DUK

Duke Energy Corporation (Holding Company)

106.38
USD
1.12%
106.38
USD
1.12%
95.48 116.33
52 weeks
52 weeks

Mkt Cap 80.90B

Shares Out 769.00M

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Duke Energy: Dependability Has Its Price

Summary Even though it was proclaimed in 2021 that earnings no longer mattered, investors had to realize that they ultimately did. As a result, the utilities sector in general has held up very well in this volatile market, and Duke Energy shares have significantly outperformed, even when dividends are excluded. Investors may rightly ask if now is the time to take a conservative position and invest in reliable, slow-growing companies with solid earnings, such as utility stocks. However, I believe that now is the time to at least consider shifting funds to more cyclical stocks of high-quality companies, and I'm thinking about selling my position in Duke Energy. Nevertheless, I would not mind holding on to my position in Duke, should the opportunities fail to materialize. Duke Energy Corp. (NYSE:DUK) is one of the largest regulated utilities in the United States, with a market capitalization of currently $85 billion and an enterprise value (EV) of $152 billion. The company serves more than eight million customers and owns facilities in the Carolinas, Indiana but also in Ohio and Kentucky. I have covered the company in a more in-depth analysis in the past, where I compared it to two other well-known utilities Southern Company (SO) and WEC Energy Group (WEC). In this article, I will outline why I still own shares in the company despite its current overvaluation, discuss the most recent earnings report, and explain whether I am a buyer at current levels. Why Do I Own Duke Energy Stock? Duke Energy is a very large and well-diversified regulated utility with a total nameplate capacity of currently 50.3 GW (Figure 1). The company also operates a commercial renewables portfolio with variable ownership structure, of which it owns a total nameplate capacity of currently 3.6 GW, mainly comprising of wind parks and solar farms. The company generates approximately 86% of its earnings from its regulated electric utility business and the rest from gas and its commercial renewables segment. Of course, Duke is highly dependent on fossil fuels, but expects to retire all of its coal plants in the Carolinas by 2030 and achieve net-zero emissions by 2050. These are certainly ambitious targets that are associated with significant capital expenditures. In this context, Duke has laid out a five-year $63 billion capital plan. Duke's current portfolio relies on very dependable energy sources, and in consultation with regulators, I am confident that the transition to renewables will occur in a manner that is acceptable to shareholders, regulators and customers alike, given that Duke Energy operates in a generally quite favorable regulatory environment. In this context, S&P Global Market Intelligence (via Regulatory Research Associates) provides a review of the regulatory climate in the various jurisdictions of the United States, ranking each on a nine-point scale from Above average/1 (Aa1) to Below average/3 (Ba3). North and South Carolina have been rated A1 and A3, respectively, Indiana A1, Kentucky A1, Ohio A3 (recently downgraded by one notch), Florida Aa3, and Tennessee has also been assigned the third-best score Aa3. The potential negative impact of the regulatory environment is probably best illustrated by the rate issues of Pinnacle West Capital Corporation. Duke's balance sheet is highly leveraged, at a net debt (including operating leases) to three-year average adjusted EBITDA ratio of 6.5. Ten years ago, the company's net debt was much more palatable at 3.5 times adjusted EBITDA. This development is characteristic of most, if not all, regulated electric utilities, but somewhat concerning nonetheless. The company's senior unsecured debt has been rated BBB by S&P and hence, Duke will likely continue to be able to refinance its debt without problems, although likely at somewhat elevated rates given the current situation. The weighted average interest rate on its $63 billion in long-term debt is a comfortable 3.5% and overall, Duke's interest coverage ratio is around 2.5 times net operating profit after taxes (NOPAT). This is slightly below Duke's interest coverage a decade ago of 2.7 times NOPAT, but certainly very acceptable for a regulated utility. Almost 75% of the company's long-term debt matures after 2026, and its upcoming maturities are illustrated in Figure 2. The company grows organically but also through acquisitions and regularly dilutes shareholders to fund its acquisitions and capital expenditures. Over the last decade, shareholders have been diluted at a compound annual growth rate (CAGR) of 5.6%. In this context, I consider for example WEC Energy Group a superior company (see my note). Nevertheless, the rate at which Duke dilutes existing shareholders has slowed considerably in recent years, i.e., to a CAGR of 2.2% over the last five years. The company pays a steadily growing dividend and this is also the main reason why I own this stock in my portfolio. From a regulated electric utility that operates in mostly favorable jurisdictions, I can expect an acceptable return on equity and hence a growing dividend. In 2021, Duke declared $3.90 in dividends per common share, compared to $2.97 ten years earlier, for a CAGR of 2.8% and thereby slightly outpacing inflation. Duke's dividend yield has become less and less attractive as the share price increased in recent years and it currently stands at slightly above 3.6%. Quite typically for a highly-leverage regulated utility, Duke's payout ratio is pretty high at 80% of adjusted net earnings. Going forward, I doubt that DUK's dividend growth will keep pace with