.5% to $1.78 in 2012 and then by 6.2% and 5.3% in the following two years. Assuming a multiple of 15x and a conservative 2013 EPS of $1.82, the stock would hit $27.30. Again, this is not worth the risk. Utilities are known for their dividend yields, and, of the three highlighted herein, Xcel offers the lowest at just 3.9%.

Ironically, the "negative growth" that is expected for PPL makes it an upside story. This is because it sets the bar rather low. Consensus estimates for its EPS forecast that it will decline by 14.3% to $2.33 in 2012, grow by 4.3% in 2013, and then decline by 9.1% in 2014. Assuming a multiple of 15x and a conservative 2013 EPS of $2.36, the stock would hit $35.4% for a 28% rise. If you want to make an investment in utilities, I would thus recommend backing the underdog: PPL.

Disclaimer: The distributor of this research report is not a licensed investment adviser or broker-dealer. Investors are cautioned to perform their own due diligence. We may change our investment opinion at any time. We seek business relationships with all of the firms in our coverage, but research covered in this note is independent.

Source: Possible 20% Downside For Duke Warrants Holding Out