The Over-Rated Utility Stock

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

The completion of Duke Energy’s (NYSE: DUK) merger with Progress Energy this quarter has made it the largest utility company of the US. Sentiments on "The Street" are generally bullish, with shorting activity in the stock decreasing over the past months. Most of the stock's returns come in the form of dividends. Amongst industry peers including Consolidated Edison (NYSE: ED), Exelon (NYSE: EXC), Southern Co. (NYSE: SO) and American Electric Power (NYSE: AEP), Duke’s dividend yield of 4.8% is second only to Exelon's 5.9%. More importantly, Duke's dividends account for about 90% of its total returns. As you’ll soon find out, it appears that dividends are the only plausible answer to why Duke's stock is in demand.

The Contradictory Fundamentals

Duke has the lowest Return on Equity (ROE) and Return on Assets (ROA) of its sector. It has an earnings growth rate of only 1.02%, lower then Southern Co's 1.43%, Consolidated Edison's whopping 30% and even American Electric Power's declining 2.74%. Look at the condition of its free cash flows (FCF) below: compared to all the peers, Duke's FCF is the only negative one!

DUK Free Cash Flow TTM data by YCharts

Duke has the second best debt to equity ratio amongst peers (0.95) but this can be deceiving. The D/E is not low because of a small amount of debt, but because of very high equity. When you compare the long term debt (LTD) of its competitors, Duke’s LTD of $20 billion is the second highest.

DUK Long Term Debt data by YCharts

Interestingly enough, while its gross profit margins are amongst the lowest, net profit margins have improved over the last few quarters to land at the second position amongst the peers. One reason is that the non-cash expense of goodwill impairment, which was around $300 million just two quarters ago and over $700 million two years ago, is not there anymore.

Unfortunately, price multiples don't look so attractive. Its price to book (P/B) is obviously the lowest because of the high equity account (as mentioned earlier). But its price to sales (P/S) is the second highest compared to competitors. Forward P/E is above that of Exelon and American Electric, and also larger than that of the average fwd. P/E of the industry, making it relatively an overvalued stock. Duke’s beta, the measure of market risk, is overall less than the average market risk of 1, but the utility is still riskier than most of its peers.

 

Important Considerations Going Forward

The past 12 months saw a rapid decline in natural gas prices. This was a result of over-supply, especially during the months of April-May this year, when natural gas traded against coal at its lowest in 10 years. Obama sees natural gas as the best alternate energy source to make the US less reliant on imported oil. As a result, we've recently seen utility companies gradually switching from coal to natural gas energy generation. According to the Reuters, natural gas prices are now rebounding (as can be verified from the chart below), and it looks like power generation using this resource will not continue to be the cheaper alternative for long.

Henry Hub Natural Gas Spot Price data by YCharts

Duke has been amongst the largest coal-backed power generation companies in the US. One of Duke's three business segments, U.S. Franchised Electric and Gas, produced 60% of its energy using coal in 2011. In 2012, reliance on Coal is expected to go down to 46%. Duke plans to increase its reliance on natural gas from 38% in 2011 to 41% in 2012. CEO Jim Rogers has recently announced, 'We’re retiring older coal plants and building new high-efficiency units fueled by natural gas.' Since his announcement, two coal-fired plants have been retired, one of which was one of the oldest and the largest.

Duke's increased reliance on natural gas could mean trouble for the company in the form of increased expenses, both from growing natural gas prices and capital expenditures on building new plants. Natural gas prices will most likely go up in the coming quarters because of higher demand. This, ultimately, means that Duke will be revising energy rates pretty soon. Rogers has acknowledged in a recent press conference that 'it’s never a good time to raise rates'. But we know it will become inevitable for the company if the worst happens.

Other major expenses may come in the form of repairing the company’s Crystal Rivers nuclear plant, which is expected to stay out of order for another 2 years and cost over $1 billion to fix. 

Botton Line

No important financial metric supports Duke's current pricing compared to others in the industry. Going beyond financials, there are other considerations that make me less optimistic about the company. Analysts at Yahoo! Finance and Market Watch understand this and have made a bearish call on this utility stock. Overvalued or not, it's definitely over-rated.

 


PalwashaS 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.If you have questions about this post or the Fool’s blog network, click here for information.

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