Duke Energy: Solid Utility With A Good Growth Profile

Duke Energy Corporation (NYSE:DUK) is a fully regulated gas and electric utility company, that generates, transmits, distributes and sells its product and services across the US Southeast and Midwest regions. It conducts all its business via its subsidiaries and hence it serves as a utility holding company. On the natural gas side, its serves around 1.6 million, comprising residential, commercial, industrial and wholesale customers across North Carolina, South Carolina, Tennessee, Ohio and Kentucky. The electricity segment has a combined retail and wholesale customer base that is several fold bigger, with over 8 million customers in the Carolinas, Florida, Indiana, Ohio and Kentucky.

Like most regulated utility companies, this one too has a plan for multi-year capital expenditures, as that is the fulcrum that drives the earnings and thus returns to its investors.

DUK also has lofty plans to reduce its carbon emissions, which can be seen in the "Road to Net-Zero" slide of its investor presentation.

DUK has put a pretty penny into its investors pockets over the last decade, but has lagged the Utilities Select Sector SPDR ETF (XLU).

We examine this utility today to see if it fits our investing theme.

The Investment Case

Duke Energy is one of the largest regulated utilities in the United States. As regulated utilities go, Duke Energy has some of the best jurisdictions to work in. North Carolina used to be a problematic area but recent legislation has focused on improving capital expenditures and allows for multiyear rate increases. including rate increases for projected capital investments. Florida is also great in this regard and is hastening the move to renewables. Indiana is perhaps the least desirable out of the three but is also heading in the right direction. Duke Energy's plans for $65 billion in capital expenditures does seem a tad ambitious when weighs against market capitalization, but the state backing is there for all of it. The recent move sell its 3.4 gigawatt unregulated renewable energy business to Brookfield Renewable Partners L.P. (BEP) (BEPC) for $2.8 billion was an important step in increasing the predictability of its earnings and adding extra heft to its credit ratings.

The investor value proposition here is the strong dividend yield coupled with 6% expected growth rates.

A lot of this is built-in thanks to how regulated utility setups work. But there is still some variability and the latest sensitivities shown highlight what can go wrong. Right up front is the ROE for electric utility segment and a 1% decrease there would drop earnings per share by 10% off the 2023 base.

The Gas segment, thanks to its far smaller size impacts things a lot less. But even there a 1% ROE decrease will drop earnings for that segment by about 10%. The final aspect is the change in interest rates and here the change will have minimal impact. Key point to note here is that all of this pertains to 2023 and since this was released after Q2-2023 results, the relative impact is modest. Duke Energy had already got the bulk of its annual financing done at the time.

Valuation

With utilities there is a three step process to investing. The first being to see if the credit metrics are fine and improving or worsening. Duke Energy fits in the upper middle here with BBB+ (Baa2-Moody's) ratings and the general trend is stable, despite some huge capex.

The second step is to ascertain if the jurisdiction is good, bad or ugly and we think it is definitely on the "good" side of the ledger here. The final step is the earnings multiple and the trade-off against the expected growth. In that regard, Duke Energy compares relatively favorably to Consolidated Edison Inc. (ED), Pinnacle West Capital Corp (PNW) and NextEra Energy (NEE).

Interestingly enough, American Electric Power (AEP) which does sport a similar growth profile and identical credit metrics, is a bit cheaper here relative to Duke Energy. Overall, the valuation looks appealing for the company although AEP may be worth a closer look for investors aiming for value.

Risk Factors

The biggest risk factor is of course what everyone knows about. Interest rates. Gone are the days of zero percent and utilities are vulnerable as they roll over their massive debt loads. One other factor here is the popularity of closed end funds which have dialed up the leverage on utilities. To maintain the same level of leverage in a down market, they have to sell the underlying securities and this could continue to keep these stocks pressured.

With a possible 6% risk-free rate environment, it is hard to argue that utilities collectively are cheap. By buying here, you are indirectly making a bet that rates are close to peaking. They might be, but as the model shows, longer term rates could move higher, even from here.

Verdict

All of this gets us to label Duke Energy as mildly attractive here with potential for 7-8% annual returns. Relative to what we expect from the broader S&P 500 (SPY), we think this is a good bet. But relative to what we can get risk-free or in quality bonds (7%-8%), we don't find it appealing. We will note here that Covered Calls do significantly improve the risk-profile of going long. We will show you how that works. At present, the price is $87.90.

The January 2025 $85 strike calls create a 13.74% yielding play, even if the price stays static or drops a bit from here.

Speculating on 7-8% returns (which would require 2% to 3% annual appreciation) is riskier than "locking-in" 13.74% returns even if the price moves down a little. If we had to play it, that is the way we would go.

Duke Energy Corporation DP REP PFD A (NYSE:DUK.PR.A)

This is an interesting play in its own right. For the longest time, this was too expensive to consider. It often traded well over par and as high as $28.50 during the go-go, yield chasing year of 2021.

For a security paying 5.75% on par, you are now getting about 6.25% on the current price. This dividend is qualified and that gives it an extra leg up versus plain interest from bonds. At current levels, it is not the worst play you can make from a regulated utility. We still cannot endorse it when there are superior securities that yield more. Agree Realty Corporation 4.250% DEP PFD A (ADC.PR.A) for example yields 6.71% and the rating of the preferred unit is one notch higher than DUK.PR.A. Of course taxation is different for REIT preferreds, so that adds another layer of complexity to comparing the two. What we can say is that in tax-deferred accounts, ADC.PR.A would definitely be superior and there are other better choices as well. So while Duke Energy's preferred unit has become cheaper, we will have to rate this a "hold" as well.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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