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Duke Energy And Southern Company Set To Soar In 2016

Unregulated utility companies’ performance likely to stay challenging in 2016 because of weak and volatile power prices. DUK and SO making correct strategic attempts to strengthen regulated operations. Stock valuations for DUK and SO are cheap, as both are trading at discounts to peers and the industry average. 2015 has been a tough year for the U.S. utility sector, mainly because of concerns regarding the Fed interest rate increase; the utility sector ETF (NYSEARCA: XLU ) is down 10% year-to-date. Moving into 2016, given the decline in the power and natural gas prices, U.S. unregulated utility companies’ performance will stay volatile and weak; however, I think U.S. utility companies with significant and growing regulated business operations will stay an attractive investment option for income-hunting investors. Duke Energy (NYSE: DUK ) and Southern Company (NYSE: SO ) are the two U.S. utility companies that have large regulated business operations and are further working to strengthen their regulated business operations, which will provide stability to their revenues and cash flows, and support dividend growths. Moreover, valuations for both the stocks stay compelling. Two Utility Stocks: DUK and SO In recent years, low power and natural gas prices has adversely affected performance of unregulated business operations. As the power and natural gas prices continues to stay weak, I think, 2016 will be another challenging year for the unregulated utility companies. In the volatile unregulated business environment, the U.S. utility companies are working to lower their unregulated business operations, which will positively affect their performance. DUK is among the leading utility companies of the U.S., and has been working to strengthen its regulated business operations by making regulated capital investments; the company is expected to make capital investments of $20 billion in the next four years, which will result in increase in its rate base and support earnings growth. The company is not only upgrading its existing regulated infrastructure, but also diversifying the power generation assets by focusing on renewable energy sources, which will improve its business risk profile and allow it to comply with changing environmental regulations. DUK plans to spend to $3 billion on renewable energy in the next four years. Moreover, in 2016, if the company decides to sell its international unregulated business operations, it will positively affect its stock price and will make its cash flows more stable. Also, once the company successfully closes acquisition of Piedmont Natural Gas (NYSE: PNY ), which is consistent with its efforts to grow regulated earnings, it could opt to undertake more regulated gas business acquisitions to strengthen its gas business. Given the company’s aggressive efforts to strengthen its regulated operations, its cash flows will improve, which will allow it to increase its dividend growth consistently in the coming years. The stock has yield of 4.75% , which is supported by its 14% operating cash flow yield, and makes it an impressive investment option for income investors. Also, investors should keep track of yearly earnings call in February, in which the company will provide update on its 5-year growth expectation, synergies related to PNY acquisition and rate case outlook. Southern Company is another utility stock which stays an attractive investment option for income investors, as it offers a solid yield of 4.7% , which are backed by its operating cash flow yield of 15% . The company generates almost 90% of its earnings from regulated operations, which provides stability to its cash flows. Similar to DUK, SO also is working aggressively to modernize and strengthen its power generation assets. Moreover, once the company’s two construction projects, Kemper and Vogtle Power plants, are completed it will portend well for its long-term earnings. Also, the company has been actively increasing its renewable energy asset base. The company spent more than $2 billion on renewable in 2015, and plans to spend another $1.3 billion in 2016, which is expected to increase its renewable energy portfolio capacity to 2,600 MW. Consistent with its renewable generation assets base growth, the company acquired almost 600 MW of solar assets from First Solar (NASDAQ: FSLR ). And also, completion of SO’s and AGL Resources (NYSE: GAS ) in the later half of 2016 will augur well for the stock price. The company’s efforts to improve its regulated power asset base will support its long-term earnings growth, and its business risk profile will improve, as it will complete pending acquisitions and ongoing construction projects. Also, the company’s cash flows will stay strong to support its dividend growth, which will improve investors’ confidence. Valuation and Summation Unregulated utility companies’ performance is likely to stay challenging in 2016 because of weak and volatile power prices. However, companies like DUK and SO, which are making correct strategic attempts to strengthen their regulated operations, will deliver healthy performances in future years. Both DUK and SO offer solid yields of 4.7% and 4.75%, respectively, which makes them attractive investment prospects for income-hunting investors. Moreover, stock valuations for DUK and SO are cheap, as both are trading at discounts to their peers and the industry average. DUK and SO are trading at forward P/E of 14.8x and 15.7x, respectively, versus the utility sector’s forward P/E of 16.5x .

