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Duke Energy Corporation: Growing Debt Should Trouble Investors

Summary Duke Energy consistently runs cash flow deficits to fund the large dividend yield. The company will have added $14B in debt from 2010-2017 using management guidance. Management may be tempted to add on risk by scaling up potentially higher margin international operations to grow cash flow, but 2015 shows how volatile these earnings can be. Duke Energy Corporation (NYSE: DUK ) is the largest utility in the United States, with a heavy concentration of its revenues coming from its regulated businesses in the Midwest, the Carolinas, and Florida. As the largest publicly-traded utility with a consistent dividend-paying history, Duke Energy has become a staple of retail investors seeking safety and reliable income in what has been a volatile market. But below the surface, Duke Energy appears to have some issues driven by its size – the 2012 merger with Progress Energy has created a massive entity with over 50 GW of energy generation in the United States alone. With so many assets, can Duke Energy maintain competitiveness and efficiency to remain on par with smaller, more nimble peers? And has the debt load of the company, now around $40B, become too much of a burden? Burgeoning Debt Load Utilities have just a handful of uses for the stable cash flow they generate. Outside of upgrading and maintaining their property and equipment (capital expenditures), most operational cash flow is used to either acquire new businesses, pay down debt, or give back to shareholders (dividends/share repurchases). (click to enlarge) Both pre- and post-merger, Duke Energy has consistently outspent what it earns from its operations. Cash from operations has not been able to cover the cost of capital expenditures and dividends over the past six years, with this deficit always exceeding one billion dollars or more a year. To fund these consistent shortfalls, Duke Energy has issued more than $8B in debt over this time. Because of this, the company now spends over $1.6B each year on interest expense, or more than 30% of its annual operating income. These levels aren’t unreasonable provided that deficit spending ends. (click to enlarge) * Duke Energy 2014 Form 10-K, projected future cash flows However, per management’s guidance above, this is unlikely to change in the short term. Duke Energy projects it will add another $6B of long-term debt in 2016/2017, a roughly 15% increase which will lead to around $200M in additional annual interest expense. While operational cash flow is slated to increase over time as these capital expenditures are recovered through rate increases, further continuation of this trend is still simply unsustainable. Net debt/EBITDA stood at 3.2x at the end of 2010; in 2014, the number reached 4.9x, with similar numbers likely in 2015. The decision to repatriate $1.2B in cash generated by the International Operations segment (incurring nearly $400M in taxes) was likely driven, at least in part, by the need for funds to pay for obligations like dividend payments. We aren’t the first to notice this as these negatives haven’t slipped by the big three debt agencies. Duke Energy has seen the firm’s ratings consistently fall below the credit quality ratings of other large utilities like Dominion Resources (NYSE: D ) or better capitalized firms in other industries like Microsoft (NASDAQ: MSFT ). Trends regarding debt should be concerning to investors, and I think it is a question both shareholders and the analyst community alike must begin taking a firm stance on with management. Asset Retirement Obligations (click to enlarge) As a further headwind, asset retirement obligations are costs associated with the cleanup and remediation of Duke Energy’s long-lived assets. As an example of these costs, when Duke Energy closes down a nuclear power plant, there are costs associated with decontamination and property restoration that the company must bear. Asset retirement obligations are a fuzzy area of accounting, in my opinion, where management has a lot of discretion in calculation costs. What we see with Duke Energy is that these obligation costs have ballooned, according to management estimates, from $12B in 2012 to $21B in 2014. These increased costs primarily relate to the Coal Ash Act, which occurred as a direct result of the Dan River spill and other coal ash basin failures. Duke Energy’s management notes a significant risk associated with these new obligations: “An order from regulatory authorities disallowing recovery of costs related to closure of ash basins could have