Tag Archives: michael-boyd

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 ).

The Dividend Discount Model And You: Proper Use And Limitations

Summary The dividend discount model is a simple valuation model for dividend investors to use in valuation. Like all models, it is only as good as the inputs used. Regardless of its drawbacks, the use of models forces investors to forecast company results and evaluate their own risk tolerance, which can only be positive for investor returns and contentment. Valuation can be a tricky subject for investors managing their own portfolios. As investors, we might like a particular company, its business, and its future prospects. But what exactly is a fair price to pay? Sure, we can look at valuation measures like P/E and EV/EBITDA and compare those numbers against historical values, but then we are just speculating that the company will return to its long-run average. Is there a better way? Financial models can be one answer to that problem. Novice investors usually start with the dividend discount model. The dividend discount model is an extremely simple, conservative valuation technique for evaluating dividend-paying stocks. While every model has its weaknesses, I believe that at the bare minimum, applying the dividend discount model to your holdings encourages you to think about, understand, and then model your portfolio holdings. Understanding the application and foundations of the dividend discount model is fairly simple. It fits into the broad bucket of discounted cash flow analysis. What we are trying to accomplish when using the model is to put a value on what a company’s future dividend cash flow is worth to us in today’s money. When we talk about “discounting” those future cash flows, we’re adjusting those numbers to reflect its value today. For example, because of the time value of money, a payout of $1,000 one year from now is worth less than $1,000 to you today. Money today has the ability to earn returns and avoid inflation, something that money in the future cannot claim. The median point where we are ambivalent between two amounts of money at different times can help us calculate our required rate of return, along with evaluating the riskiness of holding a particular stock we are analyzing. So, if our required rate of return is 8%, the discounted value of $1,000 one year from now is $925.93 ($925.93 * 1.08 = $1,000). The Basic Formula (click to enlarge) What you’ll notice from the formula is that it assumes a constant dividend growth rate. We all know dividend growth rates vary from year to year, but in the best case for modeling, we attempt to use what the long-run average will be. The weakness here as well is that the greater the dividend growth, the more minor differences between your hypothesized growth and real-world results can skew our model. So this simplistic model works best for securities with lower dividend growth rates and stable earnings. For income investors, using this model for utilities stocks should spring to mind quickly. Real-World Application Example Below, we have an example of ALLETE (NYSE: ALE ), a utility that generates energy for customers in Wisconsin, Michigan, and other surrounding states. It currently trade at $48.55/share. I’ve written a fairly pessimistic article on ALLETE , but we can see if the results from the dividend discount model back or disprove my thesis, based on various inputs. ALLETE currently yields $2.02/share annually, and has grown its dividend at an average 2.2% annual rate for the past five years, so we’ll use those numbers to run our valuation, along with an 8% required rate of return. We will assume the dividend will be $2.12 next year. P = 2.12 / (.08 – .022) P = 2.12 / 0.058 P = $36.55/share Based on this valuation, we come to a fair value of $36.55/share, or roughly 25% below current prices. To show how the model can be sensitive, let us instead change our assumptions. Perhaps based on our research, we find that going forward, management will be able to raise the dividend 3.25% annually instead of 2.2%, because maybe we have found information that has led us to believe the utility will be allowed a higher rate of return by its regulators. Additionally, we find that our own required rate of return is only 7% for ALLETE, because the stock has less financial risk than we previously thought. P = 2.12 / (.07 – .0325) P = 2.12 / 0.0375 P = $56.53/share Our calculated fair value per share is now $56.53, or more than 15% above current prices. Which is correct? That depends, based on your analysis of management’s ability to continue to raise dividends into the future and your own assumptions on the riskiness of the holding, which factor into your required rate of return. Multi-Step Models What if we think the dividend will grow at 3.5% for the next five years for ALLETE, and then 2.25%, after using an 8% required rate of return? The dividend discount model can be adapted to be used for multiple stages of growth to suit the reviewer’s needs. Year One Dividend = $2.12 * 1.035 = $2.23 Year Two Dividend = $2.23 * 1.035 = $2.31 Year Three Dividend = $2.31 * 1.035 = $2.39 Year Four Dividend = $2.39 * 1.035 = $2.47 Year Five Dividend = $2.47 * 1.035 = $2.56 Year Six Dividend = $2.56 * 1.025 = $2.62 Once we have the values, we can then discount those to their net present value: $2.23 / (1.08) = $2.06 $2.31 / (1.08) 2 = $1.98 $2.39 / (1.08) 3 = $1.90 $2.47 / (1.08) 4 = $1.82 $2.56 / (1.08) 5 = $1.74 We can then apply the constant growth model we used previously to determine their value, based on the fifth-year dividend value: P = 2.62 / (.08 – .0225) P = 2.62 / 0.0575 P = $45.57/share This value has to be discounted to net present value as well. P = 45.57 / (1.08) 6 P = 45.57 / 1.5868 P = $28.72 Add up the values of the five higher-growth dividends with your constant growth value: P = 2.06 + 1.98 + 1.90 + 1.82 + 1.74 +1.65 + 28.72 P = $39.87/share Conclusion Like any and all financial models, the dividend discount model is sensitive to the inputs used to value the security. Thus, financial modeling isn’t the grand answer to record-beating returns, and I wouldn’t advocate for retail investors to bury themselves in Excel spreadsheet models. However, financial modeling can force investors to think about issues that are extremely important to the stock valuation process, which can drive critical re-evaluations of your positions based on your own inputs and expectations. 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.