Future Growth Opportunities For Duke Energy After Piedmont Acquisition

Duke Energy expands its reach from the electric utility industry into the natural gas business. Increases Duke Energy’s stake in very profitable Atlantic Coast Pipeline while tripling gas customers. Expect to see increased EPS for Duke Energy. By Matt De Jesus I have a strong buy recommendation for Duke Energy (NYSE: DUK ) after its acquisition of Piedmont Natural Gas. Duke Energy acquired Piedmont for $4.9 billion, and will also assume around $1.8 billion of its debt, representing an enterprise value of close to $6.7 billion for Piedmont. Duke Energy paid a 40% control premium on the acquisition, paying out Piedmont shareholders $60 in cash for each share outstanding. Reasons they paid this high premium are related to the possible synergies related to the deal. This acquisition is a good deal for Duke Energy, as they try to grow in the utilities industry and possibly expand nation wide. Duke Energy is the largest electric power holding company is the country, and is headquartered in Charlotte, N.C. Before acquiring Piedmont, Duke Energy was known for producing electricity, and not a big name in the gas industry. However, with the electricity industry showing signs of stagnant growth, Duke Energy wanted a piece of Piedmont Natural Gas for a couple of reasons. First, the natural gas industry is growing, whereas the electricity industry is not. Utilities are going through a period right now where natural growth is slow, so companies, like Duke Energy, must grow through acquisitions. The natural gas market, according to Wall Street analysts, is bullish right now, so everyone is trying to get into the gas business, adding significance to Piedmont’s acquisition. They will receive all of Piedmont’s existing customers, thus tripling its number of natural gas customers from 500,000 to 1.5 million. Also, with Duke’s established brand and stake across the southeast, I expect these numbers to grow further. The second reason Duke Energy acquired Piedmont was because of the Atlantic Coast Pipeline. Now owning Piedmont, Duke Energy increases its stake in the $5 billion Atlantic Coast Pipeline to 50%. More importantly, because of the state regulations on Piedmont’s fuel delivery incorporated with the pipeline, the acquisition provides Duke Energy with a steady and predictable profit, which is very important in the utility industry. Much of a utility companies growth is based on a rate base, which is the value of property on which a public utility is permitted to earn a specified rate of return. So, utility companies make money off returns on investments in property for the company. This is why the regulated returns on the Atlantic Coast Pipeline are so important, as they are consistent and profitable. Third, the move is in line with the company’s possible plans to grow throughout the U.S. and not just stay in the Carolina, southeast area. By establishing itself in the gas industry, Duke is scaling itself for the long-term next step in its growth, which may be to take the company nationwide. This move would not be any time in the near future, as Duke must first establish itself in the gas industry. Some may question Duke Energy’s paying such a high control premium to buy out Piedmont, but in the long run, this is a great deal for the company. The deal enhances Duke’s forecast EPS rate of 4% to 6%. To give some perspective, Piedmont’s rate base and EBITDA have been rising annually at about 9%. Duke’s stock price is currently at $67.32, and has been down recently because of the debt involved with the deal and slowed growth in the electric utility industry. The 52-week low on the stock is $67.07, with the high being $89.97. This deal, in the end, will be good for Duke, and it’s investors because it will enhance EPS. The stake in the Atlantic Coast Pipeline is very integral to this, and will provide regulated profit for the company even when the market for electricity is down. Also, the market for natural gas is bullish, and with a big company like Duke Energy providing natural gas, investors will reap the benefits of the profits Duke will make from Piedmont. We’ll see Duke Energy grow in these next months/year, but it will take some time before we see the major benefits from this deal.

