Tag Archives: united-states

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 ).

I’ll Take VNQ Over The Federal Reserve: Benefit From Low Rates

Summary The Vanguard REIT Index ETF is holding a diversified portfolio of REITs that can benefit from low rates. Wage growth is a bullish factor for domestic demand. Inventories at high levels relative to sales are bearish, but goods are frequently imported rather than built domestically. If the Federal Reserve follows the mandate to maintain high employment, they will need to keep rates low. The Vanguard REIT Index ETF (NYSEARCA: VNQ ) has been one of my core portfolio holdings and I don’t foresee it going anywhere. The fund offers investors a very reasonable expense ratio of .12%, a dividend yield running a hair under 4%, and a large degree of diversification throughout the industry as demonstrated in its sector allocations: Weak Bond Yields The yield on the 10-year treasury has dipped under 2% and I don’t expect it to end the year much higher. Our economy is depending on very low interest rates, which can be a boon for the equity REITs as it offers them access to lower cost debt financing for properties. Why Treasury Yields are Limited The Federal Reserve is largely incapable of pushing rates up. It might be technically possible for them to have some influence in pushing the rates higher, but it would be a disastrous scenario. The Federal Reserve is facing a dual mandate for low and steady inflation combined with high employment. If domestic interest rates are increased, it would encourage further capital flows into the country as globally investors would seek the security of buying treasuries. The predictable impact would be a stronger dollar that encouraged companies to ship more jobs abroad and a decline in domestic asset prices due to the “cheaper” goods being imported. Essentially, when interest rates are rising, it will need to be across the globe. Raising interest rates in only one developed country is asking for problems when the tools of production can be operated on a global scale. I understand investors are clamoring for respectable low-risk yields, but increasing rates is not practical. If Those Yields Stay Low If the bond yields are remaining low, investors are going to be searching for yield in other places. With that dividend yield around 4%, VNQ is one viable option for providing some yield to the portfolio. It isn’t just demand for the shares of the REIT, though. The REIT industry has another tailwind that makes it more favorable. Wage Growth is Bullish Some major employers like Wal-Mart (NYSE: WMT ), Target (NYSE: TGT ) and McDonald’s (NYSE: MCD ) have announced very substantial increases in their base wages. This is finally showing that domestic companies are finding value in their own employees. When capital is not flowing to labor, there is less demand in the society for physical goods. As corporate earnings were climbing in previous quarters, there wasn’t enough capital flowing back to “Main Street.” A growth in wages here should help combat weakness in sales for the corporate sector. This growth in wages is a favorable sign that major employers are seeing value from labor. Many investors may scoff that the jobs provided by these employers are creating “low wage” or “low class” jobs. That makes the increase in wages even more important. In a recovery in which too many of the new jobs were failing to provide material levels of income for workers, there is finally an increase near the bottom of the pyramid. Increasing Inventories to Sales is Bearish The following chart compares inventory levels with sales: (click to enlarge) We are seeing a growth in inventory levels, which is a dangerous macroeconomic sign, as higher inventory levels encourage companies to cut production. If the physical production is reduced, there is less demand for workers. That could bring us back towards higher levels of unemployment and weaker wage growth at the bottom of the pyramid. It also indicates that earnings could take a substantial hit. Weaker Earnings Projections Should Force Rates Down For the investors that are not familiar with the accounting for inventory costs, it is important to state that higher levels of production generally stretch fixed costs across more units of production. When companies have to cut production due to inventory levels becoming too high, it results in higher costs of production. Those higher costs can effectively be wrapped into the “inventory” line item and the expense won’t pass through the income statement until the inventory is sold. When the inventory is sold, the higher costs of production flow through the income statement as “cost of goods sold.” The REIT Impact If increasing inventories results in a large reduction in labor in the United States, it would be a problem for REITs as it would signal deteriorating fundamentals. On the other hand, a great deal of inventory comes from imports and a reduction in imports would not have the same dramatic impact. According to ABC news , in the 1960s only 8% of American purchases were made overseas. Now that value is greater than 60%. Whether we talk about residential REITs, office REITs, or retail REITs, a lack of domestic employment would be a bearish sign that would indicate a reduction in the consumption of goods. For residential REITs, the impact would be a drop in the amount of demand for apartments as unemployed workers are not a solid renting demographic. For the office REITs, there is a lack of demand for office space if the companies renting that space find their sales diminishing and must cut their costs. The retail REITs face a similar problem to the office REITs as they depend on consumers buying products from their tenants. Why I’m Still Holding onto VNQ The potential for weakening levels of employment as evidenced by factors like the increase in inventories relative to sales is a material concern. Despite that concern, I choose to remain long VNQ. The increasing inventories are a concern, but imports still fund a substantial portion of inventory. If rates were rising and forcing the dollar to appreciate even further, it would be a serious risk factor for the REITs, but it would also be a challenge directly to the mandate of full employment. So long as the Federal Reserve is following that part of their mandate, they will be forced to keep the rates low. That provides support to share prices as investors seek yield and it provides support to the underlying business by keeping the cost of debt capital lower. Because the REITs can benefit from a low cost of capital and the impact of higher wages, they are in position to gain twice. On the other hand, if I’m wrong and the Federal Reserve does opt to start jacking up short-term rates, then I’ll be eating some nasty losses on my portfolio value. I can’t be certain that I’m right, but I’m confident enough that I am holding VNQ and the Schwab U.S. REIT ETF (NYSEARCA: SCHH ) in my portfolio .

