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Is There Some 'Light' in the Electric Sector?
Posted by: Victor Selva (IP Logged)
Date: October 16, 2013 05:04PM

The electric industry could face several risks like lower electric margins, a higher interest rate environment and an unfavorable commodity price trend. The S&P Electric Utilities Index increased 3.59% year to date. So let's take a look at two companies in this sector and see which one is doing better and is thus the best investment.

The AES Corporation (AES) is a global power company operating across 25 countries in five continents. The company operates in two lines of business: Generation and Utilities. A large exposure in markets like China, France, Spain and several eastern European countries provides geographic diversification that reduces region-specific risks, as well as a highly diversified earnings base.

International Operations & Acquisitions

The company has a good presence in key markets like Chile, the Philippines, India, and Vietnam, where demand for electricity is expected to grow in the future. Geographically, revenues come from: Latin American (58% of 2012 revenues), North American (21%), EMEA (7%), and Asia (4%). By countries, the largest exposures are in Brazil (32%), the U.S. (21%); Chile, Colombia and Argentine (16%); and Mexico, Central America and Caribbean (9%).

In November 2011, the company purchased DPL Inc. for $4.7 billion (cash $3.5 and $1.2 billion of debt) expanding the firm´s presence in the North American asset base while reducing its dependence on Latin America. The acquisition will generate a more stable cash flow and boost earnings per share.

Global and Local Growth Strategy

Global strategy focuses on large-scale projects. With a geographic focus to improve profitability, it concentrates on mergers and acquisitions, exploring opportunities in the climate change business such as the production of greenhouse gas reduction activities and related industries that involve environmental issues. On the local growth level, the company´s plan is to expand itself focusing on constructing new power plants.

Finally, excess cash flow makes the company reinstated its quarterly dividend in the 2012 fourth quarter after not paying one for 20 years. The dividend yield is 1.17%, well below the 4% to 5% typically offered in the utilities sector and the S&P 500 mean of 2.1%.

The Largest U.S. Utility

North Carolina-based Duke Energy Corporation (DUK) provides electric and gas utility services in the southeastern U.S. and Ohio. The company is a diversified energy company with a portfolio of domestic and international, natural gas and electric, regulated and unregulated businesses.

The Successful Merger

Duke is the largest regulated utility in the U.S. after its merger with Progress Energy. Now operations will account for over 7.1 million electric customers in the Carolinas, Florida, Indiana, Kentucky and Ohio. The merger also increases its ability to build new power plants to meet future greenhouse-gas emissions limits.

Regulated & Unregulated

Duke's regulated utilities provide a stable source of earnings and represents 90% of consolidated earnings. The company has the ability to take higher customer rates from regulators, translating into higher profits. The commercial and international segments represent the remaining 10% of Duke's operating income and are generally unregulated. In the international markets, the company conducts operations through Duke Energy International LLC that focuses on power generation in Latin America. For example, Brazil represents about half of total operating revenue. Market-based rates and annual inflation adjustments are key drivers for the firm. Other international operating revenue abroad comes from a mix of Latin American countries and a joint venture in Saudi Arabia where the company owns a 25% interest in National Methanol Company, the large producer of methanol and methyl tertiary butyl ether.

An interesting feature of the company is its commitment to returning cash to investors in the form of dividends. The current dividend yield is 4.4%, which is very good to protect the purchasing power, especially considering that it is above the industry as well as S&P 500 average dividend yields.

Finally, I always like to see one of the most important financial ratios applying to stockholders, the best measure of performance for a firm's management: the return on equity.

Company ROE ComparedtoIndustry Mean (=6.6)
AES Corporation (20) Below
DukeEnergyCorporation 4.3 Below

It is very important to understand this metric before investing in a high-growth company. Remember that when a business's return on equity is negative, in this case because the company´s bottom line failed, it means its shareholders are losing, rather than gaining value.

Final Comment

Although there is above-average earnings growth for AES, as well as a better balance sheet in the next years, its low dividend yield and negative bottom line keep me concerned. On the other hand, Duke recently merged with Progress Energy Inc.; its better balance sheet and above industry average dividend yield makes me feel confident about this stock.

Hedge fund gurus like Steven Cohen and Ken Fisher added this stock to their portfolios, so I would advise fundamental investors to consider adding Duke to their portfolios as it seems to be an attractive option for investors.

Disclosure: Victor Selva holds no position in any stocks mentioned.

Guru Discussed: Ken Fisher: Current Portfolio, Stock Picks
Stocks Discussed: AES, DUK,
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