One Of The Best Competitive Advantages To Have

| About: Duke Energy (DUK)
This article is now exclusive for PRO subscribers.

Summary

Duke Energy has a business model with a strong economic moat.

The company is diversifying in to cleaner power, which should lower regulatory and environmental risks and costs.

The dividend is very safe at a payout ratio of 75% and yield of 3.9%.

Solar is a long-term opportunity to lower costs and increase earnings.

Arguably the best thing about owning a dividend paying utility stock like Duke Energy Corporation (NYSE:DUK) is that you own a very stable business model. Since the company is a utility company its customers are essentially guaranteed. Also typical of utilities is that they tend to be monopolies.

A monopoly as a business model

The monopoly structure is usually due to a lack of a better option. Typically, the infrastructure required to create and maintain a utility runs in the billions of dollars. Depending on the customer base, it might not be feasible at to allow competition since all parties would end up losing.

Besides that, there's a lot of red tape involved in the business. This is due to state utility commission that have the ability to dictate who is and who isn't allowed to build a facility. Of course, it's not all sunshine and roses. Those same commission also dictate how much a utility company is allowed to charge for its services.

Usually, it is in the best (personal) interest of elected officials to keep rates low so that they can keep their electorate happy. This puts a permanent lid on the company's earnings power. While I understand that income investors do not necessarily seek high earnings growth opportunities, this should still be addressed since it might hamper the company's ability to increase its dividend payment.

Healthy dividends

If we look at the dividend pay, we can see that the increases since 2013 have been very minor with the payment increasing 1% and 3% in 2014 and 2015, respectively. In that same period, operating income has been relatively flat at around $5.3 billion a year since 2014.

Not surprisingly, these were also the years that saw barely any price increases. Not too worry since DUK currently has a payout ratio of 75% of its income. So, even if earnings remain flat, DUK can comfortably raise their dividend which is already above average at the current yield of 3.9%.

If one is solely after income, it seems prudent to secure an income growth that is at least equal to inflation. What inflation figure one should use as a benchmark, depends entirely on where lives.

Especially if one is situated in the United States. The country is so vast that different states might have entirely different rates of inflation. For example, California has a higher inflation rate than the U.S. as a whole currently. As a rule of thumb, a 3% annual dividend growth should be enough to protect ones purchasing power in the long run.

Buying clean power

Luckily for income investors, DUK is currently diversifying its business. The upside to this is that the company will be able to grow its earnings at a faster pace than it does now. The downside is that it might come at the expense of highly stable earnings. Whether this ends up being a positive or negative development, depends entirely on management execution and the resulting earnings mix.

Management does have a decent track record when it comes to acquisition. Since it acquired Progress Energy in 2012, it has been able to save $687 million in costs. The most recent acquisition was that of Piedmont Natural Gas and is part of a 10-year plan to increase the earnings mix of gas to 15% from roughly 8% now. For the record, Piedmont Natural Gas is also a very stable and regulated business. A benefit of this is that natural gas energy is also cleaner than that of coal which has the potential to reduce regulatory and environmental risk as opposed to coal energy.

Biggest risks are environmental and regulatory

One of the biggest risks currently is a $5.2 billion price tag for the clean-up of spilled coal ash in North and South Carolina. The company has already spent around $700 million in its attempt to clean up the coal ash. The company is attempting to increase its rates in order to pass on some of the pain to its customers.

We should also keep in mind that this is not a lump sum payment. It is expected that the $5.2 billion in cost will be incurred over the next several years. If we assume similar annual costs as that of 2016, we can conclude that the additional costs will be very manageable.

Still, regulatory and environmental risks are perhaps one of the biggest risks that this company faces. This is acknowledged on the balance sheet where we can see that the company has recorded $6.9 billion in regulatory liabilities.

This number is up significantly from 2012 when it stood at $5.6 billion. Lastly, the size of the regulatory liabilities has increased every year since 2012. Further underpinning the reality of this risk. In essence, this is part of the company's business model.

Solar as a long-term opportunity

The company is attempting to mitigate that risk by resorting to increasingly cleaner sources of energy. Currently, the company generates 4% from its fuel from hydro and solar. As solar energy becomes economical it will start to make business sense to switch over to solar energy.

Solar energy does not carry any environmental risk in the sense that it does not spill, pollute or contaminate. Until 2040, the average cost of energy from solar plants will be $41.1 per megawatt per hour versus $48.1 per hour for gas. Of course, not all places will be able to provide solar that is more economical than natural gas.

However, I am confident that it is merely a matter of time before natural gas is replaced, and depending on an investors time horizon, it would be wise to factor in this development in the decision making process. Not only will solar be cheaper it will come with less regulatory hurdles and no environmental risks. This should boost the company's earnings on three fronts. Lower cost basis, no payment for environmental clean ups and less regulatory risks and costs. Working in a solar plant is relatively safe compared to coal and gas facilities. Dealing with these safety risks comes at a cost for both the state and the utility.

Even though I am excited about the prospects of solar, it is not yet competitive enough. Given that DUK has dipped its toe in this form of energy, I am confident that the company will pounce when the time is right. It is simply good business sense to keep watching those developments since it will definitely create a more profitable company in the long term.

Takeaway and conclusion

The company has a payout ratio of 75% of its net income and the current yield stands at 3.9%. This is a very healthy ratio and indicates that there is still room left to grow the dividend despite earnings remaining relatively flat since 2014. DUK has a very good business model that comes with stable earnings. In my opinion, that should be one of the priorities when looking for income. Furthermore, the company is continuing to diversify in cleaner energy, reducing its environmental and regulatory risk.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DUK over 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.