Duke, CenterPoint Both Overvalued, Not Worth the "Safety"
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
There are few sectors that I am not interested in investing in. I tend to not buy into the "stock picking" claims of the so-called "experts" and believe that it will often lead investors into unpredictable market collapses. The key is diversification in backing attractive undervalued assets while staying away from the bubbles. Finding the next "winner" is very hard in an efficient market hypothesis.
In an ironic sense, it is therefore ironic that we value investors should be thankful that the market is not perfectly efficient. There are behavioral anomalies that almost always exist and will prevent securities from trading at their fair values, or what they would be worth to the economy or in a buyout. But not all behavioral anomalies are positive for new investors. The "herd mentality" often drives stocks above their fair values. So, getting back to the first statement of this post - "[t]here are few sectors that I am no interested in investing in - … well, actually there is one: utilities. Although some may be undervalued, the industry at large is overvalued. This is because many investors have flocked to them given concerns over the macro economy. They offer very high dividend yields north of 4% but what investors fail to consider is that they only offer steady income because they have poor growth prospects.
To consider whether the safety from income support outweighs the poor growth prospects, we need to consider the nature of dividend distributions. A company can either have "retained earnings" or make "dividends" to shareholders. In a sense, distributing dividends is a tacit admission that management does not believe it can properly reinvest. That is to say, shareholders who are investing in the company supposedly know more about creating value than the company does itself. While I like dividends for lowering uncertainty, they need to come with reasonable enough growth expectations in order to warrant an investment. Unfortunately, that is not really the case for large utility companies…
Duke Energy (NYSE: DUK), for example, trades at around 20x past earnings and is a major regulatory target. Nowhere was this best illustrated in the merger with Progress Energy (NYSE: PGN) where Duke had to make so many concessions to regulators that virtually, in fact deleteriously, no room was left for value creation. If the concessions to regulators were not enough, then certainly it was for Progress shareholders.
The transaction created a mammoth with a $24 billion top-line figure. Supposedly, fuel savings to Carolina will help drive volumes but relationships with Florida regulators have soured, and the upside story is no longer looking too hot. Possibly, Duke can generate 4% - 5% EPS growth over the next few years through 2016, but I wouldn't hold my breath. Perhaps the transaction was done more to address threats from consolidation elsewhere. Constellation Energy (NYSE: CEG) recently merged with Exelon in a $7.9 billion dollar deal. The transaction would have made the resulting company were it not for the Duke-Progress combination. Both deals will result in synergies through consolidation of back office functions but prices will still be tightly regulated regardless of economic scale. If anything, larger scale now puts a greater regulatory target on Constellation and Duke.
Even if it does generate something to the tune of 5% EPS growth, pressure will mount on the performance of the regulated assets, which have little transparency as they currently stand. And board independence is very concerning. They should have served a more active duty in reviewing the merger agreements management was endorsing. Now that Johnson has walked away with $44 million, what are the shareholders left with?
CenterPoint Energy (NYSE: CNP) similarly does not attract me. It is a relatively cheap utility at around 17x forward earnings (which says something about macro uncertainty). Only 4% annual EPS growth is forecasted over the next 5 years - not nearly enough to justify the current valuation.
In fact, if you project EPS forecasts out into 2016 and use a 15x exit multiple with a generous 7% discount rate, you will find that the stock's fair value is $15.40 - well below the current market price. And while the dividend yield of 3.9% is compelling, it is lower than many peers and likely to take a hit should dividends be classified as "ordinary income" for tax purposes. While I do not believe that dividends will see a 164% tax hike, I don't think multiples will elevate much higher from Congressional action or "dis"-action. The stock is already viewed as a safe income provider and this will go away when investors focus on higher risk and higher reward during a full recovery.
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