an adverse impact to the Regulated Utilities’ financial position, results of operations and cash flows.” – Duke Energy, 2014 Form 10-K At best, these additional liabilities will increase depreciation expenses for Duke Energy, which will impact earnings per share. At worst, public outcry and regulators will force Duke Energy to bear some or all of these coal ash cleanup costs on its own rather than recover the costs through rate increases on customers, either directly or indirectly, through more harsh rate case approvals. Compounding, Don’t Forget It (click to enlarge) Duke Energy likely draws in quite a few income investors based on the current yield. At an approximate 4.65% yield as of this writing, shares pay a handsome premium to many other utilities. However, investors need to remember the impact of their investing time horizon and do their best to anticipate the value of their investments decades from now. Based on our look at Duke Energy’s debt and recent dividend increase history, it is safe to assume big bumps in the dividend are not on the table. 2.0-2.5% annual raises, in line with recent historical averages, may actually be optimistic, in my opinion. As shown above, for a dividend-payer that pays 4.65% today and grows its dividend at 2.0%/year (not far off Duke Energy’s 2.2% average for the past five years), the yield-on-cost of this investment will be 5.13% at the end of year six. Dividend B, with a 3.5% yield today and 8% annual dividend growth, would actually have a higher yield-on-cost in just a mere six years. Conclusion Duke Energy trades cheaply on most valuation measures, but that appears to be within good reason. Yearly cash flow obligations consistently exceed operational cash flow, which has led to a growing debt burden that will approach $50B in just a few short years. Without cuts to spending (freezing the dividend, cutting operational costs) or raising additional revenue somehow (through risky expansion in non-regulated businesses), there doesn’t seem to be a clear path for Duke Energy to grow and deleverage its balance sheet. I believe investors would be much better served looking at smaller utilities as a means of gaining exposure to the sector, such as through Southwest Gas Corporation (NYSE: SWX ).

Portland General: Utility With Some Promise

Summary Short-term, headwinds exist related to heavy capital expenditures and poor weather forecasts. Long-term, spending should be down and income up, freeing up cash flow for shareholder returns. Two natural gas-fired plant openings, one in 2016 and one in 2020, will be key to company success. Portland General Electric Company (NYSE: POR ) is an electric utility that operates wholly within the state of Oregon, providing power to nearly 50% of Oregonians with over 3,400MW of available energy generation. Primarily serving residential customers, the company’s bottom line has been bolstered by domestic migration to the Northwest. From 2010-2014, the Portland metropolitan area added over one hundred thousand new residents – an annual growth rate of 5.2%. This strong local population growth has helped bolster earnings results and shareholder returns, with investors reaping 100% in total return over the past five years, roughly double the return of utilities indexes. Does Portland General have more room to run or has the utility run its course? Future Is Natural Gas, Profit Is With Hydro * Portland General September 2015 Investor Presentation Portland General has a diverse portfolio of power generation. Including purchased power, 36% of power was created from renewable sources and an additional 25% generated from cleaner-burning natural gas. This is going to change drastically over the next few years, however. Given Oregon’s progressive nature, it wasn’t a surprise to see Oregon residents campaign for clean power. Management quickly bowed to customer and political pressure, leading to plans for the elimination of all coal-fired generation in Oregon. Under the Boardman 2020 plan, Portland General will close its 518MW Boardman coal asset by 2020, instead building a natural gas facility on the site. This will be a costly project, but doing so will save the company $470M in required upgrades to meet emissions guidelines had the plant remained open until 2040 as previously guided. The risk here is that the new plant is delayed and is not completed by the time Boardman is scheduled to be mothballed. Portland General relies heavily on the Boardman plant to produce electricity as coal-fired generation is in many cases the cheapest and most reliable asset the company has. Coal represents 16.5% of available resource