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Long Duke, But Don’t Load Up Just Yet

Summary An abnormal growth trend in the past two years has caused a relatively stable industry to see much decline due to energy conservation and a lack of overall demand. Bad PR surrounding the new EPA rulings on carbon pollution and coal ash have created nightmares for Duke, resulting in a 10% decline on the year. Capitalization on the higher demand for energy during the summer could help bolster the stock short-term, along with a potential share buyback. Achieving the EPS, setting a greater growth trend for the dividend, keeping the credit ratings high, and EPS growth at least a 5% for the long-term are all pivotal to. After viewing the dividend hike to 82.5 cents a share and sifting through some high short interest stocks, I came across a well-known name: Duke Energy (NYSE: DUK ). Deep in the integrated utilities, the Charlotte -based energy company is a long-time energy producer suffering from a poor growth trend due to a lagging commodities sector and lethargic demand. The company deserves a hold rating, as very few growth catalysts are leadings its outlook. Having only had a positive FCF since 2012, now in the amount of $1.09 billion on a LTM basis, I’m concerned that the recent dividend raise might eat too significantly into FCF. Furthermore, with Lynn Good increasing her salary by 50%, but more notably her short and long-term incentive opportunities to higher multiples of her salary, I believe the money could be better well-spent given their lagging growth recently. Sure, they did implement a new retirement program , but again, there are bigger problems that Duke is facing besides employee turnover. As I figured, the stock saw a lot of downward momentum at the end of the winter, and has really just been on a slow down trend since the spring started. We’re seeing really interesting support around the $70 level. The stock is at April 2013 levels, where they were fairing much the same as they are now. The second half of 2014 proved to be an exceptional growth trend, just about scraping the $90 level, but I can’t reasonably expect the stock to trend in that direction for quite some time. (click to enlarge) Source: Bloomberg We’ve seen a good, but not great three year revenue growth trend from Duke, with most of the gains coming in 2012. With revenues now well above $25 billion, I’m concerned that they won’t be able to sustain this level. Their International Energy segment has seen a small decline of 1.15% over the past three years, which accounts for about $1.4 billion in revenue each year. While much of their efforts are concentrated in Latin America, Brazil has been of particular interest to the company. Much of the operations are similar to their domestic segment, Brazil is suffering from a poor wet season and high water demand, causing reservoirs to be low and inefficient for their hydropower plants. Furthermore, I can’t see them having huge international growth when things like their quarter interest in National Methanol Company (NMC) in Saudi continues to suffer from extremely low margins. Luckily, International Energy does not account for a substantial portion of total revenue, but it’s worth noting that hydropower in Brazil will be lower in future quarters based upon thermal power being prioritized over hydropower and this trend will continue through the end of the year, already down 52.9% in terms of pricing. Sure, there are a few construction and renovation projects that Duke has going for them, but they’re not going to see the light of day until three or four years out, let alone reach their highest potential capacity. For example, a 750 MW natural gas-fired generating plant in South Carolina, which cost about $600 million, won’t be available for use until late 2017 ( 10-Q ). Even little things like the switching from lead acid to lithium-ion batteries in the Notrees Windpower Project in Texas are important steps in helping long-term efficiency and stability for the company. They just recently gained a 40% stake in the $5 billion venture to build the Atlantic Coast Pipeline, which will bring natural gas from Marcellus and Utica in Pennsylvania to West Virginia and coast Virginia and then to North Carolina. Additionally, a 1640 MW combined cycle natural gas plant in Citrus Country Florida, expected to be finished in 2018, will cost $1.5 billion. Based upon hedging activities from many oil companies, like Oasis Petroleum (NYSE: OAS ), running out next year, the input fuel could be very cheap to Duke. On a different note, the stock repurchase program that began earlier this year still has about 15% left approved, which represents a good buyback of about $225 million. This will certainly help push the shares up for a few sessions. The Commodities Caveat Apart from construction and financial growth catalysts, which will have seemingly minimal effects, the commodities market could really end up hurting this company if prices rise. While natural gas prices, via the Henry Hub below, have been on a great YOY downtrend, which reduces input costs, there’s a caveat present. (click to enlarge) Source: Bloomberg With an oversupply of natural gas and plants at Duke reaching 94% capacity, they’re going to suffer from limited profitability. Revenues will eventually decline due to a lower margin received for their output. While demand for natural gas isn’t increasing, but is rather just being adopted as coal-based energy retreats, Duke could have a real profitability problem on its hands, considering their profit margin is expected to drop over 9% this year. The exact same case applies to oil and company management has estimated that the negative effects will be anywhere from 2.5-5% of EPS. I firmly believe their operating margin will remain strong around 24%, but I would need to see significant improvement for this utility company to fend off tough macro conditions. Speaking of said conditions, with a proposed interest rate hike from the Fed later this year, company management has stated that EPS could be affected as much as -$0.07 in the following quarter. Need For Improvement I firmly believe that their regulated utilities segment needs to start showing growth before a reasonable entry point can be made into the stock. Accounting for $22.2 billion in total revenue, the entire segment is up about 27.92% in the past three years, but this has already been priced into the stock, considering many of the gains took place in FY 2014 and FY 2012. Their primary servicing region of the Carolinas, Florida, Ohio, Kentucky, and Indiana has about 7.3 million retail customers. Yet, take a look at the factors hampering their growth: Energy efficiency and conservation efforts, particularly in residential areas The Midwest and Carolina servicing regions were lagging; residential growth, overall, was down 1.4% A higher amount of unserviceable calls than normal this past winter and an increasing number of outages this summer Their commercial power segment, which really only represents a fraction of a percent of total revenue, has suffered a 53.22% three-year decline. Their focus, here, is on alternative energy sources, primarily wind and solar. Regulation Woes Rising Regulation via the EPA’s “Clean Power Plan” set to cut carbon pollution for power plants by 30% by 2030 will pass this summer ( Bloomberg ). This effectively eliminates a coal from being the major energy generator in the long-term, as now the cost structure is unfavorable. Coal Ash Disposal has become a recent nightmare for Duke as they are now required to dispose of the coal ash at four major sites sustainably by 2019 and have all sites cleared by 2029. CBS’ 60 Minutes even dedicated an entire segment towards criticizing the current disposal process of Duke. The estimated cost is about $3.4 billion, or about 3x FCF, currently. Again, the company will still be fine in the long-term as they have a current available liquidity of $6.4 billion, and while they could use a bump up in their credit ratings, the company is standing on solid ground. (click to enlarge) Source: Company Presentation Conclusion On the back end, Duke may benefit from higher D&A costs when it comes time for quarterly reports based upon the pipeline and construction activity, Duke Energy will report quarterly earnings on August 6th, just after the end of July surge of earnings reports from major oil and gas companies. It’s worth noting that their Q3 EPS levels have been historically higher than all other calls, and with projections showing a potential 50% increase in EPS from Q2 to Q3 of this year, the stock is definitely worth considering. Looking to the future, I believe this company will most likely be fine – but there’s too much short-term negativity clouding any decent chance at profitability. Note: All Financial Data Taken From Bloomberg Database Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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.