Duke Energy- Investors Do Not Like The Piedmont Deal, Nor Do I

Summary Duke Energy is expanding its natural gas operations in the Carolinas by acquiring Piedmont. Investors doubt the steep premium being offered for Piedmont, as do I. Duke has failed to quantify the anticipated earnings accretion as I think that the company´s acquisition track record is mediocre at best. The only real appeal comes from the dividend yield as earnings multiples are inflated due to the low interest rate environment. The increase in leverage makes me very cautious amidst the historical and relative steep multiples at which Duke is trading as the future of the industry is becoming more uncertain. Duke Energy ( DUK ) announced a sizable deal as the company is looking to acquire Piedmont Natural Gas ( PNY ) in a $4.9 billion cash deal. Investors in Duke balk at the high premium being offered for Piedmont´s shares, as I fail to see real appeal as well. Add to that the poor acquisition track record of Duke, an increase in leverage, and increasingly uncertain future for the regulated industry, and I am very cautious. For these reasons, shares remain a no go in my eyes as the dividend is the only appealing factor for the shares. Amidst risks to the valuation in case interest rates rise and non-compelling dividend growth, I would be very cautious. A Strategic Deal.. Duke is looking to expand its operations in the Carolinas and Tennessee as ownership of Piedmont will give the company access to a million customers in those states. Roughly 90% of these customers are residential and customer growth has averaged roughly 1.5-2% per year. These are fairly attractive growth rates in comparison to Duke which is reporting customer growth rates of around 1% per year. The increased scale and expansion of Duke´s natural gas platform are not the only reasons behind the deal. Both companies have been working together in the $5 billion Atlantic Coast Pipeline project. Piedmont has a lot of interests in other joint ventures as well including Hardy Storage, Pine Needle LNG Storage, the Cardinal pipeline and Southstar Energy Services, among others. It must be said that the vast majority of both earnings and assets are generated through Piedmont´s regulated utility business however. Besides increasing Duke´s scale, the deal allows for the expansion of its gas infrastructure platform and the transformation towards becoming a highly regulated business. Ahead of the deal, Duke generated 85% of its earnings from regulated utility operations in the Midwest, Carolinas and Florida. Roughly 10% of the earnings are generated from the international operations in Latin America as commercial wind and solar project generate the remainder of the profits. This latest deal will only increase the relative profit share of the regulated business. The company has not discussed cost or revenue synergies from the deal besides the strategic benefits. On the deal conference call , management actually admits that no synergies have been considered in the decision to pursue this deal. It must be stated that Duke has the ability to borrow cheaply. Additionally, Duke is making a large bet on continued oversupply of natural gas in North America, keeping prices low for a long time to come. This should make natural gas the preferred energy option for decades to come, at least in Duke´s opinion. This shifts the company away from coal based generation as the electricity business is suffering from lower long term demand for electricity following increased efficiency of usage. ..Comes At A Price To obtain ownership of Piedmont, Duke is willing to pay a roughly 40% premium for Piedmont´s shares. This translates into a purchase price of $60 per share. Including the $1.8 billion in debt, the deal price comes in at $6.7 billion. While this is a sizable amount, Duke expects to finance just $500 to $750 million in the form of newly issued equity with the remainder coming from additional debt. Despite the fact that the board of both companies have already agreed in favor of the deal, and Piedmont´s shareholders are likely to do the same given the fat premium offered, closing is only anticipated late in 2016. Regulatory approval is always a tedious issue in this industry, which makes that it takes more time before deals finally close. Despite the fact that Duke is paying a 40% premium, the company anticipated accretion to adjusted earnings per share in 2017. Unfortunately Duke does not quantify this anticipated accretion although it cites that the cheap cost of debt of 4% alone is sufficient to result in accretion. This is even the case if no synergies are being realized. Adding To The Long Term Targets The vast majority of Piedmont´s business is a regulated business which is allowed to earn a return on equity of 10-10.2% from its operations. Duke anticipates that the faster growth rate of Piedmont will improve the overall growth profile as it reinforces its position as the largest US utility business. The company previously anticipated that earnings will come in at $4.55 to $4.75 per share in 2015. The deal are complementing the company´s plans to grow earnings per share by 4-6% per year through 2017. Investors should like the sound of this as the company sticks to its 65-70% payout ratio, having paid dividends for 89 years in a row now. The deal actually allows the company to make a big step with its investments plans for the years 2015-2019. The company outlined a $23-$26 billion spending plan for these four years with respect to new power generation, infrastructure investments as well as compliance and other investments. By acquiring Piedmont, Duke will complete a major step with regards to its infrastructure investments. With the deal, Duke is pulling a lot of its investments forwards in time. This does have an impact, namely that the leverage position will continue to increase in the short to medium term. Duke itself operated with a net debt load of roughly $40 billion ahead of the deal as the purchase of Piedmont will increase this number to roughly $46 billion. This corresponds to pro-forma EBITDA of some $9.7 billion, for a 4.7 times leverage ratio. The Market Is Not Buying It Shares of Duke Energy have fallen some 2.5% in response to the deal, wiping out roughly $1.2 billion in shareholder value. This wealth destruction is pretty much equivalent to the $1.4 billion premium being offered for Piedmont. The skepticism of investors can be understood, even as the deal is relatively small compared to Duke´s enterprise valuation of roughly $84 billion. The negative reaction is driven by the large premium and the fact that the deal will face some uncertainty, given that Duke already has a large presence in the Carolinas. This could potentially raise some anti-trust issues down the road. Other concerns include the mediocre track record with regards to large strategic deals which Duke has made in the past. This mostly relates to the $26 billion purchase of Progress Energy back in 2012. This deal has created some problems for Duke in recent years as it made the company an owner of nuclear plants, as Duke ended up paying multi-million dollar settlements in the years following as well. Back in 2007, Duke Energy has actually spun-off gas assets into Spectra Energy (NYSE: SE ) . Ironically, it are similar kind of assets which the company is now aiming to buy back through the purchase of Piedmont. All these deals have not really paid off for investors. While pro-forma revenues of $25 billion have increased by two-thirds over the past decade, the outstanding share base has increased by 70% as well. As a matter of fact, the book value of the company and earnings per share have only moved down, so have dividends. Of course investors have received a stake in Spectrum, although that does not make up for the disappointing results. This makes that Duke´s prime attraction is the 4.6% dividend yield amidst a very modest track record. The trouble is that this yield is very attractive on a relative basis, as those looking for income have pushed up shares of ¨yield¨ plays in recent years. As a result, Duke is now trading at similar multiples as the general market. This makes shares very risky in case the interest rate environment will change and trend upwards. Add to that the increasing leverage and an increase in the uncertainty faced by the still regulated industry, and you understand why current levels do not look appealing for long term investors. This is based on my assumption that the regulated industry model will come under pressure as advancements in notably wind and energy power generation have the potential to undermine the regulated industry business model. If you combine everything you will note that this is a very dangerous situation for long term holders of the stock. While the strategic rationale behind the increased focus on gas makes sense, the premium seems very steep as much more infrastructure has gone for sale in the form of limited partnerships in the last year. The high valuation, increasing leverage, pricey deal and the long term uncertainty for the industry all outweigh the appeal of the current dividend.