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Duke Energy (NYSE: DUK ) is a favorite high-yield dividend stock for income investors, and it’s no wonder why. The company has paid uninterrupted quarterly dividends for 90 years and is set to increase its dividend for the ninth consecutive year in 2016. Regulated utility companies such as Duke can provide safe retirement income with less risk than other types of businesses because of their predictable earnings, government-supported competitive advantages, and relatively low stock price volatility. For these reasons and more, we own several utility stocks in our Conservative Retirees and Top 20 Dividend Stocks portfolios. However, just because a stock appears to have little fundamental risk does not mean it is a safe investment. The price paid for a stock is still very important, and that is especially true for low-growth utility stocks. While utility companies can be relatively attractive income investments compared to bonds due to their potential for capital appreciation and moderate income growth, it’s still important to diversify a portfolio’s income streams in other sectors. Unexpected shocks can still happen across entire sectors, and no one living off dividends desires to deal with unpleasant, avoidable surprises when it comes to their nest egg. Let’s take a closer look at Duke Energy’s business to see if it’s a stock we should consider for our utilities exposure. Business Overview Duke Energy’s history dates back to the early 1900s, and the company is largest electric utility in the country today with over $23 billion in annual revenue and operations reaching across the Southeast and Midwest regions. Duke Energy is a regulated utility company that serves approximately 7.4 million electric customers and 1.5 million gas customers, including customers from its planned $4.9 billion acquisition of Piedmont Natural Gas (more on this later). Regulated utilities account for about 90% of Duke Energy’s business mix, but the company also has a commercial portfolio of renewables and gas infrastructure (5%) and an international energy business in Central and South America (5%), which it recently put up for sale. The company’s regulated utilities primarily rely on coal (29%), nuclear (27%), and natural gas (23%) for its generation of electricity. Hydro and solar generate another 1% of the company’s total energy, and Duke Energy also purchases about 20% of its power. Click to enlarge Source: Duke Energy Investor Presentation Business Analysis Regulated utility companies are essentially monopolies in the regions they operate in. With the exception of Ohio, all of Duke’s electric utilities operate as sole suppliers within their service territories. Building and operating the power plants, transmission lines, and distribution networks to supply customers with power costs billions of dollars, and it would generally be unprofitable and inefficient to have more than one supplier for a region. State utility commissions also have varying degrees of power over the construction of generating facilities, which further restricts competition. The downside to the “monopoly” enjoyed by regulated utilities is that their services are priced by state commissions. This is done to keep prices fair for consumers and allow utility companies to earn a reasonable, but not excessive, return on their investments to encourage them to provide safe and reliable service. A utility company’s attractiveness is largely driven by the states it operates in. Some have more favorable demographics (e.g. population growth) and regulatory bodies. Duke Energy’s mix is generally favorable. Over the past three years, base rate cases approved to Duke Energy have granted the company a return on equity ranging from 9.8% to 10.5% across the Carolinas, Ohio, and Florida. We think these returns are very reasonable and suggest a generally favorable set of regulatory bodies in Duke’s core operating states. In addition to the industry’s promotion of stability, Duke’s business has undergone a rather significant transformation over the last five years to improve the reliability of its earnings and cash flows. Duke Energy’s biggest move was its acquisition of Progress Energy in mid-2012 for over $13 billion, significantly enhancing the company’s scale and market share in regions such as the Carolinas. Duke Energy has realized over $500 million in cost synergies from the deal and become a more efficient energy provider. The company next entered the regulated pipeline business in 2014 to help its efforts to replace coal power plants with cleaner and cheaper natural gas generation facilities. In October 2015, Duke Energy announced a deal to acquire Piedmont Natural Gas for $4.9 billion to boost its push into gas. Piedmont is a regulated gas distribution company that delivers natural gas to customers in the Carolinas and Tennessee. The company owns valuable gas infrastructure that currently supports