Duke Energy: 8% Annual Total Returns Make This Utility A Hold

About: Duke Energy Corporation (DUK)
by: Kody's Dividends

Duke Energy is a Dividend Contender, having raised its dividend for the past 12 years.

Despite the risks that utilities are exposed to, I believe Duke Energy's durable business model and proven management team will be able to guide the company through those risks.

However, shares of Duke Energy are trading at a 13% premium to my target price.

Between the 4.1% yield, 5% earnings growth, and a 1.2% annual valuation multiple contraction, Duke Energy is likely to deliver 7.9% annual total returns over the next decade.

With the stock market continuing its ascension to record levels, it is becoming quite clear that less and less companies are trading at what I consider a reasonable valuation. A 10 year bull market with no immediate end in sight will do that.

Image Source: Gurufocus

In a rate starved environment like the one we're living in, it should come as no surprise that investors have flocked to utilities, making it one of the more overvalued sectors in the stock market.

In stark contrast to my other article this week on BlackRock, Duke Energy (DUK) is trading very close to its lofty 52 week high of $91.67 a share. This should come as no surprise when we refer to the chart above and observe that the utility sector sports a Shiller PE of 30.3, which is up considerably from just a year ago.

Between the dividend safety and growth profile of Duke Energy, along with its reasonably strong fundamentals, there is a lot to like about the company. I'll be discussing why despite the fact that I believe Duke Energy is an excellent company and a position I would like to increase in my portfolio, the valuation is simply too stretched to even consider the possibility at this point.

A Safety And Growth Profile That Every Conservative Income Investor Should Consider

As a dividend growth investor, I seek to maintain a delicate balance between the safety and growth of my dividend portfolio. I believe Duke Energy offers an attractive mix of the two considering it is a utility.

I'll first determine the safety of the company's dividend by assessing the EPS payout ratios, and by comparing my rating to that of Simply Safe Dividends. While I like to also include an analysis of FCF, it isn't a helpful metric to use for utilities because their FCF is generally negative due to investing in other capital projects that come with guaranteed rates of returns, which are subject to local regulatory approval.

Duke Energy generated adjusted EPS of $4.72 during FY 2018 against $3.635 in dividends per share paid during that same time, for an EPS payout ratio of 77.0%.

Duke Energy recently affirmed its 2019 guidance of $4.80-$5.20 in adjusted EPS. Assuming a ~4% increase in the quarterly dividend from $0.9275/share to $0.9625, Duke Energy will pay out $3.78 in dividends per share during FY 2019, for an EPS payout ratio of 75.6%, using the midpoint adjusted EPS figure of $5.00.

Overall, I see no issues with a payout ratio in the mid 70% range for a utility and this is in line with the company's target payout ratio, so I would rate Duke Energy's dividend as reasonably safe.

Image Source: Simply Safe Dividends

Given my analysis above of Duke Energy's dividend safety, it's not shocking to note that Simply Safe Dividends and I agree that Duke Energy's dividend is safe for the foreseeable future.

Now that we've established Duke Energy's dividend is safe going forward, the next aspect of the company's dividend profile that we need to account for is the growth aspect.

Image Source: Simply Safe Dividends

When we consider that management expects long-term earnings growth of 4-6%, and that analysts at Yahoo Finance and Nasdaq are forecasting 4.9% and 7.1% 5 year earnings growth rates, it seems reasonable to conclude that earnings growth should fall in the 5% range.

If the company is able to achieve a long-term 5% earnings growth rate, we could see a slight acceleration in the dividend growth rate from the 3% of the past 5 and 10 years to a 4-5% growth rate in the future.

Next, we'll delve into the fundamental reasons that I believe management will be able to deliver upon its long-term earnings growth expectations.

A Business Model Necessary To The Functioning Of A 21st Century Economy And Experienced Management Team

Image Source: Duke Energy Spring Update 2019 Investor Presentation

Duke Energy is one of the largest regulated utilities in the United States, with operations throughout the country.

