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Duke Energy: More Dividends In The Pipeline

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About: Duke Energy Corporation (DUK)
by: Benjamin Black
Benjamin Black
Value, long-term horizon, dividend investing, growth at reasonable price
Summary

At its current valuation, Duke seems fairly priced compared with recent years, but a relatively high dividend makes the stock potentially attractive.

With a couple of sizable projects (pipelines in western Ohio and the Carolinas), Duke faces large continued investment costs, which will likely constrain earnings growth in the immediate future.

Some funky accounting tricks have helped goose revenues in at least one state, but is this truly a sustainable tactic?

Recent quarterly results were mixed, but a slight earnings surprise at least showed management appears to be on track, despite certain project cost overruns.

Introduction

Duke Energy Corp. (NYSE:DUK) is one of the largest regulated utilities in the U.S. and has areas of operation "spanning the Midwest, Florida, and the Carolinas." South Carolina has become an increasingly difficult state in which to operate, as regulators there have capped ROE at 9.5%, which is comparatively low to other utilities and to what shareholders expect, reflecting the ultra-thin tightrope that regulated utilities must walk between profit generation for shareholders and state-mandated customer protection. Still, DUK’s geographic footprint happens to be in areas with strong economic fundamentals, generally speaking, which should help to put a floor on energy consumption, while laying the groundwork for possible future rate hikes, as demand remains relatively strong. Given this backdrop, certain challenges remain, from necessarily heavy investments on infrastructure to high regulatory hurdles in some areas, so the stock does possess some downside risk. I’ll get into some of the nitty-gritty details and then circle back for a wider perspective to help investors make a more informed decision on DUK.

Important Recent Developments

One major area of focus for management has been the Atlantic Coast Pipeline in the Carolinas, which is an ongoing project to be completed over the next couple of years and should help with the firm’s natural gas revenue. To cover the cost of the pipeline, management recently held an equity offering of 25 million shares, priced at $86.45 per share, the proceeds of which (over $2 billion) were used to help pay for the roughly $7.5 billion cost of the joint venture (along with Dominion Energy (D) and Southern Company (SO)). The aforementioned investment costs and increasing regulatory hurdles will undoubtedly constrain profitability, and will, in all likelihood leave forward earnings growth below the industry average for the immediate future. If anything, the dividend has become more important than ever to existing shareholders, and as such, should be monitored very closely for any surprises, as any disappointments could lead to a dive in share price.

The Dividend Story

YTD share price performance badly lags peers, at just 1% compared to the utility sector’s 18% run so far this year. Given the poor performance of the share price, dividends have comprised the bulk of shareholder returns over the last year. DUK currently pays an annual yield of 4.4%, which is significantly higher than the industry average of roughly 3%. Additionally, the company has made regular quarterly dividends for 93 straight years, which is quite a feat in and of itself.

DUK Dividends (10-year chart)

(Source: Author)

Similar to REITs in that they typically pay out a relatively high proportion of earnings as dividends (though they are not required to do so), utilities behave somewhat similarly to other income-oriented investments. Due to the high levels of debt needed to finance their capital-intensive operations, and the bond-like nature of the underlying stock, utilities tend to go up when rates fall and down when rates rise - i.e., there is an inverse relationship between interest rates and share price. Given that the Fed is currently enacting a policy of periodically cutting rates to keep the economy growing, the current environment is a salutary one for utility investors, generally speaking.

Quarterly Results

Third-quarter results showed slightly higher-than-expected earnings and lower-than-expected revenue, which seemed to concern investors given share price action following the news. Compounding matters was the announcement of the dilutive equity offering, putting existing shareholders in a bit of a bind. In response to the news, and despite the earnings surprise, the share price suffered a 10% drop off of its 52-week highs. Throwing another wrench in the works is the worrying delay in the Atlantic Coast Pipeline construction (thanks largely to regulatory scrutiny), which has already seen sizable cost overruns, as the projected cost of the project has ballooned from $5.1 billion to as high as $7.8 billion.

Diving into the details, third-quarter results showed net income of $1.33 billion, or $1.82 per share, on revenue of $6.94 billion, compared to net income of $1.07 billion, or $1.51 per share, on revenue of $6.63 billion a year ago. Allowing for one-time losses, the adjusted earnings actually totaled $1.31 billion, or $1.79 per share, compared with adjusted earnings of $1.18 billion, or $1.65 per share, in the year-ago period. The biggest chunk of DUK’s earnings are derived from its electric utilities segment, and also showed the largest total gains - from $1.18 billion to $1.37 billion - an improvement of 16% year over year. The highest rate of growth, however, occurred in its commercial renewables segment, which saw income totaling $40 million, rising from $26 million a year ago, or an increase of 54%. This is one segment to keep an eye on, as it will likely become an increasingly important driver of growth in the future despite its marginal impact today. To get a sense of the long-term earnings picture, I've provided a 10-year chart of EPS below:

