Duke Energy Corp. (DUK, Financial) is a popular holding in many retirement portfolios because of the company’s generous and dependable dividend.
The company has paid uninterrupted dividends for more than 90 years and increased its payout each calendar year since 2005.
With a dividend yield above 4%, a high Dividend Safety Score and low stock price volatility, Duke Energy is worth a closer look.
Let’s review the company's business and dividend profile to see if it is a solid candidate for investors living off dividends in retirement.
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 is a regulated utility company that serves approximately 7.4 million electric customers and 1.5 million gas customers, including customers from its $4.9 billion acquisition of Piedmont Natural Gas.
Regulated electric utilities account for 89% of the company's earnings, but it also has a fast-growing gas infrastructure and utilities business (8%) and a commercial portfolio of renewables (3%).
Management sold Duke Energy’s international energy business (which was 5% of earnings) last year to reduce its earnings volatility and focus the company completely on its core domestic operations.
The company’s regulated utilities primarily rely on coal and oil (34%), nuclear (34%) and natural gas (28%) for its generation of electricity. Hydro and solar generate another 4% of the company’s total fuel.
Duke Energy continues investing in cleaner power generation (e.g., natural gas), which has helped reduce its fuel mix of coal and oil from 61% in 2005 to under 35% today.
Business analysis
Many utility companies are essentially government-regulated monopolies in the regions they operate in. For instance, aside from in Ohio, all of Duke’s electric utilities operate as sole suppliers within their service territories.
Power plants, transmission lines and distribution networks cost billions of dollars to build and maintain in order to supply customers with power.
It is not economical to have more than one utility supplier in most regions because the base of customers is only so big relative to the investments required to provide them with electricity and gas.
Competition is further reduced by state utility commissions, which have varying degrees of power over the companies allowed to construct generating facilities.
The monopoly status of most regulated utilities has a major downside however. The price they can charge for their services is controlled by state commissions.
This is done to keep prices reasonable for consumers while providing utility companies with enough of an incentive to earn a reasonable return on their investments made to provide safe and reliable service.
As a result, it is very important to analyze the geographic regions a utility company operates in. Some states have more favorable demographics (e.g., population growth) and regulatory bodies. Fortunately, Duke Energy plays in generally favorable regions.
The company has earned a very stable and healthy return on equity between 9% and 11% in each of its regions over the last few years.
Source: Duke Energy Investor Presentation
These returns seem likely to remain stable over the coming years, in part because the rates charged to Duke Energy’s customers largely remain well below the nationwide average (only one of the company’s regions, Florida, charges a slightly higher rate).
This favorable differential should also make it easier for the company to win approval for higher rates in the coming years, supporting the returns earned by its ongoing growth projects.
Customer growth also remains positive across the company’s regions, supporting a base level of retail load growth in Duke Energy’s large electric business.
Combined with the company’s cost management, this growth has helped support its return on equity even without significant rate cases since 2013.
In addition to the favorable demographics and regulatory frameworks in its core markets, Duke Energy’s business has undergone a rather significant transformation over the last five years to improve the reliability of its earnings and cash flows.
The company’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 much stronger growth profile.
This is because new pipelines coming online will allow gas to replace dirtier power sources such as coal in regions where gas was previously inaccessible.
Piedmont roughly tripled Duke Energy’s natural gas business to 1.5 million customers and helped establish a platform for future growth in gas infrastructure projects.
In fact, management expects its business mix from natural gas to expand from 8% today to 15% within 10 years.
Besides acquisitions, Duke Energy has disposed 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 sold its struggling international energy business for a couple billion dollars in 2016.
Each of these segments had less predictable earnings and greater macro risk compared to the company’s domestic regulated businesses.
Duke Energy believes its current business mix is now 100% focused on its core operations, which only accounted for 75% of net income in 2011.
Overall, the company appears to have a strong moat. It has excellent scale as the largest electric utility in the country, owns a portfolio of complementary businesses with numerous growth opportunities and operates primarily in regions with generally constructive 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, Duke Energy is likely here to stay.
Key risks
Uncontrollable macro factors such as mild temperatures and volatile industrial activity can impact Duke Energy’s near-term financial results. These are transitory issues that have little to no bearing on the company’s long-term earnings potential however.
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 acquisitions).
The rates Duke Energy can charge its customers are decided at the state level. Fortunately, most of the regions Duke Energy operates in have generally favorable regulatory environments and are characterized by positive population and economic growth.
The company is banking on these conditions remaining stable as it continues investing for growth, however, and depending on states to approve rate increases in order to earn a fair return on its capital-intensive investments. The company will file several rate cases in 2018.
The Environmental Protection Agency (EPA) also creates risk for utility companies in the form of enhanced safety and emissions standards. Duke Energy recently estimated its notorious coal ash spill, which took place in North Carolina in 2014, could require cleanup costs in excess of $5 billion over the next few years.
The company hopes to pass on these higher costs to ratepayers, but it is too early to say how regulators will respond. Duke Energy has the financial strength to survive an unfavorable outcome, but environmental costs can clearly be substantial headwinds.
Additionally, over the very long term, electric utility companies will need to deal with the reality that demand is gradually decaying due to increasing energy efficiency and distributed generation (e.g., rooftop solar).
Duke has earmarked $1 billion for growth investments in commercial renewables over the next few years, but it is still a relatively small proportion of the overall business (3% of earnings). The company’s acquisition of Piedmont also helps the company with growth outside of regulated electric utility services.
A final risk to be aware of is tax reform. One of the issues at stake is whether or not interest expense should be allowed as a deduction on new debt. Utility companies require substantial amounts of debt to support their capital-intensive operations, so this proposal would hurt earnings.