With High-Yield ETFs, Costs Can Be Hidden

By Gershon Distenfeld More and more investors see exchange-traded funds (ETFs) as an easy and inexpensive way to tap into the high-yield market. We have some friendly advice for them: look again. Financial advisors who use ETFs as core holdings in their clients’ portfolios-and even some institutional investors-often tell us they like them for two big reasons. First, ETFs passively track an index, which means they’re cheaper than actively managed funds. Second, they’re liquid. Unlike mutual funds, which are priced just once a day, ETFs can be bought and sold at any time, just like stocks. But when it comes to high yield, ETFs aren’t really that cheap or that liquid. Look for the Hidden Costs Let’s start with costs. Sure, some ETF management fees are quite a bit lower than mutual fund fees-but that mostly goes for ETFs that invest in highly liquid assets such as equities. In a less liquid market, like high yield, expense ratios can be as high as 40 or 50 basis points-not that much lower than many actively managed mutual funds. It’s also easy to overlook some of the hidden costs. For instance, anyone who wants to buy or sell an ETF must pay a bid-ask spread, the difference between the highest price that buyers are willing to offer and the lowest that sellers are willing to accept. That spread might be narrow for small amounts but wider for larger blocks of shares. And when market volatility rises, bid-ask spreads usually widen across the board. And ETF managers can rack up trading costs even when market volatility is low. This is partly because bonds go into and out of the high-yield benchmarks often-certainly more often than stocks enter and exit the S&P 500 Index. To keep up, ETF managers have to trade the bonds that make up the index more often. Frequent trading can also cause ETF shares to trade at a premium or discount to the calculated net asset value. In theory, this situation shouldn’t last long. If an ETF’s market price exceeds the value of its underlying assets, investors should be able to sell shares in the fund and buy the cheaper underlying bonds. But the US high-yield market has more than 1,000 issuers and even more securities, and it can be difficult for investors to get their hands on specific bonds at short notice. That means investors often end up overpaying. This can work the other way around, too. If something happens to make investors want to cut their high-yield exposure, the easiest way to do that is to sell an ETF. That can push ETF prices down more quickly than the prices of the bonds they invest in, adding to ETF investors’ losses. We saw this in May and June, when worries about higher interest rates rattled fixed-income investors. Outflows from high-yield ETFs outpaced those from the broader high-yield market ( Display ). Are Passive ETFs Really Passive? Investors might also want to consider whether high-yield ETFs are truly passive. For example, the manager of an S&P 500 equity ETF can easily buy all the stocks that make up the index. But as we’ve seen, that isn’t so easy in high yield-the market isn’t as liquid. ETF managers compensate for this by using sampling techniques to help them decide which securities to buy. Can a fund that requires active decision making and frequent trading be considered passive? We think that’s a fair question. Not as Deep as You Think Here’s another question worth asking: just how liquid are ETFs? Those who look closely may find that the pool isn’t quite as deep as they thought. Why? The growing popularity of ETFs means they have to hold an ever larger share of less liquid assets. If the underlying asset prices were to fall sharply, finding buyers might be a challenge, and investors who have to sell may take a sizable loss. Does this mean ETFs have no place in an investment portfolio? Of course not. We think that a well-diversified portfolio may well include a mix of actively managed funds and ETFs-provided that the ETFs are genuinely low cost and passive. We just don’t think those attributes apply to high-yield ETFs. And we suspect that investors who decide to use them as a replacement for active high-yield funds will come to regret it. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

