Duke and Other Utility Companies: The Switch to Natural Gas

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

Utilities are considered to be amongst the least volatile investments. Their defensive nature against changing business cycles makes them some of the safest plays on the market. However, when you look at the performance of the top utilities ETFs, you want to question if utilities really are the answer. SPDR Utilities ETF has had a year-to-date negative return of 1.9% and a five year negative return of 16.82%. Similarly, Vanguard Utilities ETF has returned negative 1.5% year-to-date and negative 13.6% for five years.

Duke Energy (NYSE: DUK) reported its third quarter earnings on Thursday of last week, and its stock fell shortly afterwards. Duke missed revenues by $70 million, reporting $6.72 billion, but beat EPS estimates by $0.02, reporting adjusted EPS of $1.47. The stock's year-to-date price appreciation return is -6.1%. In one year the stock has returned -0.5%, and today it is down another 1%. More than two thirds of this overrated stock's total returns come in the form of dividends, and the stock is down 5.2% from the time I first wrote on it in early October.

Duke's Q3 Summary

Duke Energy's third quarter results jointly include results of Duke and Progress Energy, with which it merged in mid-year 2012. Duke's third quarter's adjusted EPS of $1.47 is down $0.03 from prior year's Q3 adjusted EPS of $1.50. This adjusted EPS excludes $457 million in merger-related costs, a one-time $180 million in costs to complete a new coal plant in Indiana, and other unusual items. The company owes this decline to unfavorable weather conditions. However, bear in mind that the company benefited from higher consumer rates in the Carolinas.

On non-adjusted GAAP basis, Q3 EPS was $0.85, compared to $1.06 for the prior year quarter. Unadjusted net profits were $594 million, up from last year Q3's $472 million. The decline in non-adjusted EPS, despite higher net profits, is a results of increase in post-merger total shares outstanding which rose to 699M from 444M last year.

Post-merger total operating revenues almost doubled from $3.96 billion last year to $6.72 billion this year, but so did the long term debt. Duke's long-term debt has increased to $35 million from $17 million at year-end 2011. Cash & equivalents are also down from $2.1 billion at year-end 2011 to $1.76 billion this year. In addition to the merger costs, a rise in debt and a fall in cash is a result of high capital investment costs that Duke had to face this year, as it makes a switch from coal-powered energy generation to natural gas-powered generation.

It's official! Natural Gas is the way to go!

With President Obama back in the office, we can expect that the transition to green energy resources will continue. The switch from coal to natural gas has picked up pace. Utilities are expected to retire another 27,000 megawatts of coal-fired capacity within the next four years of the President's reign. While some utility companies like American Electric Power (NYSE: AEP) and Southern Co. (NYSE: SO) have tried fighting legal battles against environmental regulations before adopting Natural Gas as the economical alternative, Duke decided much earlier to replace its coal-fired plants with natural gas.

In order to comply with environmental safety rules, Duke is closing up on its $9 billion program to modernize its plants. The utility company is also retiring 6,800 megawatts of its older, less efficient coal-fired capacity. Duke's investment in new natural gas-fired plants is expected to start paying off in the coming years. Its natural gas projects in the Carolinas, Dan River, Lee, and Sutton are within the assigned budget so far. The Dan River and Lee plants are expected to be available for use by year end.

The large capital investments to achieve this transition are being partly met through increase in electricity rates in the areas of investment and partly through debt. Duke achieved better results despite unfavorable weather condiitions, due in part to these very rate revisions this year. Duke's subsidiary, Progress Energy, with which it merged four months ago, has also filed its first case of revised rates in 25 years in North Carolina. The new rates are expected to go into effect by mid-2013.

Nonetheless, in Duke's CEO Jim Rogers' view, politics (read: Obama's love for natural gas) is not affecting the switch from coal to natural gas plants. He suggests it is the low natural gas prices instead. He also believes coal will continue to power about 35%-40% of U.S. total electricity demand for this year.

You can see a comparison of natural gas prices to Duke's stock price below. As one rises, the other falls--maybe that's coincidental. But also notice, natural gas prices are no longer as low as they were in the second quarter. Natural gas's spot price is  starting to head north as demand for natural gas rises. This poses a potential threat to utilities heavily reliant on natural gas as an input.

<img src="http://media.ycharts.com/charts/41d26e68b428a136cc68c5c0f46a1cb8.png" />

DUK data by YCharts

Before Duke's merger with Progress Energy, Exelon Corp (NYSE: EXC) was the largest utility company of the US. Despite generally better fundamentals than Duke, Exelon's stock is down over 30% in just one year, and it continues downward. This, I believe, is in part due to Exelon's failure to efficiently make the switch to Natural Gas as an alternate energy source. Exelon depends on its coal-fired nuclear plants for 90% of its energy generation. After the Fukushima Daiichi nuclear disaster in Japan, natural disasters in the US, like the recent hurricane Sandy, also raise safety concerns about nuclear plants.

Duke and Exelon's peer Southern Co. has, in a sensible move, shifted its focus from nuclear and coal sources to natural gas. Nuclear power presently supplies only 16% of Southern Company's generation. Natural Gas is now the biggest energy generation source employed by Southern Co. that powers half of its energy generation this year, even surpassing coal.

Beginning this year, American Electric Power generated 24% of its energy through natural gas. Three years ago, AEP depended upon coal as its main energy source, generating 66% of its energy through coal. The utility now projects dependence on coal to be cut down to 51% by 2016 and dependence on natural gas and other environment friendly renewable resources to increase. American Electric Power is also in the process of building new natural gas plants, some of which went live earlier this year.

Duke Energy’s current fuel mix for generation is 47% coal, 25% gas, 20% nuclear and 8% hydro & other. As for the stock, in my view Duke is close to its fair valuation at the moment. Management's full year adjusted diluted EPS guidance lies within the range of $4.20 to $4.35. Analysts expect full year EPS of $4.27. A forward P/E of 14.69 and an avgerage EPS of $4.27 gives it a fair price of $62.80. It's a hold!

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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