We reaffirm our buy recommendation for Duke Energy Corp. (DUK) because of its expected future synergies, cheap valuations, long-term adjusted EPS growth of 4%-6%, expected increase in efficiency from retirement of old coal-fired power plants, and high dividend yield of 4.7%.
We are updating our thesis on Duke Energy, as the industry and the company are reducing their dependency on coal-fired plants. Electricity-generating companies in the U.S. are expected to reduce their coal generated electricity capacity in the future. According to one study, in the next five years, 59,000MW-to-77,000MW of coal-fired plants are expected to retire. Duke Energy is working on making its generation capacity more efficient and reliable. It has been retiring old coal power plants and adding natural gas power plants to address environmental concerns, to improve grid reliability, take advantage of lower gas prices, and lower its coal refining costs.
In recent years, the U.S. has seen a shift in the fuel used for electricity generation. Usage of coal for electricity generation has been decreasing and dependence on natural gas has been increasing. This is because of lower natural gas prices, volatile coal prices, and environmental issues associated with coal usage. Natural gas is considered to be one of the cheapest sources of electricity generation; almost half the price of coal. Coal-fired carbon emissions are on a decline because of utility companies moving towards cheaper and cleaner energy sources. In April 2012, according to U.S. government data, natural gas contribution in electricity generation was 32%, equaling that of coal fired plants. Moreover, it is expected that by 2020, almost 12% of total national coal capacity will be retired.
Duke Energy Corp. is United States' largest utility. The company is working on its fleet modernization plan, and on increasing its dependence on natural gas for electricity generation. Progress Energy, a subsidiary of Duke, closed two coal power plants, which included the first coal powered facility, built in 1923. The two plants include the Cape Fear power plant, which had a generation capacity of 316MW, and the H.B Robinson Unit 1 Power plant, with a generation capacity of 177MW. Two other coal fired plants located at Cape Fear River were also retired in 2011. The chart below shows the transition of Duke Energy Corp. from coal to gas in the last two years.
Duke is building natural gas fueled units, at the same time as it is retiring coal fired plants to keep up with demand. Natural gas fueled power plants with a total generation capacity of 920MW are under construction and are expected to start operations by the beginning of 2013. Another natural gas plant, with a capacity of 625MW, is expected to be operational by the end of 2013.
Reducing the number of coal fired plants will also help the company satisfy regulatory authorities and interest groups, who have been raising their voice against coal usage for electricity generation due to environmental concerns. Natural gas powered plants are considered more environment friendly. It is believed that they emit up to 95% less nitro oxide and up to 50% less carbon dioxide as compared to coal fired plants.
Duke offers an attractive dividend yield of 4.7%. Dividends have been increasing by almost 3% per annum in the last five years. It has an operating cash flow yield of 8.7%. It has a high payout ratio of 89%. It has a lower debt-to-equity (95%) than its competitors, and a healthy interest coverage multiple of 5.5x.
Duke has been able to maintain its margins at healthy rates in the last five years, despite volatile input prices used for electricity generation.
Gross Profit Margin
Comparing its forward P/E of 14.5x and P/B of 1.3x to its competitors, it can be observed that Duke Energy is trading at a discount. Its forward P/E is also at a discount compared to its five-year historical P/E of almost 16x. Based on the industry average forward P/E multiple of 16.2x and the mean estimate of EPS of $4.423, for the year ending 2013, we calculate a price target of $72. This gives investors an opportunity for an upside potential of 11%.
Debt to Equity
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Southern Company (SO)
Edison International (EIX)
American Electric Power (AEP)
Source: Yahoo Finance and Reuters
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.