Duke’s gas-fired generation in the Carolinas and will be further expanded to help with Duke’s ongoing conversion from coal to gas. Regulated gas companies also offer strong and predictable returns on capital (Piedmont’s return on equity is about 10%) and should continue to benefit as a result of the natural gas surplus in the U.S. Compared to electricity sales, which seem likely to slow as energy usage becomes increasingly efficient, gas has a stronger growth profile (Piedmont has investment pipeline growth of 9%). This is because new pipelines coming on-line will allow gas to replace dirtier power sources such as coal in regions where gas was previously inaccessible. Piedmont will about triple Duke’s number of natural gas customers to approximately 1.5 million and help establish a platform for future growth in gas infrastructure projects. After the deal closes, Duke Energy expects roughly 90% of its assets to earn regulated returns, which should provide very reliable earnings. Duke Energy has also gotten rid of non-strategic assets to lower its risk profile and improve the quality of its earnings. Management sold the company’s merchant Midwest commercial generation business to Dynergy for $2.9 billion in early 2015 and placed its struggling Latin American generation business up for sale in February 2016. Each of these businesses had less predictable earnings and greater macro risk. Duke Energy believes its current business mix is now 100% focused on its core operations, whereas 25% of the company’s 2011 net income was derived from non-core businesses. Management now expects to spend $8 billion on new generation investments, $10 billion on gas & electric infrastructure, and $2 billion on commercial & regulated renewables to drive 4-6% annualized earnings growth over the next five years. Overall, we believe Duke Energy has a strong moat. The company has excellent scale as the largest electric utility in the country and operates primarily in regions with generally favorable demographic trends and regulatory frameworks. Management has simplified Duke’s mix to focus on core regulated businesses that provide reliable earnings and new growth opportunities in natural gas and renewable generation resources. While the utility sector is gradually evolving, we believe Duke Energy is here to stay for a long time to come. Duke Energy’s Key Risks Uncontrollable macro factors such as mild temperatures and industrial activity can impact Duke Energy’s near-term financial results. However, we believe these are transitory issues that have little bearing on the company’s long-term earnings potential. The bigger risks worth monitoring are changes in state regulations, population growth trends in key states, increased environmental regulations, and execution of the company’s business strategy (e.g. large projects and acquisitions). The rates Duke Energy can charge its customers are decided at the state level. Similar to what we observed when we analyzed Southern Company (NYSE: SO ), another regulated utility, most of the regions Duke Energy operates in have generally favorable regulatory environments and are characterized by positive population and economic growth. However, the company is banking on these conditions remaining stable as it continues investing for growth and depending on states to approve rate increases to earn a fair return on its capital-intensive investments. The Environmental Protection Agency (EPA) also creates risk for utility companies in the form of enhanced safety and emissions standards. Duke is still dealing with its notorious coal ash spill that took place in North Carolina in 2014, and the company is gradually shifting its mix of power away from coal in favor of cleaner sources such as natural gas. Finally, over the very long term, electric utility companies will need to deal with the reality that demand is gradually decaying thanks to increasing energy efficiency and distributed generation (e.g. rooftop solar). Duke has earmarked about $2 billion for growth investments on commercial and regulated renewables over the next five years, but it’s still a relatively small proportion of the overall business. The company’s acquisition of Piedmont should also help the company with growth initiatives outside of regulated electric utility services. Dividend Analysis: Duke Energy We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Dividend Safety Score Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak. Duke Energy’s Dividend Safety Score of 80 indicates that the company has a very safe dividend payment. Duke’s dividend has consumed 81% of its diluted earnings per share over the last 12 months. A payout ratio this high is usually cause for some concern because it provides less wiggle room in the event of an unexpected drop in profit. However, regulated utility companies are able to safely maintain higher payout ratios because their earnings are (generally) extremely steady, making