the current rate of inflation, as underscored by the latest increase by 2.1%, but I do not consider this particularly concerning, as I hold the shares as an alternative to a long-term bond, with the possibility of capital gains and a slowly growing payout. How Did Duke Perform In Q1 2022? The company recently reported its Q1 2022 earnings of $1.3 per share on an adjusted basis, well on track for full year adjusted midpoint earnings per share of $5.45. GAAP-based earnings took a hit due to charges related to the 2022 Indiana Supreme Court ruling on coal ash. Increased operating costs (25% YoY, mainly related to fuel costs) also took their toll. Nevertheless, Duke's Electric Utilities and Infrastructure segment's earnings increased from $820 million to $896 million YoY on an adjusted basis, primarily due to higher volumes and pricing ($185 million), offset by storm expenses of approximately $54 million and expenses of approximately $55 million related to operations, maintenance, etc. Duke's Gas Utilities and Infrastructure segment reported income of $254 million (no adjustments), up slightly from $245 million a year ago, mainly due to favorable rate case impacts, slightly offset by higher operations and maintenance expenses. The company expects to continue to be able to grow earnings per share at a CAGR of 5% to 7% which is quite positive against the backdrop of extensive capital expenditures in connection with the replacement of phased-out coal-fired power plants and investments in renewable energies. However, it should not be forgotten that the depreciation of these investments takes a very long time and therefore only a small part of the expenditure is expensed each year. For further information, page 174 of Duke's 2021 10-K gives a good overview over the current average remaining useful life of its plants. Am I Currently A Buyer Of DUK Stock? As already noted, Duke's dividend yield has been trending down in recent years due to the appreciating share price, but also due to the slowly-growing dividend. I invested in the company primarily because I consider it to be what is commonly referred to as a "bond proxy", although I do not like the connotation of this term which suggests the safety and rights of a debt instrument. Against the backdrop of the current interest rate environment, I consider a yield of at least 4%, preferably 5%, adequate for a regulated electric utility. As interest rates rise, treasury bonds appear increasingly attractive, as the spread between Duke's dividend yield and the current yield of long-term treasuries has fallen to approximately 0.6%. I consider this no longer a meaningful margin of safety. Another reason why a small percentage of my portfolio consists of regulated utilities, is their low volatility in the current environment. At the end of the day, earnings do matter, even if we have gone through a phase of two years where it was once again, "This time it's different." Hence, I am not overly surprised how well my utility holdings hold up against the broader market. However, the metrics in Table 1 and the FAST Graphs plot in Figure 3 also indicate that DUK is currently overvalued, as investors increasingly flee to reliable, income-generating stocks. In the context of the growth projections in the plot, it seems worth noting that the company's earnings have been estimated by analysts with a high level of accuracy, mostly with a 5% margin for error or better, based on two-year forecasts. On the basis of adjusted operating earnings, the magnitude of overvaluation does not seems overly concerning, but if debt is included in the equation, DUK seems very expensive indeed. Whereas in 2011, the shares traded at an EV/EBITDA multiple of below 10, they currently change hands at a multiple of 15. This is partly due to the significant increase in the company's debt, but also to the rise in the share price with a CAGR of around 5%. While I have no intention of selling my DUK position and shifting into cash, I do plan to opportunistically shift my holdings when stocks of more cyclical - but very high-quality - companies lose disproportionate value. However, since I see the Federal Reserve's room for rate hikes as limited, I would not mind holding on to my stake in DUK if the opportunity for bargains in high-quality cyclical companies does not present itself. Thank you very much for taking the time to read my article. In case of any questions or comments, I'm very happy to read from you in the comments section below. This article was written by I am dividend investor with a strong emphasis on value investing and aim for a balanced mix of current high-yielders and dividend growth stocks. Although it is often not comfortable, being a contrarian helps my return a lot. I mainly invest in dividend-paying stocks but also maintain a small speculative portfolio.Feel free to reach out to me by dropping a message on Seeking Alpha. Do hit the 'Follow' button if you like the content and would love to read more. Disclosure: I/we have a beneficial long position in the shares of DUK, SO either through stock ownership, options, or other derivatives. 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. Additional disclosure: The content is for informational purposes only and may not be considered investment advice. It is not my intention to give financial advice and I am in no way qualified to do so. I cannot be held responsible and accept no liability whatsoever for any errors, omissions, or for consequences resulting from the enclosed information. The writing reflects my personal opinion at the time of writing. If you intend to invest in the stocks mentioned in this article – or in any form of investment vehicle generally – please consult your licensed investment advisor. Comment

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