A Negative Payout Ratio Is Never A Good Thing

By Chad Henage - September 7, 2012 | Tickers: AEP, DUK, EXC, SO | 0 Comments

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I've seen multiple people speculate that there is a dividend bubble in the current stock market. If this is true, it's very likely that this “bubble” is occurring in the utilities industry. For the novice investor, utility stocks appear safe, don't change much, and pay a much better yield than CDs or many bonds. However, not all dividends are created equally, and one of the more worrisome utility dividends lies with Duke Energy (NYSE: DUK).

I've been watching Duke very carefully for the last year or so, as I know the company usually comes highly recommended to income hungry investors. If there is one major concern about the company, it has to be the sustainability of the current dividend. While investors might expect the merger with Progress Energy to solve this problem, it doesn't appear this will be the case. In fact, the progress (no pun intended) Duke made in its recent earnings, could be hurt by the slowdown at their merger partner.

In the recent quarter, Duke reported revenue up 1.22% and adjusted EPS up 3.03%. The company's largest segment is its U.S. Franchised Electric & Gas division, which saw revenue growth of 5.81% and income growth of over 13%. The company's biggest challenge was their International Energy division, which showed revenue down 2.22% and income down 17.32%. The company's smallest division is their Commercial Power unit. This division saw revenue down over 15%, but cost controls allowed income to increase 6.67%. The bad news for Duke shareholders is, the company's pending acquisition target (Progress), showed revenue down 0.75% and diluted EPS down 65%. Though there might be cost efficiencies brought about through the merger, you can see that combining these results would have hurt Duke's revenue and earnings per share. Realistically investors are not buying Duke for huge earnings growth, as much as for the current income from the company's dividend. The problem as I see it, is the company's dividend appears in serious trouble.

There are several factors that lead me to believe that Duke's dividend could be a problem going forward. The first is, the company's interest expense increased 14.29% versus last year. Progress also showed an increase in their interest expense of 7.41%. A second factor is, between the two companies long-term debt is increasing overall. Duke cut its long-term debt by just over 1% in the last year, but Progress increased its long-term debt by 8.71%. When you add these challenges to the fact that Duke's cash and short-term investments are down over 23% on a year-over-year basis, it appears the combined company may be weaker than investors would expect. While all of these factors are risks, there is nothing that presents a greater risk to Duke's dividend than their free cash flow situation.

When looking at any company's dividend, investors should examine the free cash flow situation carefully. Unfortunately, Duke is not alone in the utility segment when it comes to problems with free cash flow versus their dividend payment. However, of the several utilities I looked at; only Duke showed negative free cash flow. Take a look at the comparison of Duke versus several of their competitors. I think you'll see the utility industry is riding a fine line between affordable dividends and the next dividend blow up.

As you can see, there is a huge difference in the free cash flow payout ratio of each of the companies over the last year. While it's true the utility industry is consolidating, and each of these companies can ask for rate increases that may change their payout ratios, a large negative payout ratio is not something that's easy to overcome. This negative payout ratio at Duke Energy is the primary reason I would suggest investors avoid the shares at the current time. In comparison to their competition, not only is the dividend a challenge, but the relative value of the stock compared to their growth rate is an issue as well.

On an overall basis, it appears that multiple utilities are selling for valuations primarily driven by their dividend yield. Of the four companies mentioned above, Duke carries the second highest P/E ratio, but the second lowest future growth rate. Given the company's financial challenges, this should be a huge red flag for investors as well. Other companies in the utility industry would appear to represent a better value. Though Southern Co. is a popular recommendation for income investors, the company's huge payout ratio and P/E ratio over 17 make me nervous. When it comes to American Electric Power, the company's payout ratio is not ideal, but their valuation is slightly better than the other companies. For income hungry investors, it looks like Exelon could be the best deal. The company offers the highest yield at about 5.7%, and is the only one with a less than 100% payout ratio. No matter which other utility is selected, all three seem to be better options than Duke. A utility that's highly regarded, with clear financial issues, and negative free cash flow, would seem to be the perfect recipe for a dividend disaster.

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