utilities one of the best stock sectors for dividend income . Using management’s “adjusted” earnings, Duke Energy’s payout ratio is closer to the company’s target range of 65%-70%. As seen below, Duke’s payout ratio has been above 60% each of its last 10 fiscal years. Source: Simply Safe Dividends Not surprisingly, utility companies hold up relatively well during economic recessions. As seen below, Duke Energy’s revenue edged down by just 4% in 2009. While customers use somewhat less electricity during periods of weak growth, they still need it to live. DUK’s stock also fared well in 2008 and outperformed the S&P 500 by 15%. Source: Simply Safe Dividends As we mentioned earlier, regulated utility companies earn very stable earnings. As a state-regulated monopoly company selling non-discretionary services, it’s no surprise to see Duke Energy’s consistent results below. Source: Simply Safe Dividends Duke Energy’s earnings are steady, but regulators control the rates the company can charge customers to ensure pricing is fair. As a result, the returns Duke can earn on its capital projects are capped, and the company’s return on invested capital has remained in the low- to mid-single digits over the last decade. Source: Simply Safe Dividends The capital-intensive nature of utility companies makes them heavily dependent on debt to run and grow their businesses. As seen below, Duke has less than $1 billion in cash on its balance sheet compared to nearly $40 billion of debt. However, the company’s excellent business stability has enabled Duke Energy to maintain an A- credit rating with Standard & Poor’s . While the company’s free cash flow will remain restricted the next few years to fund its major growth investments, forcing it to lean even more on debt markets, we still view Duke as a healthy business as well. Click to enlarge Source: Simply Safe Dividends Overall, the stability of Duke Energy’s earnings and non-discretionary nature of its services significantly boosts the safety of its dividend payment despite its levered balance sheet and relatively high payout ratio. Dividend Growth Score Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak. While regulations generally protect utility company’s earnings and market share, they also limit growth opportunities. As a result, most utility businesses have below-average dividend growth rates, and Duke Energy is no exception. The company’s Dividend Growth Score is 20, which suggests that its dividend growth potential is lower than 80% of all other dividend-paying stocks in the market. However, its dividend has been reliable. Duke Energy has made quarterly dividend payments since the 1920s and will raise its dividend for its ninth consecutive year in 2016, keeping it a far distance from joining the dividend aristocrats list but rewarding shareholders nicely. For most of the last 10 years, Duke Energy grew its dividend by an annualized rate of about 2%. However, management expects to double the dividend’s growth rate to 4% per year to better reflect an improvement in Duke’s lower risk business mix and core earnings growth rate of 4%-6% per year. Source: Duke Energy Investor Presentation Higher dividend growth will cause Duke Energy’s earnings payout ratio to increase from its 65%-70% target to closer to 75% in the near term as its growth investments continue, but the payout ratio is expected to turn down over time. Valuation DUK’s stock trades at 16.8x forward earnings estimates and has a dividend yield of 4.2%, which is slightly below its five-year average dividend yield of 4.4%. Since 2009, the company has met its long-term annual adjusted diluted earnings per share growth objective of 4%-6%. Assuming Duke Energy’s growth projects continue helping its core businesses realize 5% annual earnings growth over the coming years, the stock’s total return potential appears to be about 9% per year. Considering the stability of Duke Energy’s earnings, which are largely composed of regulated utility operations, we think the stock is reasonably valued today but not a bargain. Conclusion For investors seeking exposure to utility stocks and safe dividend income, Duke Energy appears to be a reasonably-priced blue chip dividend stock to consider. Almost all of the company’s business mix consists of regulated operations, which provide predictable earnings with low volatility. Most of the regions Duke Energy plays in are also characterized by favorable demographics and historically supportive regulatory bodies. While there is some long-term risk resulting from lower electricity usage trends, the rise of clean renewables, and the company’s major growth investments, we think Duke Energy will remain an appealing income investment for many years to come. 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. I have no business relationship with any company whose stock is mentioned in this article. Scalper1 News
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