Table of Contents
Introduction
On June 26, 2020, I wrote an article called “Duke Energy: One Of The 6 Must-Own Dividend Stocks”. Duke Energy (NYSE:DUK) was indeed one of the first 6 stocks of my dividend growth portfolio, which I established in June of 2020. Now I have 22 different stocks in my portfolio. 2 of them are utilities – the full list can be seen in my Seeking Alpha bio. When I buy stocks I always look for quality first. However, I also look for stocks that I enjoy. Companies that fascinate me. I also own stocks that just make sense. Duke Energy is one of these stocks. I don’t know where the stock is trading most of the time. I couldn’t even tell you if it’s at its all-time high or 5% below it. Duke is boring. And that’s a good thing as it’s the safest dividend stock in my portfolio.
In this article, I will write a much-needed update and explain why I like Duke so much.
Putting The “Q” In Quality…
With a market cap of $81 billion, Duke is America’s second-largest regulated electric utility company. Headquartered in Charlotte, North Carolina, the company operates in the Carolinas, Indiana, Ohio, and Kentucky, as well as the Sunshine State, Florida.
Duke generates roughly 86% of its earnings from regulated electricity. 9% from gas, and 5% from commercial renewables.
Utilities are among the most defensive investments in the world for the obvious reason that people and companies need electricity. The only cyclical aspect of the business is that higher economic growth boosts electricity needs. Industrial and commercial demand is much more volatile than residential demand, which is mainly dependent on secular trends like the adoption of technology and migration. In 2021, the company saw a 1.6% growth rate in electric customers. This came from 1.8% growth in the Carolinas and Florida (both 1.8%) and just 0.8% growth in the Midwest. This makes sense as people moved to the Carolinas and Florida (among other states) from higher-taxed states.
In 2022, Duke expects to grow total retail electric volumes by 1.5% with up to 2.0% growth in industrial demand due to higher economic output.
Meanwhile, the company continues to invest in cleaner energy sources, which is boosting capital expenditures (“CapEx”) as I will show you in this article, but it lowers overall operating costs. O&M costs have declined by 1.4% per year since 2016 thanks to the transition away from coal, a modernized grid, and the ability of the company to leverage its scale to somewhat offset inflation.
In 2021, Duke generated $5.24 in adjusted earnings per share. The company’s original guidance was $5.00-$5.30. Through 2026, the company expects to grow earnings by 5-7% per year with $5.45 in EPS in 2022. Duke expects to benefit from the aforementioned increase in customers, and rate increases – among other factors.
With that said, there is no reason to buy utility companies for capital gains. However, it is important to buy utility companies that do not dilute shares so much that investors get dividends but end up with high capital losses in case they ever want to sell. The thing is that utility companies issue stock to finance projects. Duke had 700 million shares outstanding in 2017. In 2021, the company had 769 million shares outstanding. While share buybacks enhance the value of every share, issuing shares achieves the opposite. However, that’s not a big issue for DUK. While total net income has grown by 110% since 2007, earnings per share have increased by 6%. That may not seem like a lot, but it incorporates the company’s massive share dilution during this period.
Share dilution is not going to end anytime soon. The company has a $63 billion 5-year CapEx plan. Between 2022 and 2026, the company is expected to spend this much on modernization of its grid and push for net-zero through investments in nuclear, renewables, storage, and hydro. During the 2027-2031 period, CapEx will likely end up above $70 billion.
The graph below shows the company’s funding gap, although the high net debt level messes a bit with the visibility of the other indicators – my apologies for that. What we are looking at is roughly $9.7 billion in gross CapEx last year. Operating cash flow was $8.3 billion. What this means is that the company needs external funds to cover CapEx. Free cash flow has consistently been negative since Duke (and its peers) started to ramp up CapEx after 2014. However, bear in mind that the company also pays a 3.7% dividend yield. This adds another $3.0 billion to the funding gap. Hence, it’s no surprise that share dilution has picked up with a surge of almost $28 billion in total long-term debt since 2014.
But then again, please be aware that the company does generate value as earnings per share growth is expected to remain positive – and it was positive in the past as well.