capacity but generated 28% of the load in 2015 and is run at capacity nearly constantly. The company’s peak power load in 2014 was 3866MW which was already above currently available company-owned power generation and the shortfall from the Boardman plant closure could force Portland General to increase purchased power during peak times. While these costs will inevitably be passed along to the consumer because of Portland General’s clauses with the Public Utility Commission of Oregon, higher prices could still cause a slack in energy demand and bad press is never good for the bottom line. The company’s Carty Generating Station, slated to be completed in 2017, will help cover future shortfalls built is imperative for investors to track how the new Boardman facility’s construction is proceeding over the coming years. This risk is noted in the company’s 10-K: “Beyond 2018, PGE may need additional resources in order to meet the 2020 and 2025 RPS requirements and to replace energy from Boardman, which is scheduled to cease coal-fired operations in 2020. Additional post-2018 actions may also be needed to offset expiring power purchase agreements and to back-up variable energy resources, such as wind generation facilities. These actions are expected to be identified in a future IRP. PGE expects to file its next IRP with the OPUC in 2016.” – Portland General, 2014 Form 10-K From a profitability standpoint, the key to the company’s energy costs however is hydroelectricity. Hydroelectric generation can be the lowest cost source of generation for Portland General if conditions are right. The state of the Deschutes and Clackamas Rivers (tributaries of the Columbia River) is key. Both of these rivers’ headwaters are fed by the Cascades, a mountain range spanning from Canada to Northern California. In general, the greater the snowfall, the better the power generation is for hydroelectric when the spring thaw comes. Unfortunately for Portland General shareholders and highlighted in a recent prior SeekingAlpha article by Tristan Brown , weather models show lower than average snowfall likely for Oregon, along with a more mild winter in regards to temperature. This presents a double whammy for Portland General in the form of higher energy costs and lower revenue in the winter months during which customers typically draw around 10-15% more electricity than in the summer months. Past Operating Results (click to enlarge) Operating results have been steady and rather uneventful over the past five years (my own estimates used for the back half of 2015). Of note however is depreciation/amortization costs have been increasing dramatically due to the large capital investments the company has been making over the past five years, developing relatively more expensive wind/solar farms and the costs associated with the Carty Generating Station. Overall, this is steady-as-she-goes results that utility investors like to see. (click to enlarge) Frequent readers of my utilities research know that I look for solid coverage of capital expenditures and dividends from operating cash flow for mature utilities. Starting in 2013, Portland General reversed course and begun stepping up the leverage as capital expenditures rose for the natural gas plants at the Carty Generation Station and the old Boardman location. To fund this, Portland General issued $865M in long-term debt in 2013/2014 and also issued $67M worth of common stock in 2013 to cover the cash flow gaps. While this picture looks currently worrisome, it should moderate over time. Capital expenditures are expected to fall from the $600-650M range in 2015 to $289M in 2019, back to levels we saw in 2011/2012 when cash flow was positive. Unfortunately, Portland General won’t see much recovery in the form of increased rates because of offsetting factors, based on the overall breakdown of the 2016 rate case filing: (click to enlarge) Conclusion Portland General saw a little bit more renewed interest after the 7% dividend increase in 2015, well in excess of 2% annual growth from 2009-2014. In regards to operating income, however, 2016 looks unclear given the poor weather outlook. Earnings per share are likely to be flat to down in 2015/2016, so I would not expect a repeat of that hefty 2014 dividend increase. Before entering a position, I would like to see the valuation come down along with more visibility on completion of the two big natural gas facilities (early 2016 should give excellent insight into schedule on Carty Generation Station). Overall, however, shares are quite fairly valued given the long-term prospects of the region. Being long won’t hurt you.