Duke Energy estimates the net impact of the current tax reform blueprint in the House would be 5% dilutive to the company’s earnings by 2021 – not a big headwind, but not ideal either.
Dividend safety
We analyze at least 25 years of dividend data and over 10 years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with companies that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been and how to use them for your portfolio here.
Duke Energy’s Dividend Safety Score of 85 indicates that the company has a very safe dividend payment.
The company's projected payout ratio for 2017 is about 75%, which is in line with management’s target payout ratio (70% to 75%) but might seem risky at first glance.
Most regulated utility companies are able to maintain higher payout ratios without jeopardizing their dividends because they generate such stable earnings however. Duke Energy’s payout ratio has remained above 60% over the last decade.
Source: Simply Safe Dividends
The chart below shows regulated utility companies have very stable earnings. As a state-regulated monopoly selling non-discretionary services, it is no surprise to see Duke Energy’s consistent results, which enable it to run its business with a higher payout ratio.
Source: Simply Safe Dividends
Another factor impacting our Dividend Safety Scores is how well a company performs during recessions. Fortunately, utility companies hold up relatively well, making their dividends more secure.
In fact, Duke Energy’s revenue edged down by just 4% in 2009, and the company’s stock outperformed the S&P 500 by 15% in 2008. Customers still depend on electricity and gas even during periods of weak growth.
Source: Simply Safe Dividends
While Duke Energy’s business is generally steady, regulators control the rates the company can charge customers to ensure pricing is fair.
As a result, the returns the company can earn on its capital projects are capped and its return on equity has remained in the mid-single-digits over the last decade.
Source: Simply Safe Dividends
The biggest risk to utilities’ dividends is generally their dependence on debt and equity sales to run and grow their capital-intensive businesses.
As seen below, Duke Energy has less than $1 billion in cash on its balance sheet compared to nearly $50 billion of debt.
Source: Simply Safe Dividends
The company’s cash flow stability, however, thanks to its high mix of regulated businesses, has enabled Duke Energy to maintain an A- credit rating with Standard & Poor’s.
While the company’s free cash flow will remain restricted the next few years to fund its $37 billion of growth investments from 2017 to 2021, forcing it to lean even more on debt and equity markets, Duke Energy still appears to be a very healthy business.
In January, S&P affirmed Duke Energy’s ratings and revised their outlook from negative to stable. The company also has available liquidity of $5.6 billion from its credit facilities.
Overall, the stability of the utility company’s earnings and non-discretionary nature of its services significantly boost the safety of its dividend payment despite its levered balance sheet and relatively high payout ratio.
Dividend growth
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good and 25 or lower is considered weak.
Duke Energy’s Dividend Growth Score is 27, which suggests the company’s dividend is likely to grow slower than the market’s over the coming years.
While regulations generally protect utility company’s earnings and market share, they also limit growth opportunities. As a result, most utility businesses have below-average dividend growth rates, and Duke Energy is no exception.
Despite its slower growth profile, Duke’s dividend has certainly been reliable. The company has made quarterly dividend payments since the 1920s and increased its dividend each year for more than a decade.
While the company is far from joining the Dividend Aristocrats list, long-term shareholders have been rewarded with predictable income growth.
For most of the last 10 years, Duke Energy grew its dividend by an annualized rate of about 2%. Management recently doubled the dividend’s growth rate to 4% per year to better reflect its lower risk business mix and core earnings growth rate of 4% to 6% per year.
Management targets a 70% to 75% payout ratio for the company through 2021, which is right where the company’s payout ratio is expected to be in 2017.
Assuming Duke Energy’s growth projects go as expected and deliver 4% to 6% annual earnings growth, investors should be safe to assume about 4% annual dividend growth the next few years.
Valuation
Duke's stock trades at a forward price-earnings multiple of 17.9, which is in line with the utility sector’s forward P/E multiple of 17.9. The sector’s current P/E multiple, however, is 25% higher than its 10-year average multiple of 14.3. I have been reluctant to add new capital to my low-growth utility holdings for this reason.
The stock has a dividend yield of 4.1%, which is somewhat below its five-year average dividend yield of 4.3%.
Assuming Duke Energy’s growth projects continue helping its core businesses realize 4% to 6% annual earnings growth over the coming years, the stock’s total return potential appears to be about 8% to 10% per year (4.1% dividend yield plus 4% to 6% annual earnings growth).
Since 2009, the company has met its long-term annual adjusted diluted earnings per share growth objective, supporting higher confidence behind management’s guidance.
The company’s earnings growth is also driven by relatively low-risk activities – base rate increases, investment riders, major capital projects to modernize the grid and growth in its gas utilities and infrastructure business.
Considering the stability of Duke Energy’s earnings, which are largely comprised of regulated utility operations, the stock seems a bit expensive today.
I would feel more comfortable buying the stock at a price closer to $70 per share, which would put its P/E multiple more in line with its long-term average and push the dividend yield closer to 5%.
The dividend is especially important considering the company’s relatively low-growth profile. In fact, 75% of Duke Energy’s total return was achieved through dividend reinvestment (rather than price appreciation) over the last 20 years.
Conclusion
Duke Energy is one of the best utility stocks for safe dividend income. The company’s regulated operations provide predictable earnings, and most of the regions Duke Energy plays in are also characterized by favorable demographics and historically constructive regulatory bodies.
While there is some long-term risk resulting from lower electricity usage trends, the rise of clean renewables and the company’s major growth investments, Duke Energy seems likely to remain a safe and appealing income investment for many years to come.
At a more attractive entry price, I would like to add Duke Energy to our Conservative Retirees dividend portfolio.
Disclosure: The author had no position in Duke Energy at the time of writing.
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