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Earnings Review: Drought, Currency Impact On International Business Dents Duke’s Q4 Results

The largest electric utility company in North America, Duke Energy (NYSE: DUK ) reported its fourth quarter and full-year earnings for the fiscal-year 2015 on Thursday, February 18th. The company reported adjusted earnings per share of 87 cents, 7% below consensus estimates of 94 cents . Management attributed the earnings miss on the impact of mild weather conditions and the negative impact of currency translation, as revenue earned from international operations in South America was worth less when translated back into the U.S. dollar. For the full year, revenue stood at $23.46 billion , down 2% from 2014’s $23.93 billion. Operating income rose by 2.1% year over year as operating expenses fell by close to 3% on lower fuel expenses. The decline in operating costs was offset by higher operation and maintenance expenses, as well as higher depreciation and amortization expenses. Segment wise, increased pricing as well higher wholesale net margins led to a 9% increase to $601 million in the reported adjusted income of the Regulated Utilities division. Lower margins for National Methanol and the unfavorable impact of currency translations meant that the adjusted income of the International Business dropped by 5.6% to $68 million for the full year. The company’s commercial power business reported an adjusted income of $41 million for the full year, up 28% from last year’s $32 million, on the back of higher margins in wind and solar generated power. The commercial power business which now includes unregulated renewable assets and commercial electric and gas transmission investments but not the Midwest Commercial Generation business, which the company sold to Dynergy last year. We have a $68 price estimate for Duke Energy , which is about 9% below the current market price. Key Drivers For 2016 Due to a tougher regulatory environment, Duke has had to forego short-term profitability and focus on optimizing its asset base. The company has focused on increasing investments in natural gas and renewables, while getting lowering its exposure to unregulated markets. In 2016, the company expects most of its growth in the regulated utilities business to come from opportunities that will be unlocked by the $5 billion investments in growth that it has made. Management expects retail load to grow by around 0.5% year over year, and that should result in some bottom-line growth for the company. Most of its growth in 2016 is expected to result from the integration of the North Carolina Eastern Municipal Agency’s (NCEMPA) assets that it purchased for $1.25 billion and closed in July of last year. Additionally, the company has been focusing on reducing operational and maintenance costs. On the commercial power front, Duke expects to benefit from a $1.5 billion investment in Renewables and from its stake in the joint venture in the Atlantic Coast pipeline with Piedmont and Dominion. However, there has been a lag in getting regulatory approval for operations in certain jurisdictions. This, coupled with the loss of earnings from the Midwest power generation business, will offset some of the gains from new investments. On the international front, management said that reservoir levels in Brazil increased throughout 2015, which will enable the company to purchase power at a lower cost in 2016, resulting in higher margins. However, lower exchange rates between currencies in South America and the U.S. dollar, and low Brent crude oil prices, will mean lower revenue for the company’s National Methanol business. Additionally, Duke is considering exiting from its international business, but no timeline has been specified on this front, making the performance of the international business in 2016 less important. Most of Duke’s growth will come from its core business, which the company expects to grow between 4% and 6% in 2016. Disclosure: No positions.

Financial Stress Index Is Screaming, ‘Bear Market Rally’