It also helps that the company’s total equity (total assets minus total liabilities) has been in a steady uptrend, which means money on investments isn’t wasted. It ends up as “value” on the balance sheet.
In this case, quality is the company’s ability to transition its company to net-zero and a modernized infrastructure without sacrificing the balance sheet. The company will do far more than $10 billion in annual CapEx to exit coal by 2035. This will require debt. The good thing is that the company’s history has shown that accelerating CapEx is possible without destroying value through debt. In this case, it also comes with stronger earnings growth as the company is hiking prices to invest in renewables. As a result, the company has a BBB/Baa2 balance sheet, a 112% funded pension plan, and cost management that allows for faster earnings growth.
… And The “Y” In Yield
High-yield investors have been in a tough spot since the pandemic. Since the pandemic, dividend yields have fallen off a cliff. Prior to the pandemic, the S&P 500 yield used to be close to 2%. Now it’s below 1.40%. The high yield ETF (VYM) is yielding just 2.9% instead of more than 3.0%, and utilities (XLU) are yielding just 2.8%. DUK’s yield is roughly 90 basis points above the XLU yield and 30-40 basis points below its longer-term median.
In other words, the definition of “high yield” changed after the pandemic. Investors who wanted high yield were more or less forced to buy energy stocks or certain companies they may not have invested in under “normal” circumstances. I know for a fact that a lot of the retail traders who I talk to started buying mortgage REITs and high-yield ETFs only for the sake of achieving a higher yield.
The graph below shows the difference between Duke’s dividend yield and the S&P 500 dividend yield. It’s roughly 233 basis points, which is more or less the 5-year average. Also, and with regard to share dilution, the stock has returned the same as the utility ETF and the high-yield vanguard ETF, which includes stocks like PepsiCo (PEP), Coca Cola (KO), and banks like JP Morgan (JPM). If we zoom out further, the performance is slightly worse, but overall, that’s a neat total return for a stock with a yield close to 4%.
Unfortunately, but not unexpected, dividend growth is low. Since 2015, dividends have grown by 3.1% per year. It does beat pre-pandemic inflation and the impact on an already high yield is bigger, but it’s not a thing that will get dividend growth investors excited. But that’s OK as these numbers are justified by earnings growth and the numbers are sustainable on a long-term basis.
In terms of valuation, we’re dealing with an $81 billion market cap and $68 billion in net debt. That gives us an enterprise value of $149 billion. That’s 12.1x this year’s EBITDA consensus of $12.3 billion.
Historically speaking, that’s an “OK” price. Nothing to get very excited about, but also not a price that should keep people from buying. Additionally, as the lower half of the chart below shows, utilities seem to be bottoming versus the S&P 500. This is likely because the 10-year yield is losing steam as investors know that “aggressive” Fed rate hikes will cause pressure on inflation to rise.
The DUK stock price seems to be working on a breakout close to $107-$108. Year-to-date, the stock is up slightly more than 1% versus an 11.6% correction for the S&P 500. I think this breakout could be for real and I would not be surprised if the stock were trading at $110 2-3 months from now.
Takeaway
Duke Energy is one of my favorite stocks in my portfolio – and one of the initial six holdings. The company is extremely boring, which is a good thing. Most of the time I have no idea where it’s trading and I do not check its quarterly earnings frequently – unless I’m checking if the company is still on track to generate value as I did in this article.
DUK is a good stock for both high yield dividend investors and dividend growth investors who want to add some higher yield to their portfolio. The company is in fantastic shape and in a good position to achieve multiple things including reaching net-zero without letting high debt destroy its balance sheet, growing its business without neglecting earnings growth, and paying a high dividend without achieving its growth targets.
Yes, dividend growth is low, but the yield is giving us a nice premium over the market. And, investors are not buying into a stock without potential capital gains as it does keep up with its utility and high-yield peers.
With regard to timing, I think the stock is about to move higher. Regardless of that, I believe DUK is a great company investors can buy and add to almost at any price as outliers to the upside are very rare. The valuation is good and I will likely reinvest some dividends next month.
(Dis)agree? Let me know in the comments!