DUK 10-year EPS

(Source: Author)

When a Rate Hike is not a Rate Hike

Ok, so while recent results have been somewhat mixed, and there have been some hiccups here and there with some of its larger infrastructure investments, the company is generally on track with its stated goals. I did come across a piece of news, which kind of concerned me though, and I want to discuss it here. In the heart of its Midwest operations, DUK has a strong presence in the state of Indiana, where the company has miraculously managed to substantially raise revenues over the past decade without the need for commensurate rate hikes. How is this possible? Well, the company has been increasing customer bills largely through the use of add-ons called “trackers” or “riders.”

In Indiana, fully 40% of the average consumer bill is comprised of add-ons, compared to the 15% from peer utilities in the area. Essentially, DUK has managed to pass on increasing costs (from local projects, etc.) to customers more deftly than competitors, while maintaining lower-than-average “base rates,” a common metric used for service comparison. However, this may not be a sustainable strategy for the long term as customers and regulators finally begin to catch on, so past success should not be seen as predictive of future results for revenue growth in the state. I also personally think that this kind of tactic can backfire, particularly in a highly regulated industry, so I advise investors in this stock to include this in their calculus when determining a suitable margin of safety for the stock, as I smell a potential class action suit somewhere down the road. Such a future development may not have a huge impact on earnings, but it does still call into question the stewardship and direction of the company and whether or not management is adhering to its stated values.

Valuation

To help paint a clearer picture of where the stock currently stands, I’d like to provide a quick rundown of some key valuation and balance sheet metrics:

  • P/B: 1.45 (5-year average of 1.38)
  • P/CF: 8.94 (5-year average of 8.43)
  • P/S: 2.55 (5-year average of 2.4)
  • P/E: 18.42 (5-year average of 20.87)
  • Quick Ratio: 0.26
  • Current Ratio: 0.72
  • Interest Coverage: 2.74
  • Debt/Equity: 1.39
  • ROA: 2.35% (5-year average: 2.06%)
  • ROE: 8.03% (5-year average: 6.5%)
  • ROIC: 4.96% (5-year average: 4.31%)
  • Net Margin: 13.99% (5-year average: 11.3%)
  • PEG Ratio: 3.87 (5-year average: 3.1)
  • Enterprise Value/EBITDA: 12.19 (5-year average: 11.03)

* The above data is drawn from a combination of the Morningstar and StockRow websites.

Based on these numbers, it would appear that share valuation is relatively in line with its recent history, so it does not represent any sort of deep value, however, shares are not particularly rich either. It is encouraging to see some slight improvements in efficiency and profitability figures, and that should bode well for future profit growth and provide strong underpinnings to future dividend growth as well.

As with most utilities, large debt levels are a significant hurdle, and the deterioration in debt/equity and debt/assets, along with falling quick and current ratios over the past 10 years, shows decreasing liquidity and solvency, increasing the risks of leverage. If debt is used wisely, however, it can have a multiplier effect on earnings, when the investments from the proceeds outweigh the cost of debt financing.

DUK Debt to Equity (10-year)DUK Current Ratio (10-year)

(Source for the above two charts: Author)

I do think the pipeline costs will end up being big growth drivers, so the such leverage is less concerning than it might otherwise be, but keep an eye on debt levels nonetheless and note any further deterioration in the balance sheet. The current rate environment (the Fed is cutting rates) does temporarily help in this regard, as the company may have opportunities to refinance certain debt issues and improve its financing costs. While large investments will likely continue to weigh on earnings for the foreseeable future, higher operational efficiency should help soften the blow of rising costs, so again, profit growth will be steady, if not spectacular, which is kind of what you expect in a utility anyway.

The Final Verdict

I personally think that for dividend investors seeking a stable income stream from a stock, DUK is one of the better utility names out there given the relatively high yield and sufficient earnings to cover those growing payouts. While the average dividend growth of 3.5% over the last 5 years isn’t spectacular and slightly lags the peer average of 4%, it has traditionally kept pace with the industry, and I would expect healthy dividend growth going forward, particularly given the future completion of some large projects in the pipeline (no pun intended) and the attendant increase in revenue. Basically, DUK is a boring, stodgy stock which could be a part of fairly dependable foundation for any equity portfolio. That said, the upside is understandably limited and some headline and financial risks remain, so I would rate the company a firm “neutral.” That said, this is one to keep in your watchlist, and any major pullback in share price should warrant a serious look. I’d also advise current shareholders in the stock to hold onto their current position, provided your required rate of return for such funds isn’t particularly high.

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.