Things were looking up for Duke Energy (DUK) . The electric utility company was steadily moving ahead on its plans to use less coal to generate power and to exit its international businesses. It was also getting close to completing a multibillion-dollar acquisition of Piedmont Natural Gas, something it did in October.
But the prospect of a Federal Reserve interest rate hike late this year has weighed on shares of Duke Energy and other utilities. (Fed policymakers meet this week and are widely expected to raise their short-term interest rate target.)
Investors shouldn't fret, however. Duke Energy has a lot going for it, and the 6.8% selloff in its shares over the past six months provides an excellent opportunity to get in on this stock at a bargain price. The 4.5% yield sweetens the deal.
Duke Energy serves 7.4 million U.S. customers and has three primary business segments: electric utilities and infrastructure (in the Carolinas, Florida and the Midwest), gas utilities and infrastructure, and commercial renewables. It plans to make about $25 billion of regulated growth investments from 2016 to 2020 and says this supports adjusted earnings per share growth in the 4%-6% range from its core business.
Electric utilities are boring and "unsexy" businesses, so their stocks tend to trade without the extreme volatility of higher-risk, speculative businesses. Still, leading utility stocks have logged significant losses in the past six months. Southern (SO) is down 6.7%, Consolidated Edison (ED) is down 7.8%, American Electric Power (AEP) is down 10% and PPL (PPL) is down 16%.
The blame falls squarely on the Fed and the near-certain speculation that it will raise interest rates. Utilities borrow a lot to fund their continuing investments, so higher rates tend to mean higher borrowing costs.
Higher rates don't mean profits vanish, however. It all depends on the business and risk management. We are reasonably confident that Duke Energy, which has a history of successfully integrating large acquisitions, is charting a new path for itself.
Duke's electric utilities and infrastructure segment already gives it small but decent growth. Duke has taken care to limit exposure to earnings volatility too. For instance, its deals to exit Latin America by selling off assets for more than $2 billion are not just moneymaking moves. The deals ensure foreign currency exposure is brought down to zero. Forex can play havoc on an otherwise simple profit and loss statement. By offloading the international business, Duke Energy has now become an entirely U.S.-focused business.
The slow southbound grind on Wall Street for Duke Energy has meant that its valuations are now pretty reasonable. The stock trades at a price-to-earnings ratio of 16.4 based on earnings estimates for the next year. This is a discount to peers like NextEra Energy (NEE) , which has a forward P/E of 17.7, and Consolidated Edison, which has a forward P/E of 17.5.
So, in terms of valuation, there is little to complain about. From a pure income perspective, Duke Energy offers a lucrative 4.5% yield backed by the knowledge that the company, despite its acquisitions and investment expenses, has hiked annual dividends for close to a decade.
Putting the pieces together, the derisked, regulated business of Duke Energy, coupled with gas exposure (via its purchase of natural gas giant Piedmont) has laid the foundation for solid returns over the medium term. If you buy Duke stock today, you can expect a total return of 12%-13% in the next year without taking much risk.
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