ALLETE: Not A Compelling Buy For Dividend Investors

Summary Reliance on aging coal-fired power generation is a risk. Capital expenditures and dividend payments exceed operational cash flow. Dividend yield is solid but has not grown and is unlikely to grow meaningfully in the future. ALLETE, Inc. (NYSE: ALE ) primarily operates as a regulated utility, providing services for customers in Wisconsin, Michigan, Minnesota, and Illinois. By comparison to some utilities, ALLETE’s largest customers are primarily industrial in nature, with these large customers (mining and paper industries primarily) drawing 54% of KWH generated. Because of this, ALLETE profit is tied directly to the health of these industries. Luckily, Minnesota mining production has continued at full-speed even in the face of a global rout in commodities that have deeply impacted the iron and steel industries. Investors who own ALLETE should focus more of their attention on the health of ALLETE industrial customers rather than traditional utility research, such as demographic trends and unemployment growth in the service areas that primarily affect residential consumers. Aging Infrastructure And Management’s Plan The vast majority of energy production for ALLETE comes from coal-fired power generation. At the end of 2014, 64% (1,277 MW) of energy production was coal-fired. The majority of these coal-fired plants are getting quite old — while units 3 and 4 at the Cohasset, MN facility are the newest (producing 75% of generation at this massive facility), these were still originally constructed in 1973 and 1980. Like a large swath of US coal-fired plants, obsolesce may soon be around the corner. The average lifespan of a coal-fired plant is forty years, according the National Association of Regulatory Utility Commissioners . While the Cohasset facility has seen many updates over the years, facts remain that the bones of the facility have aged. Those that follow my work on utilities know that I’m a big fan of natural gas and other renewable power regeneration. This isn’t driven by my own personal feelings on the environmental impact. Regardless of your thoughts on environmental regulation, investors should nonetheless be aware of the fact that the Environmental Protection Agency has begun taking a harder stance on coal and that course is unlikely to change. Regulations on pollutant emission will likely only continue to strengthen and so will the cost burden on utilities to maintain necessary updates on these aging coal-fired plants. As a recent example of the cost impact, ALLETE is nearing completion of an environmental upgrade at one of its plants; total cost will run $260M to bring the plant into compliance with the Mercury Emissions Reduction Act. While this is cost recovery eligible through rate increases on the retail customer and if approved these customers will have no alternative but to bear the cost, industrial customers (which if we remember constitute the majority of revenue) do have the option to pursue other providers with approval from the state or can generate their own electricity on-site. This is why it is imperative that investors who remain long on ALLETE as a company pay close attention to the strides the company is making in renewables and natural gas. The company is targeting a production goal of thirds — one-third of energy production with coal, one-third with renewables, and one-third with natural gas. This was most likely driven in part by the Minnesota Next Generation Energy Act of 2007, which requires 25% of retail energy sales to be from renewables by 2025, with hurdles of 17% in 2016 and 20% in 2020. These hurdles are around the corner, but luckily ALLETE does have a foundation to work off of. There is some minimal existing hydroelectric production (105 MW) spread throughout Minnesota, but the likely new crown jewel for ALLETE is its Bison Wind Energy Center in North Dakota, which produced 497 MW of energy at the end of 2014. Further bolstering renewables production is the agreement reached to purchase hundreds of megawatts of production from AES Corporation (NYSE: AES ) early on in 2015. I’m long AES Corporation, and I see this as a win/win for both companies. AES has spread itself way too thin around the globe and these asset sales make sense to let the company gain focus on more core facilities. ALLETE in return gains solid wind production facilities that will likely be immediately accretive to earnings per share. As another related victory for ALLETE in the renewables space, the deal for ALLETE to construct a wind farm for Montana-Dakota Utilities, a division of MDU Resources Group (NYSE: MDU ) shows that the company has an industry reputation for knowing what it is doing when it comes to wind construction. Operating Results (click to enlarge) Total revenue has grown at a 5.81% over the past five-year period and this trend is set to continue with revenue projected at 1.2B for 2015. Fuel expenses have fallen as coal prices have taken a nosedive, a benefit that many utilities have enjoyed in recent years. This input cost windfall has resulted in expanding operating margins. Net income growth would have been stronger if not for a burgeoning debt load; total debt now stands at nearly $1.4B, almost double the $773M the company held in 2014. This is due to the fact that capital expenditures have massively outstripped operational cash flow over the past five years. Operational cash flow totaled $1.2B in the 2010-2014 period; capital expenditures totaled $1.8B. This out-of-balance is before factoring in dividends, which totaled another $350M. This is not what you want to see from a utility. By comparison, Calpine Corporation (NYSE: CPN ), which I own, has seen nearly $3.8B in operational cash flow versus $2.8B in capital expenditures over the same timeframe. This falls back to the cost of running and maintaining coal-fired plants. Calpine primarily operates extremely new, high-technology natural gas plants, the direct opposite of ALLETE’s current portfolio. Management is guiding these costs to fall over the next five years, capital expenditures are guided to average $250M/year versus the prior five-year average of $360M. Even with those decreases, ALLETE may continue to run into a situation where they must raise more debt to fund all their obligations. Conclusion While investors might be tempted by the 4% dividend yield, investors should keep in mind the five-year average dividend growth rate has only been 2.2% and this is unlikely to change. No large catalysts exist for substantial earnings per share and dividend expansion in my opinion. Total shareholder returns are likely to lag a broader utility index and investors would likely be better off in other names with more opportunity. Larger peers like American Electric Power (NYSE: AEP ) or prior-mentioned name AES Corporation present more compelling stories for stable dividend growth. 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.