Behavioral Reasons For You Being Merely An Average Investor

Summary Most of us are held back by our behavioral barriers. Knowing them helps you to understand why markets behave as they do. Anchoring and the bandwagon effect are one of the most important. If you are not happy with your investing returns, then you can basically find fault in two areas: Your knowledge of investing, or your behavioral barriers. This article will go through the most common behavioral barriers that you need to understand before you can climb over them towards greater wealth. I have long believed that investment success requires far more than intelligence, good analytical abilities, proprietary sources of information, and so forth. The ability to overcome the natural human tendencies to be extremely irrational when it comes to money is equally important. Warren Buffett agrees, commenting that, “Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ… Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” The following text is taken and modified from my master’s thesis that focused on value investing and behavioral finance. If you want to read more on the subject, two excellent books to read are Thinking, Fast and Slow and Beyond Greed and Fear . For even deeper knowledge on the matter, you can look for articles written by people named in the following text. Behavioral financial experts basically do not have much faith in the rationality of investors and therefore are against the idea that markets are efficient. If it was, then value premium would be easily explained by the relationship between risk and return. Lakonishok, Shleifer and Vishny write that, due to irrational behavior, the market prices value stocks lower and growth stocks higher. Naive investors typically overreact to the stock market related news and forecast the same growth far into the future. Because of this type of actions, they enhance the effect that might have already been taking place. In simple cases, purchase happens because stock price has gone up, and selling happens because price had gone down. But, as a simple example, this can be due to one large investor selling or buying a large amount at the same time, resulting in a price change. Some investors might take this as a sign of change and hop on or off the train. This type of investor behavior can also be explained, at least partly, by agency issues. Many professional investors might be under pressure from their bosses, clients, or due to peer competition they are forced to deliver quick results. Therefore, they are being forced to favor short-term profits over better quality investments that require longer holding periods. This type of investment pattern is often seen among institutional investors and even CEOs. Also for any professional investor, it is greatly easier to recommend the purchase of well-doing growth stocks that have a good track-record, than value stocks with a long period of negative returns. Representativeness A financial example to explain representativeness is the winner-loser effect that was proven by De Bondt and Thaler. They find that stocks that have been biggest winners during the past three years do much worse than the stocks that were the biggest losers during that same timeframe. De Bondt proves that as analysts make long-term earnings forecasts, their views tend to be biased to the direction of recent success of the firm. Meaning that analysts are overly optimistic about recent winners and feel pessimistic about recent losers. Also, De Bondt finds that market predictions are overly optimistic (pessimistic) after three-year bull market (bear market). Therefore, it becomes quite clear that analysts’ recommendations are not particularly useful when they can be linked to representativeness. One reason for this behavior is that people underweigh evidence that disconfirms their prior views and overweigh confirming evidence (Shefrin). Overconfidence In simple terms overconfident people overestimate their skills to complete a difficult task and therefore are surprised more often than they anticipated. Clarke and Statman proved that people are overconfident. They showed this by simple questions such as: How long is the Nile? Give your answer with minimum and maximum so that you are 90 percent confident that the actual length is inside your low and high guess. They asked this type of questions in survey form and found that most people are not well aware of such things but are overconfident as their high guesses were often very low compared to the actual numbers. So when people are overly confident they set too narrow confidence bands in such questions and just like financial analysts, are surprised by the results. One way to understand this is to think of a stock you were following and should have sold much earlier than you did, but you didn’t because you kept believing it can’t go lower. Anchoring and Failure to Adjust Mendenhall and Abarbanell and Bernard find evidence that analysts underreact to earnings information. Even when they get to adjust their forecasts based on new information (such as a profit warning), they are still underreacting to actual results. Their work shows that analysts fail to appropriately tweak their forecasts. What happens is that, as analysts anchor their expectations to previous information, then surprises that happen are even larger in the end. This failure to adjust expectations can then lead to value stocks and large price jumps. Psychology and limits to arbitrage Arbitrage refers to a situation where investors are able to gain a riskless profit due to the market mispricing an asset. By buying an undervalued asset and cashing the profit when prices have returned to normal. In reality the risk is that the market can continue to misprice the asset even further. This is called as the “Noise trader risk”, introduced by