The Right Municipal Bond ETF Right Now

Summary Puerto Rico problems raises concerns in municipal bond space. Take a look at a more conservative muni ETF that targets debt from dedicated revenue streams. Highlight of the Deutsche X-trackers Municipal Infrastructure Revenue Bond ETF. By Todd Shriber & Tom Lydon Chicago. Detroit. Puerto Rico. Increasingly precarious financial positions in those cities and territories and others across the U.S. have cast a pall over the municipal bond market. The cases of Chicago, Detroit and other cities across the U.S., including several mid-sized cities in California, underscore the pressure public pensions and post-employment benefits, such as healthcare for public workers, are putting on state and municipal finances. Those weakening financial positions are prompting advisors and investors to consider alternatives to general obligation bonds when building out the municipal section of fixed income portfolios. There is an exchange traded fund for that and that fund is the Deutsche X-Trackers Municipal Infrastructure Revenue Bond Fund (NYSEArca: RVNU ) . RVNU seeks to limit or reduce exposure to public pension risk, not avoid or eliminate it, by focusing solely on bonds that fund, state and local infrastructure projects such as water and sewer systems, public power systems, toll roads, bridges, tunnels, and many other public use projects where the interest and principal repayments are generated from dedicated revenue sources. Toll roads, tunnels and water systems may not sound like the sexiest investment themes, but with public pension issues afflicting states from New Jersey to Pennsylvania to California, revenue bonds, including those held by RVNU, can be seen as the “new black” of the municipal bond market. “RVNU allows us to offer a product that focuses on investment-grade revenue bonds,” said Deutsche Asset & Wealth Management (Deutsche AWM) Portfolio Manager Blair Ridley in an interview with ETF Trends. “We focus on revenue issuers that by that heir nature usually carry less pension risk as compared to general obligation issuers. We’re trying to follow those issues with dedicated revenue streams, or ‘essential purpose bonds. In any economic environment, people will pay their electric bill and their water bill.” RVNU’s index is intended to track federal tax-exempt municipal bonds that have been issued with the intention of funding, state and local infrastructure projects such as water and sewer systems, public power systems, toll roads, bridges, tunnels, and many other public use projects. The index will attempt to only hold those bonds issued by state and local municipalities where the interest and principal repayments are generated from dedicated revenue sources. A succinct way of highlighting RVNU’s utility in the current municipal bond market environment comes courtesy of Deutsche AWM portfolio manager Ashton Goodfield. She said, “RVNU has less exposure to headline risk. The revenue streams are more stable in up and down economic environments. These revenue streams are what pays back principal and interest on the bonds.” RVNU is just over two years old holds 44 bonds. The ETF’s underlying index, the DBIQ Municipal Infrastructure Revenue Bond Index, holds over 800 bonds. As Ridley notes, RVNU has “a lot of room to add holdings.” RVNU employs a representative sampling methodology in order to match the traits and returns of its underlying index. RVNU has the flexibility to go as far down the ratings spectrum as BBB, but bonds rated either AA or A currently comprise over 86% of RVNU’s index, according to issuer data. At a time of heightened concerns regarding bond liquidity, RVNU ensures liquidity by tilting more than 75% of the fund’s lineup to issues with $100 million or more outstanding. Another obvious concern is rising interest rates and how higher rates will affect longer duration bond funds. RVNU’s index has a modified duration of 6.53 years. That longer duration has been something of a hurdle for RVNU, but one the ETF can easily overcome. “Our focus is on finding the most attractive part of the yield curve,” adds Ridley. “RVNU finds bonds with 10-year calls because those have the same sensitivity as bonds with 10-year maturities.” Since coming to market, RVNU has taken its lumps. The ETF debuted in the midst of the 2013 taper tantrum and the Detroit bankruptcy, but at a time when some of the largest U.S. states, including California and Illinois, are awash in massively under-funded public employee pension obligations, some investors are looking to diversify away from GO bonds while still keeping exposure to munis. “Clients are asking about GOs and pensions,” said Goodfield. “There are some municipalities that aren’t managing these issues well. While true, we think it’s important to say many general obligation issuers are managing these issues well Some investors have a negative outlook and want to be solely in revenue bonds.” As Goodfield notes, awareness of public pension issues is on the rise. That could prove to be good for RVNU over the long-term. Deutsche X-Trackers Municipal Infrastructure Revenue Bond Fund (click to enlarge) Tom Lydon’s clients own shares of RVNU. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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.