Image Source: Duke Energy Spring Update 2019 Investor Presentation

Duke Energy operates in the following three business segments:

Electric Utilities & Infrastructure: As indicated on page 9 of Duke Energy's most recent 10-K, this segment provides retail electric service to 7.7 million customers in Florida, Indiana, Kentucky, North Carolina, Ohio, and South Carolina. The company derived 85% of its adjusted EPS in FY 2018 from this segment.

Gas Utilities & Infrastructure: As stated on page 17 of the company's most recent 10-K, this segment serves residential, commercial, industrial, and power generation natural gas customers, including customers served by municipal customers who are wholesale customers. The segment provided services to over 1.6 million customers in FY 2018 and it contributed to 9% of the company's adjusted EPS during that time.

Commercial Renewables: As per page 20 of the company's most recent 10-K, this segment acquires, develops, builds, operates, and owns wind and solar renewable generation throughout the continental US, which includes non-regulated renewable energy and energy storage businesses. This segment accounted for the remaining 6% of the company's adjusted EPS in FY 2018.

For perspective, Duke Energy generated over 97% of its revenue through regulated utility operations in FY 2018 (page 87 of the company's most recent 10-K). While the downside to regulation is that the company has to jump through hoops to gain regulatory approval and there is always the risk the regulator will require additional measures be taken which a company may not be able to recover from customers through increased rates, regulated utilities come with guaranteed rates of returns, allowing for a higher degree of certainty in financial results than non-regulated operations.

Image Source: Duke Energy Spring Update 2019 Investor Presentation

As most are aware, the transition away from dirtier carbon based energy is in the early innings but is certainly underway at this point.

This is no more evident than when we examine Duke Energy's ambitious plan to reduce CO2 emissions 40% by 2030 from 2005 levels. The company's plan revolves around a combination of more environmentally friendly and cost effective natural gas, nuclear energy, and renewable energy, as opposed to the coal-fired power plants of the past in the United States.

The company's Western Carolinas Modernization Project is on track for a late 2019 in-service date while the company also boasts the largest regulated nuclear fleet in the United States, and also plans on building 1,350 MW of Commercial Renewables projects in the years ahead. This will allow the company to reduce its use of coal/oil use from 61% of fuel to 15% of fuel by 2030.

The company's earnings growth will come in two forms in the years ahead, as would be expected from a utility.

Image Source: Duke Energy Spring Update 2019 Investor Presentation

The first way is that as the company expands its base by investing $37 billion into capital projects over the next 5 years, its number of customers and revenue, and therefore earnings will increase.

From 2019 to 2023, the company expects to expects its regulated electric and gas earnings base to increase by over 20%, which would work out to a ~4% annual growth rate in its EPS during that time.

When we add in that Duke Energy will also see a slight increase in its base rate over time, that is how we arrive at the 4-6% earnings growth the company is aiming for over the next 5 years, which I believe is a realistic assumption.

While the balance sheet leaves a bit to be desired in my view, Duke Energy still possesses a BBB+ credit rating from Fitch (stable outlook), an A- credit rating from S&P (negative outlook), and a Baa1 credit rating from Moody's (stable outlook), suggesting the company still maintains a decent balance sheet outlook.

The final component of Duke Energy that adds to my confidence in the company's ability to achieve its growth target is the fact that the management team is highly experienced and proven.

The company's CEO, Lynn Good has been with Duke Energy for over 16 years, starting out with Cincinnati based Cinergy, which later merged with Duke Energy. Good has been CEO of Duke Energy since 2013 and prior to joining the company, she was a partner at two international accounting firms, including a career with Arthur Andersen.

Duke Energy's COO, Dhiaa Jamil boasts over 38 years of energy experience, having served as president of the company's regulated generation and chief nuclear officer.

Finally, Duke Energy's CFO, Steven Young joined the company in 1980 as a financial assistant. He has served in his current role of CFO since 2003.