Long, Shleifer, Summer and Waldman. Noise trader risk happens when irrational investors keep moving the price of an already mispriced asset to the same direction, despite the actions of one or more rational investors. Also transaction costs add more risk to the equation therefore limiting arbitrage behavior. Mental accounting A typical investor does not see every euro that he possesses as being identical. Mental accounting theory helps to explain why it is quite typical for investors to divide their money to “safe” money invested in low-risk assets, while investing their “risk capital” very differently. Once money has been placed in one mental account, it no longer is a direct substitute for money in another mental account. Mental accounting theory tries to understand this psychology of decision making. Mental accounting has three components, according to Thaler. First, outcomes are apprehended and experienced. Based on this, decisions are made and later evaluated. Second, activities and sources are categorized. For example to invest or to save and also the use of these funds for spending such as housing and food. Lastly, these accounting activities are rebalanced daily, weekly, monthly or so depending of that person’s personal preferences. Gross claims that in cases where a client’s investment is at a loss a stockbroker can keep its customers by using words “Transfer your assets”, instead of referring to selling and buying. Selling would lead investors to acknowledge their losses, but now they merely transfer their money from one mental account to another. Myopic loss aversion People have stronger reaction to losses in their wealth, than they do to increases even if gains are bigger than losses. Psychologically losses are taken approximately twice as heavily compared to gains. A myopic investor is defined as a person who tends to make short-term decisions over long-term ones, and often evaluates his/her losses and gains. An example of this would be to follow a myopic and a non-myopic investor. Myopic investors would likely avoid stocks and invest in assets such as safe and stable government bonds. If he had stocks, he would constantly check the market and, in case of a loss, feel it emotionally as very painful. Therefore, myopic loss-aversion leads investors to choose portfolios that are overly conservative. While a non-myopic investor would not check the market as often and would be comfortably unaware if his wealth happens to take an occasional downhill. Therefore, he prefers long-term investments with better returns over safer government bonds. (Thaler, Kahneman, Tversky and Schwarz) Framing As defined by Tversky and Kahneman, the term “decision frame” means the acts, outcomes and contingencies that a decision maker associates with a certain choice. This one frame depends on personal characteristics, norms, habits and also on how the problem is presented. As problems can be presented in many different ways, that can also change the outcome of framing. According to Tversky and Kahneman, “Individuals, who face a decision problem and have a definite preference, might have a different preference in a different framing of the same problem, and are normally unaware of alternative frames of their potential effects on the relative attractiveness of options.” Prospect Theory Developed by Tversky and Kahneman, it is an alternative theory to analyze decision making in situations that contain risk. Prospect Theory (PT) focuses on gains and losses instead of wealth. Also, instead of using probabilities and risk aversion, PT uses decision weights and loss aversion. An outcome is called a prospect, and a prospect includes a decision with some level of risk. Decisions are made in two levels: The editing and evaluation levels. In the editing level, possible outcomes are put in order, according to some heuristic. This can be explained by people looking at the outcomes and they make a mental note of an approximate and possible average outcome. By using that average as their reference point, they’ll then categorize lower outcomes as losses and higher ones as gains. So Tversky and Kahneman state that humans prefer focusing on gains and losses instead of their final wealth. The Bandwagon Effect This is a form of group thinking. With stocks, it refers to a situation when more and more people start to buy a certain stock, the more will follow, therefore increasing the demand more and more. They might do this despite their individual beliefs and opinions, simply because other people are doing it. As more and more people join, those that are still out are under group pressure to “join the fun”. The expression, “hop on the bandwagon” is typically used when this kind of a group effect is happening. Bandwagon effect has two sides to it, according to Shefrin. First, it is believed that a crowd must know something. Second, losers don’t want to be alone. In the case of negative returns, the pain of regret is eased by the knowledge that many others made the same mistake. This theory helps us to understand why growth and value stocks perform as they do. As more and more people abandon the stock, it becomes a value stock when enough people have “left the bandwagon”. Growth stocks are the opposite until they reach their peak when the first people start jumping off. The most rational investors should be the first ones to jump on and off the stock. Conclusion The world is full of information to learn. The hard part is learning to control yourself. When you understand and remember these behavioral barriers, you are above the average investor and closer to greater wealth. The bandwagon effect is one of the most basic ones, but also the most important one, in my opinion. It explains the market behavior during the most critical times, during a bubble and a crash. 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.