Duke: Valuation Gets Lofty For Quality Utility (NYSE:DUK)

Duke Energy Corporation (NYSE:DUK) has both energy utilities and infrastructure business as well as the gas utilities & infrastructure business. Primarily regulated, this duo forms the two main reporting segments for this company, with the balance of activities falling under the all encompassing “other”.

Its energy utilities & infrastructure operations comprise generation, transmission, distribution, and sale of electricity. This arm serves over 8 million retail customers in the Carolinas, Florida, Indiana, Ohio and Kentucky. Duke also serves the wholesale electricity needs of customers like municipalities and cooperative utilities under this setup. The business generates electricity using primarily natural gas and fuel oil, nuclear energy, and coal. Duke’s gas utilities & infrastructure operation services around 1.7 million customers and includes residential, commercial, industrial, and power generation natural gas customers, along with municipalities. Geographically, the customers for this operation are located in the Carolinas, Tennessee, Ohio and Northern Kentucky.

We have covered this Fortune 150 company last October, and we gave it a “hold” rating or in other words, we stayed on the sidelines. It has made a whopping 19% and change for its investors since then.

We believed that this utility company was capable of making 7-8% annually from that point (and said as much in that piece), but risk-free or quality bonds would get us that anyway. We outlined the risk factors of owning a utility when interest rates were high.

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.

Source: Duke Energy: Solid Utility With A Good Growth Profile

We suggested an in-the-money covered call play to lock in close to 14%, as an alternative for investors that wanted a piece of the action.

We typically choose the path of least volatility for our investments and prefer to get our annualized return fix via options. The commons outperformed the option play in this case, but in hindsight, we would still choose the downside protection via calls under the current macro conditions.

Duke’s Q1 results are fresh off the oven, and we will take the opportunity to review the numbers and update our thesis.

Q1-2024 Results & Outlook

Duke delivered a strong Q1-2024, with adjusted earnings vaulting from $1.20 to $1.44 per share. The primary driver was weather, which added 15 cents, and the rest came from rate cases and ROEs on expanding cost. Interest expense was a small detractor, but the Duke’s well spaced out maturities have minimized financing needs during rising rates.

The key reason for owning regulated utilities is that you are making a play on volumes. Duke’s volumes in Q1-2024 were tepid, but the utility expects a rising trend in the later quarters of the year.

There is some widespread development from the onshoring trend in play, and volume growth from both data centers and manufacturing could push Duke passed the 2% levels in late 2024 and 2025.

On the regulatory front, the company continues to have some of the most favorable settings you can find. One example here is highlighted, where Duke is requesting 11.15% ROE.

Obviously, them requesting it does not mean they will get it. But utilities know how the game is played, and they tend to ask around the ballpark of what they expect. You can contrast that number with what other utilities around the country are getting.

Management affirmed that they were still headed for $5.85 to $6.10 in adjusted earnings for the year, and the stock has been doing extremely well of late.

Valuation

At 17X earnings, Duke may not appear extremely expensive for a utility delivering 6% growth.

That has been the mantra from management that you add the 4% yield to 6% growth, and you get 10% with very low risk. This in turn, of course, pushes the stock up and makes equity issuance very sweet. So you have a self-fulfilling prophecy of sorts. There is generally not much we can find wrong with the idea except that these 17X-20X multiples have become normal, only from a Zero Interest Rate Policy (ZIRP) perspective. If you examine the non-ZIRP era of 2004-2008 (even before the crash), most utilities traded well below that range.

This remains the danger here and one that can result in a significant blowback. Most investors tend to say that they can ignore that as long as the dividends ring into the bank on time. But with chronic debt and equity issuers like REITs and utilities, the cost of equity is not something to be taken lightly. If the stock drops enough, all your earnings estimates will drop as well. This can also have a blowback on credit ratings. So Duke here is at best a “hold/neutral” and is rapidly converging at a point where we might even be able to go to a “Sell”.

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

Those wanting a regular income stream from a top quality utility have often gone up the capital stock. Duke is indeed one to have a preferred share that still makes the last rung of the investment grade ladder.

At present, the stock is trading near par and offers a 5.8% stripped (next ex-dividend date is May 15, 2024) yield.

This is not particularly bad, but not one we can get really excited about either. Even if you believe interest rates are about to go to zero in the next 2 years, you have to keep in mind that this can be redeemed at $25.00 at any point after June 15, 2024.

There are far better prospects here in today’s market, and we would give this a pass as well.