Solid Income Company With A Dividend Increase Coming Soon: American Electric Power

Summary American Electric Power has an excellent total return over the last 33-month test period. American Electric Power’s dividend is 3.9% and has been increased nine of the last ten years. American Electric Power can continue its steady upward trend of approximately 4% as it focuses on its $12.2 billion plan for regulated transmission and distribution assets. This article is about American electric Power (NYSE: AEP ) and why it’s an income company that’s being looked at in The Good Business Portfolio. American Electric Power Company is a utility holding company. The Good Business Portfolio Guidelines, total return, earnings and company business will be looked at. Good Business Portfolio Guidelines. American electric Power passes 10 of 10 Good Business Portfolio Guidelines. These guidelines are only used to filter companies to be considered in the portfolio. There are many good business companies that don’t break many of these guidelines but will still not be considered for the portfolio at this time. For a complete set of the guidelines, please see my article ” The Good Business Portfolio: All 24 Positions .” These guidelines provide me with a balanced portfolio of income, defensive and growing companies that keeps me ahead of the Dow average. American Electric Power is a large-cap company with a capitalization of $26.4 billion. AEP provides electric utility services to about 5.348 million customers in 11 states over a total area of 197,500 square miles. The company derived 25% of its consolidated system retail revenues in 2014 from its utilities in Ohio, 14% from Texas, 13% from Virginia, 11% from West Virginia, 11% from Oklahoma, 10% from Indiana, 5% from Louisiana, 5% from Kentucky and the remainder from other states. American Electric Power has a dividend yield of 3.9% and its dividend has been increased for nine of the last ten years. The payout ratio is moderate at 60%. American Electric Power therefore is not a growth story at this time but may be as the steady growth of the company continues. The dividend is expected to be increased at the end of October and is estimated to be increased $0.02/quarter or a 4% increase. American Electric Power income is good at $3.54/share which leaves AEP plenty of cash flow, allowing it to pay its high dividend and have a enough left over for its capital campaign I also require the CAGR going forward to be able to cover my yearly expenses. My dividends provide 2.8% of the portfolio as income and I need 2.2% more for a yearly distribution of 5%. American Electric Power has a three-year CAGR of 5% just meeting my requirement. Looking back five years $10,000 invested five years ago would now be worth over $18,255 today (from S&P IQ). This makes AEP a good investment for the income investor with its steady 4% dividend and earnings growth. American Electric Power’s S&P Capital IQ has a three-star rating or Hold with a price target of $55.0. This makes AEP fairly priced at present and a good choice for the income investor. Total Return and Yearly Dividend The Good Business Portfolio Guidelines are just a screen to start with and not absolute rules. When I look at a company, the total return is a key parameter to see if it fits the objective of the Good Business Portfolio. American Electric Power did better than the Dow baseline in my 33.0 month test compared to the Dow average. I chose the 33.0 month test period (starting January 1, 2013) because it includes the great year of 2013, the moderate year of 2014 and the losing year of 2015 YTD. I have had comments about why I do not compare the total return to the S&P 500 average. I use the Dow average because the Good Business Portfolio has six Dow companies in it and is weighted more to the Dow average than the S&P 500. Modeling the Dow average is not an objective of the portfolio but just happened by using the 10 guidelines as a filter for company selection. The total return makes American Electric Power appropriate for the growth investor with the 4% dividend good for the income investor. The dividend is lower than average and covered and has been paid and increased each year for eight years of the last ten years. DOW’s 32.5-month total return baseline is 25.71% Company Name 33.0 Month total return Difference from DOW baseline Yearly Dividend percentage American Electric Power 42.15% 16.44% 3.9% Last Quarter’s Earnings For the last quarter (July 2015) American Electric Power reported earnings that beat expected at $0.88 compared to last year at $0.80 and expected at $0.80 and revenue missed by $180 million. This was a good report. Earnings for the next quarter are expected to be at $0.95 compared to last year at $1.01. The steady growth in AEP should provide a company that will continue to have slightly above average total return and provide steady income for the income investor. Business Overview American Electric Power Company, Inc. is a utility holding company. It operates in five segments. The vertically integrated utilities segment generates, transmits and distributes electricity through AEP Generating Company, Appalachian Power Company, Indiana Michigan Power Company, Kingsport Power Company, Kentucky Power Company, Public Service Company of Oklahoma, Southwestern Electric Power Company and Wheeling Power Company. The Transmission and Distribution Utilities segment transmits and distributes electricity through Ohio Power Company, AEP Texas Central Company and AEP Texas North Company. The Generation and Marketing segment’s subsidiaries consist of non-utility generating assets, a wholesale energy trading and marketing business and a retail supply and energy management business. AEP Transmission Holdco is a holding company for AEP’s transmission joint ventures and AEP Transmission Company, LLC. The AEP River Operations segment transports liquid, coal and dry bulk commodities. With electric usage increasing in the United States the diversity of American Electric Power assets should allow the company to continue its growth and safely pay a moderately increasing dividend. Takeaways and Recent Portfolio Changes American Electric Power is a income company. Considering AEP’s steady slow growth and its total return better than the Dow average, AEP is a buy for the income investor. The only negative for AEP is when the Fed starts raising interest rates that will cause rising interest expense, giving AEP a headwind for a couple of years. AEP is not being added to The Good Business Portfolio right now since there are no open slots in the portfolio the Good business Portfolio is limited to 25 positions and AEP will be considered when there is an open slot. Of course this is not a recommendation to buy or sell and you should always do your own research and talk to your financial advisor before any purchase or sale. This is how I manage my IRA retirement account and the opinions on the companies are my own.