Duke Energy Corporation: Growing Debt Should Trouble Investors
Summary Duke Energy consistently runs cash flow deficits to fund the large dividend yield. The company will have added $14B in debt from 2010-2017 using management guidance. Management may be tempted to add on risk by scaling up potentially higher margin international operations to grow cash flow, but 2015 shows how volatile these earnings can be. Duke Energy Corporation (NYSE: DUK ) is the largest utility in the United States, with a heavy concentration of its revenues coming from its regulated businesses in the Midwest, the Carolinas, and Florida. As the largest publicly-traded utility with a consistent dividend-paying history, Duke Energy has become a staple of retail investors seeking safety and reliable income in what has been a volatile market. But below the surface, Duke Energy appears to have some issues driven by its size – the 2012 merger with Progress Energy has created a massive entity with over 50 GW of energy generation in the United States alone. With so many assets, can Duke Energy maintain competitiveness and efficiency to remain on par with smaller, more nimble peers? And has the debt load of the company, now around $40B, become too much of a burden? Burgeoning Debt Load Utilities have just a handful of uses for the stable cash flow they generate. Outside of upgrading and maintaining their property and equipment (capital expenditures), most operational cash flow is used to either acquire new businesses, pay down debt, or give back to shareholders (dividends/share repurchases). (click to enlarge) Both pre- and post-merger, Duke Energy has consistently outspent what it earns from its operations. Cash from operations has not been able to cover the cost of capital expenditures and dividends over the past six years, with this deficit always exceeding one billion dollars or more a year. To fund these consistent shortfalls, Duke Energy has issued more than $8B in debt over this time. Because of this, the company now spends over $1.6B each year on interest expense, or more than 30% of its annual operating income. These levels aren’t unreasonable provided that deficit spending ends. (click to enlarge) * Duke Energy 2014 Form 10-K, projected future cash flows However, per management’s guidance above, this is unlikely to change in the short term. Duke Energy projects it will add another $6B of long-term debt in 2016/2017, a roughly 15% increase which will lead to around $200M in additional annual interest expense. While operational cash flow is slated to increase over time as these capital expenditures are recovered through rate increases, further continuation of this trend is still simply unsustainable. Net debt/EBITDA stood at 3.2x at the end of 2010; in 2014, the number reached 4.9x, with similar numbers likely in 2015. The decision to repatriate $1.2B in cash generated by the International Operations segment (incurring nearly $400M in taxes) was likely driven, at least in part, by the need for funds to pay for obligations like dividend payments. We aren’t the first to notice this as these negatives haven’t slipped by the big three debt agencies. Duke Energy has seen the firm’s ratings consistently fall below the credit quality ratings of other large utilities like Dominion Resources (NYSE: D ) or better capitalized firms in other industries like Microsoft (NASDAQ: MSFT ). Trends regarding debt should be concerning to investors, and I think it is a question both shareholders and the analyst community alike must begin taking a firm stance on with management. Asset Retirement Obligations (click to enlarge) As a further headwind, asset retirement obligations are costs associated with the cleanup and remediation of Duke Energy’s long-lived assets. As an example of these costs, when Duke Energy closes down a nuclear power plant, there are costs associated with decontamination and property restoration that the company must bear. Asset retirement obligations are a fuzzy area of accounting, in my opinion, where management has a lot of discretion in calculation costs. What we see with Duke Energy is that these obligation costs have ballooned, according to management estimates, from $12B in 2012 to $21B in 2014. These increased costs primarily relate to the Coal Ash Act, which occurred as a direct result of the Dan River spill and other coal ash basin failures. Duke Energy’s management notes a significant risk associated with these new obligations: “An order from regulatory authorities disallowing recovery of costs related to closure of ash basins could have an adverse impact to the Regulated Utilities’ financial position, results of operations and cash flows.” – Duke Energy, 2014 Form 10-K At best, these additional liabilities will increase depreciation expenses for Duke Energy, which will impact earnings per share. At worst, public outcry and regulators will force Duke Energy to bear some or all of these coal ash cleanup costs on its own rather than recover the costs through rate increases on customers, either directly or indirectly, through more harsh rate case approvals. Compounding, Don’t Forget It (click to enlarge) Duke Energy likely draws in quite a few income investors based on the current yield. At an approximate 4.65% yield as of this writing, shares pay a handsome premium to many other utilities. However, investors need to remember the impact of their investing time horizon and do their best to anticipate the value of their investments decades from now. Based on our look at Duke Energy’s debt and recent dividend increase history, it is safe to assume big bumps in the dividend are not on the table. 2.0-2.5% annual raises, in line with recent historical averages, may actually be optimistic, in my opinion. As shown above, for a dividend-payer that pays 4.65% today and grows its dividend at 2.0%/year (not far off Duke Energy’s 2.2% average for the past five years), the yield-on-cost of this investment will be 5.13% at the end of year six. Dividend B, with a 3.5% yield today and 8% annual dividend growth, would actually have a higher yield-on-cost in just a mere six years. Conclusion Duke Energy trades cheaply on most valuation measures, but that appears to be within good reason. Yearly cash flow obligations consistently exceed operational cash flow, which has led to a growing debt burden that will approach $50B in just a few short years. Without cuts to spending (freezing the dividend, cutting operational costs) or raising additional revenue somehow (through risky expansion in non-regulated businesses), there doesn’t seem to be a clear path for Duke Energy to grow and deleverage its balance sheet. I believe investors would be much better served looking at smaller utilities as a means of gaining exposure to the sector, such as through Southwest Gas Corporation (NYSE: SWX ).