Management is incredibly important in ensuring the vision of the company is realized, and with the proven experience of Duke Energy's management team, I believe the company will be able to deliver upon its growth targets for shareholders. It is for this reason along with the company's resilient business model and heavy investments in the future that I believe Duke Energy will be an attractive investment in the years ahead at the right price.

Risks To Consider

Although Duke Energy is a leading player among utilities, that certainly doesn't make the company immune to risks. After all, every equity has its own set of unique risks for investors to consider before placing an investment.

The first risk for investors to consider is that as a regulated utility, Duke Energy is subject to the legislation and regulation that affect electric generation/transmission and natural gas transmission/distribution (page 24 of the company's most recent 10-K).

If regulatory agencies where Duke Energy has operations decide to not allow the recovery of costs in providing services to the company's customers or don't allow it on a timely basis, this would have a negative impact on the company's financial results. Additionally, the expansion of federal and state regulations that are designed to promote energy efficient technologies could result in customer adoption of these technologies, which may cause a redundancy in Duke Energy's existing infrastructure investments. This could negatively impact the company's financial results if it is unable to fully recover the costs and investment in generation.

Another risk that may not be as apparent is the risk that should the United States enter into a recession, Duke Energy may be forced to lower its rates if the recession is severe enough and long enough to warrant such action from regulatory agencies.

While this would be a change from past economic recessions where lower utility demand is offset by rate increases, as I outlined in a previous article on WEC Energy, Yale economist and law professor Yair Listokin makes a reasonable argument for lower utility rates and the intervention of law to combat a recession as best as possible.

Although it still seems to be an unlikely occurrence, I wouldn't entirely discount the possibility of such event transpiring at some point in the future. While it wouldn't alter Duke Energy's long-term results to lower allowed rates of returns in a recession because of the allowed increased rates of returns in expansionary economic periods, it would mean that Duke Energy's financial results would be a bit more choppy along with other utilities. This would be a notable departure from the historically steady returns of utilities regardless of economic conditions.

Yet another risk to Duke Energy is that the company is subject to a variety of environmental laws and regulations that govern how the company is to minimize the impact on air and water quality, in addition to the handling of solid waste and hazardous waste (page 26 of the company's most recent 10-K). It is worthwhile to mention that as our understanding of our impact on the environment continues to expand, increasingly burdensome regulations that increase compliance costs for utilities such as Duke Energy also become more likely.

Any lapse in compliance with these regulations or misfortune could result in catastrophic events (be it a rare nuclear plant disaster or gas line explosions) that damage the environment of one or more of Duke Energy's service areas, which would almost surely result in massive liabilities and even penalties and sanctions against Duke Energy (page 27 of the company's most recent 10-K).

Finally, as a utility Duke Energy often relies upon a combination of retained cash flow, the issuance of debt, and the issuance of equity (page 31 of the company's most recent 10-K). The reliance on the issuance of shares has resulted in Duke Energy's share count expanding from over 688 million as of January 2016 to 727 million as of January 2019.

While this type of increase in share count is fine as long as the company continues to make investments in capital projects that provide adequate rates of return, any notable downturn in the company's stock could effectively eliminate that financing method for the company due to it becoming dilutive to shares. Given that the company has a bit weaker balance sheet than I would generally like to see from a utility, an inability to borrow much more capital without the risk of a credit downgrade and inability to issue shares out of fear of dilution could result in Duke Energy being unable to raise the capital necessary to meet its 4-6% long-term earnings growth target.

Although I have discussed what I believe to be the key risks facing Duke Energy, I certainly haven't discussed all the risks that accompany an investment in Duke Energy. I would refer interested readers to pages 24-32 of the company's most recent 10-K for a more complete discussion of the risks associated with an investment in Duke Energy.

A Great Utility Trading At A Moderate Premium

Now that we've discussed Duke Energy's fundamentals and we have a better understanding of the risks to Duke Energy, we'll discuss the current stock price with relation to what I believe to be Duke Energy's fair value.

