Stocks

Duke Energy Corp (DUK): A Reliable High-Yield Dividend Stock

Duke Energy Corp (DUK): A Reliable High-Yield Dividend Stock by Simply Safe Dividends

Duke Energy (DUK) is a favorite high-yield dividend stock for income investors, and it’s no wonder why. The company has paid uninterrupted quarterly dividends for 90 years and is set to increase its dividend for the ninth consecutive year in 2016.

Regulated utility companies such as Duke can provide safe retirement income with less risk than other types of businesses because of their predictable earnings, government-supported competitive advantages, and relatively low stock price volatility.

For these reasons and more, we own several utility stocks in our Conservative Retirees and Top 20 Dividend Stocks portfolios. However, just because a stock appears to have little fundamental risk does not mean it is a safe investment. The price paid for a stock is still very important, and that is especially true for low-growth utility stocks.

While utility companies can be relatively attractive income investments compared to bonds due to their potential for capital appreciation and moderate income growth, it’s still important to diversify a portfolio’s income streams in other sectors. Unexpected shocks can still happen across entire sectors, and no one living off dividends in retirement desires to deal with unpleasant, avoidable surprises when it comes to their nest egg.

Let’s take a closer look at Duke Energy’s business to see if it’s a stock we should consider for our utilities exposure.

Business Overview

Duke Energy’s history dates back to the early 1900s, and the company is largest electric utility in the country today with over $23 billion in annual revenue and operations reaching across the Southeast and Midwest regions. Duke Energy is a regulated utility company that serves approximately 7.4 million electric customers and 1.5 million gas customers, including customers from its planned $4.9 billion acquisition of Piedmont Natural Gas (more on this later).

Regulated utilities account for about 90% of Duke Energy’s business mix, but the company also has a commercial portfolio of renewables and gas infrastructure (5%) and an international energy business in Central and South America (5%), which it recently put up for sale.

The company’s regulated utilities primarily rely on coal (29%), nuclear (27%), and natural gas (23%) for its generation of electricity. Hydro and solar generate another 1% of the company’s total energy, and Duke Energy also purchases about 20% of its power.

Duke Energy

Source: Duke Investor Presentation

Business Analysis

Regulated utility companies are essentially monopolies in the regions they operate in. With the exception of Ohio, all of Duke’s electric utilities operate as sole suppliers within their service territories.

Building and operating the power plants, transmission lines, and distribution networks to supply customers with power costs billions of dollars, and it would generally be unprofitable and inefficient to have more than one supplier for a region. State utility commissions also have varying degrees of power over the construction of generating facilities, which further restricts competition.

The downside to the “monopoly” enjoyed by regulated utilities is that their services are priced by state commissions. This is done to keep prices fair for consumers and allow utility companies to earn a reasonable, but not excessive, return on their investments to encourage them to provide safe and reliable service.

A utility company’s attractiveness is largely driven by the states it operates in. Some have more favorable demographics (e.g. population growth) and regulatory bodies. Duke Energy’s mix is generally favorable. Over the past three years, base rate cases approved to Duke Energy have granted the company a return on equity ranging from 9.8% to 10.5% across the Carolinas, Ohio, and Florida.

We think these returns are very reasonable and suggest a generally favorable set of regulatory bodies in Duke’s core operating states.

In addition to the industry’s promotion of stability, Duke’s business has undergone a rather significant transformation over the last five years to improve the reliability of its earnings and cash flows.

Duke Energy’s biggest move was its acquisition of Progress Energy in mid-2012 for over $13 billion, significantly enhancing the company’s scale and market share in regions such as the Carolinas. Duke Energy has realized over $500 million in cost synergies from the deal and become a more efficient energy provider.

The company next entered the regulated pipeline business in 2014 to help its efforts to replace coal power plants with cleaner and cheaper natural gas generation facilities. In October 2015, Duke Energy announced a deal to acquire Piedmont Natural Gas for $4.9 billion to boost its push into gas.

Piedmont is a regulated gas distribution company that delivers natural gas to customers in the Carolinas and Tennessee. The company owns valuable gas infrastructure that currently supports Duke’s gas-fired generation in the Carolinas and will be further expanded to help with Duke’s ongoing conversion from coal to gas.

Regulated gas companies also offer strong and predictable returns on capital (Piedmont’s return on equity is about 10%) and should continue to benefit as a result of the natural gas surplus in the U.S.

Compared to electricity sales, which seem likely to slow as energy usage becomes increasingly efficient, gas has a stronger growth profile (Piedmont has investment pipeline growth of 9%). This is because new pipelines coming on-line will allow gas to replace dirtier power sources such as coal in regions where gas was previously inaccessible.

Piedmont will about triple Duke’s number of natural gas customers to approximately 1.5 million and help establish a platform for future growth in gas infrastructure projects. After the deal closes, Duke Energy expects roughly 90% of its assets to earn regulated returns, which should provide very reliable earnings.

Duke Energy has also gotten rid of non-strategic assets to lower its risk profile and improve the quality of its earnings. Management sold the company’s merchant Midwest commercial generation business to Dynergy for $2.9 billion in early 2015 and placed its struggling Latin American generation business up for sale in February 2016. Each of these businesses had less predictable earnings and greater macro risk.

Duke Energy believes its current business mix is now 100% focused on its core operations, whereas 25% of the company’s 2011 net income was derived from non-core businesses. Management now expects to spend $8 billion on new generation investments, $10 billion on gas & electric infrastructure, and $2 billion on commercial & regulated renewables to drive 4-6% annualized earnings growth over the next five years.

Overall, we believe Duke Energy has a strong moat. The company has excellent scale as the largest electric utility in the country and operates primarily in regions with generally favorable demographic trends and regulatory frameworks.

Management has simplified Duke’s mix to focus on core regulated businesses that provide reliable earnings and new growth opportunities in natural gas and renewable generation resources. While the utility sector is gradually evolving, we believe Duke Energy is here to stay for a long time to come.

Duke Energy’s Key Risks

Uncontrollable macro factors such as mild temperatures and industrial activity can impact Duke Energy’s near-term financial results. However, we believe these are transitory issues that have little bearing on the company’s long-term earnings potential.

The bigger risks worth monitoring are changes in state regulations, population growth trends in key states, increased environmental regulations, and execution of the company’s business strategy (e.g. large projects and