What if investors had a way to determine the extent of “stress” in the financial system? And what if those stress levels could tell investors whether or not riskier assets (e.g., stocks, higher-yielding debt, etc.) can succeed without definitive U.S. Federal Reserve intervention? Consider the Cleveland Financial Stress Index (CFSI). The CFSI monitors the well-being of a wide range of financial markets, including credit, equity, foreign exchange, funding, real estate and securitization. According to the Cleveland Fed, a CFSI reading greater than 1.855 represents the highest threat level to the financial system. We’re sitting at 1.91. Click to enlarge Both the Asian Currency Crisis in 1998 and the eurozone Debt Crisis in 2011 wreaked havoc on the typical U.S. stock. Small company shares, mid-sized company shares as well as shares of the average large company declined 20%-30%. On the other hand, when the popular market cap-weighted Dow and S&P 500 barometers approached the 20% bear market line in those crises, the U.S. Federal Reserve promptly stepped in. In 1998, the Fed orchestrated a bailout of the infamous hedge fund, Long-Term Capital Management, and sharply cut interest rates. In 2011, the Fed helped coordinate worldwide central bank stimulus as well as introduced “Operation Twist” — selling short-dated U.S. Treasuries to buy longer-dated U.S. Treasuries for the purpose of depressing borrowing costs. What about 2008? The U.S. Federal Reserve did slash interest rates dramatically in the first quarter. What’s more, the Fed organized the bailout of Bear Stearns in March of that year, sparking a relief rally that kept the S&P 500 well above the bear market demarcation line for three more months. But it wasn’t enough. Even cutting the Fed Funds overnight lending rate to 0% by December wasn’t enough. The Fed wasn’t able to inspire confidence again until quantitative easing (QE) began in 2009. The recent rally for riskier assets here in 2016 is similar to relief rallies in the past; that is, shorter-term gains often overshadow longer-term financial distress as well as deteriorating market internals. For instance, a rising price ratio for iShares 7-10 Year Treasury (NYSEARCA: IEF ):iShares iBoxx High Yield Corporate Bond (NYSEARCA: HYG ) is indicative of a preference for risk-off investment grade credit over speculative higher yielding credit. Is there anything in the present IEF:HYG price ratio to suggest that the longer-term trend is abating? Now step back in time to the 10/2007-3/2009 bear. The IEF:HYG price ratio steadily marched higher until March of 2008. The Fed bailout of beleaguered financial firm Bear Stearns temporarily provided relief for risk assets, but the relief rally ended three months later. Once more, the IEF:HYG price ratio ascended like a mountain climbing enthusiast. History teaches us that the Fed is unlikely to ride to the rescue unless the Dow and the S&P 500 challenge bear market territory. Even then, the rescue endeavor would require sufficient firepower. These historical precedents, then, make the current relief rally particularly troubling. For the Fed to wait until the major benchmarks buckle means that the financial system may grow increasingly unstable. And by then, cutting rates back to the zero bound or twisting shorter-term maturities to purchase longer-dated ones may be insufficient. Again, the Fed’s own assessment tool places the financial system at the highest level of instability, Grade 4 “Significant Stress.” Recall that the iShares All World Ex US Index ETF (NASDAQ: ACWX ) has already depreciated 25%-plus from the top. Small caps in the Russell 2000 (NYSEARCA: IWM )? Ditto. Transportation stocks in the iShares DJ Transportation ETF (NYSEARCA: IYT )? Nearly 30% erosion. Bear market descents have occurred in virtually every stock arena. It follows that when a wide range of stock types are fading, and when a wide range of debt types of different credit quality relative to U.S. treasuries are faltering, popular benchmarks like the Dow and S&P 500 eventually follow suit. The S&P 500 SPDR Trust (NYSEARCA: SPY ) will not be a lone exception. A hold-n-hope advocate may not wish to change any aspect of his/her portfolio holdings, regardless of financial stress levels, historical probability, technical trends or fundamental overvaluation concerns. On the flip side, an investor who wishes to reduce exposure to downside risk can use a bear market rally to his/her advantage . Jettison a lower quality junk bond ETF for a higher quality investment grade corporate bond ETF like iShares Intermediate Credit (NYSEARCA: CIU ). Trade in a lower quality stock ETF for a higher quality stock ETF like iShares MSCI USA Quality Factor (NYSEARCA: QUAL ). And disregard those who boldly declare that “cash is trash.” My moderate growth and income clients have witnessed less volatility and have experienced better risk-adjusted returns with roughly 20%-30% cash/cash equivalents since last summer. (And that’s before the levee broke .) Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

PFF Dodges Bullets From The Banking Sector

Preferred stock ETFs were once considered a tiny corner of the alternative income marketplace that had dodged the bullet of credit contraction. High yield mainstays like junk bonds, master limited partnerships, and even REITs have felt the pain of income investors reeling in their risk targets and running for the safety of high quality bonds. That picture changed dramatically this month as the iShares U.S. Preferred Stock ETF (NYSEARCA: PFF ) fell 5% from high to low and is scrambling to claw its way out of the abyss. This uptick in volatility may come as a surprise to many who had become accustomed to small prices changes in the index over the last several years. Preferred stocks are somewhat of a hybrid instrument that carry qualities of both equity and debt instruments. Therefore, with interest rates falling, it must be an equity-driven event that is causing this turmoil. A quick check behind the scenes of PFF reveals that this fund owns a diversified mix of 260+ individual preferred securities. Yet the single largest underlying sector is banks (42%) and diversified financial companies (18.50%). Together these two groups make up over 60% of the total portfolio and will therefore contribute an outsized portion of the fundamental price action. An overlay of PFF versus the SPDR S&P Bank ETF (NYSEARCA: KBE ) shows that the preferred stock index began a pronounced downside move in tandem with the sharp dive in publicly traded bank stocks (blue line). Click to enlarge PFF had a much more muted percentage drop than KBE. However, it is clear that the stress in banking stocks is also translating to a measure of fear in the underlying preferred market as well. Another interesting phenomenon with this price action has been the relatively swift and sharper recovery in PFF versus KBE. While banks are barely off their lows, PFF has been able to recover more than half of its corrective move. Only time will tell if this V-bottom formation will hold or if there will be another round of selling that will again test the resolve of income investors. I have owned PFF for clients in my Strategic Income Portfolio for a number of years and have been pleased with its makeup and performance over that time frame. A fund of this nature provides us with exposure to an alternative asset class with a much lower beta than a traditional dividend equity fund. It has also demonstrated a much stronger comparable income stream than a diversified bond fund. We view preferred stocks as a tactical opportunity in the context of a diversified income portfolio . This means that they are typically sized smaller than a core holding and may be added or removed as necessary to accommodate the current interest rate or stock market environment. Moving forward, I will be closely monitoring the price action in this sector to determine if we should scale back our position or continue to hold as this recovery develops further. Either way, our process will entail incremental steps and a thorough evaluation of the income landscape to ensure proper alignment with our conservative mandate . Disclosure: I am/we are long PFF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: David Fabian, FMD Capital Management, and/or clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell, or hold securities.