The first valuation metric that I'll use to determine the company's fair value is the 13 year median TTM dividend yield.

According to Gurufocus, Duke Energy's TTM yield of 4.12% is well below its 13 year median TTM dividend yield of 4.49%.

Assuming a reversion in Duke Energy's yield to a fair value yield of 4.5% and a fair value of $82.44 a share, the company trades at a 9.3% premium to fair value and poses 8.5% downside from the current share price of $90.10 (as of July 4, 2019).

The second valuation metric I'll use to arrive at a fair value for Duke Energy's shares is the 13 year median price to sales ratio.

According to Gurufocus, Duke Energy's price to sales ratio of 2.63 is near its 10 year high of 2.8, and is well above its 13 year median price to sales ratio of 2.16.

A reversion in Duke Energy's price to sales ratio to 2.16 and a fair value of $74.00 a share means that Duke Energy is trading at a 21.8% premium to fair value and poses 17.9% downside from the current price.

Image Source: Investopedia

The third and final valuation method I'll use is the dividend discount model or DDM.

The first input into the DDM is the expected dividend per share, which is simply the company's annualized dividend per share. In the case of Duke Energy, that amount is currently $3.71.

The next input into the DDM is the cost of capital equity, which is a fancy term for an investor's required rate of return. While the required rate of return will vary from one investor to the next, I'll be using a 10% rate of return because that has historically outperformed the broader market over the long-term.

The third and final input into the DDM is the long-term dividend growth rate, which is also the most difficult input to reasonably estimate. To do so requires both a qualitative and quantitative analysis of a company's dividend payout ratio (and whether that ratio is likely to contract, hold steady, or expand in the future). Other important considerations include the long-term earnings growth rate of the company, industry fundamentals, and an analysis of the company's balance sheet.

Image Source: Duke Energy Spring Update 2019 Investor Presentation

I believe that Duke Energy's dividend growth will replicate whatever the company can deliver in earnings growth over the long-term. I have confidence that Duke Energy will be able to deliver 5% earnings growth over the long-term, which means the company should be able to deliver a 5% dividend growth rate over the long-term as well.

Plugging in the above variables, we arrive at a fair value of $74.20 a share. This represents a 21.4% premium to fair value and indicates shares of Duke Energy pose 17.6% downside from the current price.

Averaging our three fair values together, we arrive at a fair value of $76.88 a share. This implies that shares of Duke Energy are trading at a 17.2% premium to fair value and pose 14.7% downside from the current price.

Although I arrived at the average fair value above, I would be willing to pay $80 a share to add to my position in Duke Energy. This would indicate that shares of Duke Energy are trading at a 12.6% premium to my target price and pose 11.2% downside from their current price should they reach my target price.

Summary: A Company For Every Dividend Growth Portfolio, But Only At The Right Price

Duke Energy is a well-run company operating in the steady utility industry, which means the company offers a safe dividend, as well as a dividend that can slightly outpace inflation. This is a major reason I believe the company belongs in every dividend growth portfolio.

Despite the risks facing the company as a utility, I believe the company's resilient business model and savvy management team will be able to guide the company to its 4-6% long-term earnings growth target.

Unfortunately, the shifting of funds into the utility sector in the midst of a low interest rate environment has sent shares of Duke Energy to somewhat lofty levels.

At the current price, shares of Duke Energy offer a 4.1% dividend yield, likely 5% earnings growth, and 1.2% valuation multiple contraction, resulting in annual total returns of 7.9% over the next decade.

A return to $80 a share would offer a much different dynamic for investors. Between a yield of 4.6%, 5% earnings growth, and a static valuation multiple, Duke Energy would be likely to generate annual total returns of 9.6% over the next decade from an entry price of $80 a share. Considering the lower risk profile of utilities compared to other sectors of the economy, a 9.6% annual total return over the next decade would be quite desirable from my viewpoint.

Disclosure: I am/we are long DUK. 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.