This Utility Is Making Progress, But Is It Enough?

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I'll admit that I have a problem with many utility stocks. I firmly believe that income-hungry investors are chasing yield in these shares without regard for valuation. There are multiple examples of stocks in this industry that are trading for two, three, or even four times their expected growth rates. I tend to stick with the Peter Lynch theory that the P/E ratio of a company should be somewhere near the company's growth rate. He specifically pointed out examples where the P ran too far, and the stock had to either “take a breather”, or drop to bring this ratio back in line. As one of the most successful investors, if it's good enough for Lynch, it's good enough for me. I'm aware that stock prices don't exist in a vacuum, but when short-term interest rates rise, some of these stocks are going to get clobbered. One of the poster children for this set up is Duke Energy (NYSE: DUK).

I'm not saying Duke is a terrible company. I've been impressed with their ability to manage the unpredictable regulatory environment and grow their earnings. Their recent merger with Progress Energy makes Duke the largest utility in the country. However, I have trouble with the fact that the stock sells for 14.4 times next year's projected EPS, and yet is expected to grow at just over 3%. Duke isn't the only one in this boat. Other popular utilities like Southern Co. (NYSE: SO), Exelon (NYSE: EXC), and Consolidated Edison (NYSE: ED) also come to mind as problem stocks if short-term rates rise. Each of these companies is selling for a multiple that is at least three times their respective growth rates. However, there are huge differences between Duke and these other three companies behind the scenes. The good news for Duke investors is the company is improving its operations. The bad news for investors is, the company has some difficult challenges ahead.

In the last three months, Duke saw EPS drop by 2% even though Progress customers were added to the ranks. The company's largest division, U.S. Franchised Electric and Gas, saw a huge increase in segment income of 92.16%, due primarily to the addition of these Progress customers. While the International Energy and Commercial Power divisions saw a drop in segment income, they are small pieces of the pie compared to the company's U.S. Operations. Let's face it though; one of the main reasons that investors buy shares in a stock like Duke is for the dividend. Since the company's financials determine the sustainability of the dividend, let's look at the company's financial statements.

One of the main reasons that EPS fell on a year-over-year basis is, the company's outstanding share count increased over 58% because of the merger. In addition, the company's operating margin dropped off a cliff. Last year, Duke's operating margin was 25.43%, in the current quarter this measure decreased to 18.71%. When you look at their competition, it's clear Duke has some work to do. Southern Co. and Consolidated Edison reported operating margins of 34.46% and 24.72% respectively. You can see that before the merger Duke would have placed comfortably in the middle of these two companies on this measure. Exelon has run into its own set of problems with pricing, and its own merger, and the company's operating margin has dropped to just 9.19%. Though Duke is comfortably doing better than Exelon, the company is going to have to squeeze out some serious cost savings to return to their previous level of efficiency. One positive note is because of the addition of Progress, the company's operating cash flow increased by over 31% year-over-year. In addition, the structure of the deal allowed Duke to basically maintain their debt-to-equity ratio. Duke is moving in the right direction with their dividend payout ratio as well.

It's no stretch to say that Duke's free cash flow payout ratio has been terrible for a while. In the prior two years, the company reported negative free cash flow. Even in the most recent three quarters, Duke reported negative free cash flow. However, in the last three months, the company was able to report positive free cash flow. While this would seem like a huge win for the company, their free cash flow payout ratio still sits at a dangerous 143%. If we look at their competition, Duke again has some work to do. Exelon has a very high dividend right now at 7.24%, but management has already tipped its hat by saying the dividend would have to be “revisited” if pricing doesn't change. Exelon is dealing with a 90.78% payout ratio currently, and based on the huge drop in the stock it seems the market is counting on a dividend cut. The two healthier utilities of the group are Consolidated Edison and Southern Co. Each of these companies has a payout ratio of less than 60%, and each offers a competitive yield of at least 4.3%. With Duke offering a yield of about 4.81%, the natural question to ask is, why would investors take a risk on Duke and their higher payout ratio?

To be honest, I don't have a great answer for that question. Duke is making progress, but by all accounts Southern Co. looks like the best stock of the bunch. The company pays a yield that is within 0.3% of what Duke offers, and yet their payout ratio is just 41.2% versus 143% at Duke. The fact that Southern Co. has the highest operating margin of the group means the company should be able to turn revenue into earnings more easily. In addition, while Duke and Consolidated Edison are expected to grow earnings by about 3%, Southern Co. is expected to see over 5% EPS growth in the next few years. Duke shareholders have been rewarded handsomely by sticking with the shares, but other utilities seem to offer a better value. Buyer beware, making progress is one thing, but Duke still has big challenges and their small advantage on yield doesn't seem worth the risk.

MHenage has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Exelon and Southern Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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