Tag Archives: author

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 ).

AGL Energy Is Hitting The Sweet Spot Right Now

Summary AGL Energy’s net income and free cash flow look uninspiring, but one needs to dig deeper to find the true story. The net income was negatively impacted by an impairment charge whilst almost half of the capex consists of growth capex. Using the sustaining capex and taking AGL’s cost reduction plans into consideration, the company is trading at a 2018 FCF yield of 8-9% and that’s quite appealing. Introduction Very few people might know AGL Energy ( OTCPK:AGLNY ) ( OTCPK:AGLNF ), but this $7.5B market cap company is one of the largest electricity and gas providers in Australia. It trades in energy, but also creates its own power through its renewable and non-renewable power plants. Surprisingly, there’s a decent volume in shares of AGL Energy on the company’s OTC listing, but I would obviously strongly recommend you to trade in the company’s shares through the facilities of the Australian Stock Exchange. As you can imagine, the ASX offers much more liquidity as the average daily dollar volume in AGL Energy is $25M. The ticker symbol is AGL . 2015 was a tad better than expected… I was really looking forward to see the final results of AGL Energy’s financial-year 2015 (which ended in June of this year). We already knew that year wouldn’t be a good year when discussing the net profit, as the company had to record an A$600M ($420M) impairment on some of its (upstream gas) assets. This impairment charge was due to delays in starting up the gas production as well as a lower expected gas price. This obviously meant the book value of those assets might have been overly optimistic, so an impairment charge was the right decision. (click to enlarge) Source: Annual report And indeed, even though the revenue increased by 2% to A$10.7B ($7.5B), the EBITDA fell by a stunning 40% to A$946M. As there’s of course still the usual depreciation expenses and interest expenses, the net profit fell by almost 62% to just A$218M ($145M). Ouch! (click to enlarge) Source: Annual report Even the cash flow statements were a bit uninspiring. The operating cash flow was A$1.04B, and after deducting capital expenditures to the tune of A$744M, the net free cash flow was approximately A$300M ($210M). All this sounds pretty boring and uninspiring, but I prefer to look to the future instead of at the past. But the 2016-2018 period will contain some very nice surprises From this year on, there will be numerous improvements. First of all, the net income will sharply increase again as I’m not expecting to see much more impairment charges. That’s very nice to keep the mainstream investors happy, but my readers already know I care more about cash flow statements than about net income, so I dug a bit deeper, and I’m extremely pleased with what I discovered. Of the A$744M in capital expenditures in FY 2015, only A$395M ($275M) of that amount was classified as “sustaining capex” . As it’s essential for cash flow statements to find out what the normalized free cash flow is, one should only use the sustaining capital expenditures and exclude the growth capex. So if I’d to deduct the A$395M from the A$1,044M in FY 2015, the adjusted free cash flow increases to almost A$650M ($455M). But there’s more. AGL Energy remains on track to complete the objectives it has outlined to reduce costs by FY 2017. AGL’s plan consists of cutting operating costs in, for instance, IT and supply contracts whilst on top of that, the sustaining capital expenditures will decrease from A$395M in 2015 to A$315M in FY 2017. This would increase the adjusted free cash flow by approximately A$200M per year to A$850M ($600M). And keep in mind this doesn’t take the organic growth into consideration, as I’m expecting the company should be able to increase its revenue and operating revenue (whilst reducing the operating costs and sustaining capex). Source: Company presentation And this really puts AGL in an enviable position. The net debt/EBITDA ratio as of at the end of its financial-year 2015 was acceptable at 2.4, but this should start to drop extremely fast as the EBITDA will increase whilst the net debt will be reduced. In fact, even after paying a handsome 4% dividend yield. According to my calculations, in FY 2018, AGL Energy should have a net adjusted free cash flow after paying dividends of approximately A$400M, and this will probably be used to reduce the net debt (which will have a snowball effect as it will reduce the company’s interest expenses, increasing the net operating cash flow). It will also be interesting to see how AGL intends to spend the US$850M in cash flow it expects to generate through asset sales. Investment thesis So yes, AGL Energy’s 4% dividend yield is safe and will very likely be increased in the future. Don’t let the low net income fool you, the cash flow statements are explaining this story much better and the adjusted free cash flow is definitely sufficient to cover AGL’s dividend expenses. I’m also really looking forward to see if the company can indeed reduce its operating costs and sustaining capex, because if it would effectively be able to do so, AGL is trading at an expected free cash flow yield of 8-9% by FY 2018. I’m keeping an eye on AGL Energy and might pull the trigger during a weak moment on the market. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

This Is One Heck Of A Great Bond ETF

Summary The Vanguard Long-Term Bond ETF does everything right. If investors could only hold one bond ETF, this one would be a very strong contender for that spot. The fund offers solid income, a low expense ratio, and negative correlation to most major equity classes. If you don’t like this ETF, tell me why, because I do not see a single weakness here. This is a great ETF. There are only a few ETFs that really catch my eye as I’m researching them. This is one that immediately stands out for being absolutely exceptional. It has pretty much everything an investor could want for a bond ETF. I’ve shown a strong preference for funds that I can trade without commissions from my Schwab account because it makes frequent rebalancing more appealing. I would love to see this fund show up on there, but I don’t expect Vanguard funds to show up on the Schwab list at any point. For investors that have access to free trading on Vanguard ETFs, look into using the Vanguard Long-Term Bond ETF (NYSEARCA: BLV ). This ETF comes with everything I want (except free trading) and nothing I don’t want. Let’s go through the fund. Expense Ratio The expense ratio is only .10%. That is beautiful. Just try to find a way to complain about a long term bond fund with over 2000 different holdings and an expense ratio of .10%. This is ideal. Characteristics The fund is offering a fairly respectable yield to maturity of 4.2%. In the last decade investors may have scoffed at the idea of 4.2%, but in the new normal this is great. Some investors may expect yields to increase, but I doubt the Federal Reserve can pull that rabbit out of the hat when other countries have lower rates. An increase in domestic rates would result in a surge of cash inflows to the U.S. as foreign investors would seek dollars to buy up the higher yielding treasury securities. The resulting appreciation of the dollar would slam domestic employment and contradict one of the two dual mandates of the Federal Reserve. Until we see some major changes in the world economy, 4.2% is a fairly reasonable yield. Types of Bonds The Vanguard Long-Term Bond ETF is structured precisely how I would want it to be structured. The holdings include some foreign exposure without a very large allocation and a mix between industrial bonds and treasury bonds. Despite a strong allocation to treasury securities, there are no Agency MBS or Commercial MBS. Investors wanting access to those securities can acquire them on leveraged basis at a substantial discount to book value by buying mREITs. I see no reason to pay book value, but I would like a long term bond ETF with a heavy emphasis on high quality debts. Credit Quality The holdings are all solid. This is investment grade debt with a significant portion being treasury debt. This is a very solid ETF to have in your portfolio if the market starts tanking. I put together a demonstration of the role BLV plays in a sample portfolio. Building the Portfolio The sample portfolio I ran for this assessment is one that came out feeling a bit awkward. I’ve had some requests to include biotechnology ETFs and I decided it would be wise to also include a the related field of health care for a comparison. Since I wanted to create quite a bit of diversification, I put in 9 ETFs plus the S&P 500. The resulting portfolio is one that I think turned out to be too risky for most investors and certainly too risky for older investors. Despite that weakness, I opted to go with highlighting these ETFs in this manner because I think it is useful to show investors what it looks like when the allocations result in a suboptimal allocation. The weightings for each ETF in the portfolio are a simple 10% which results in 20% of the portfolio going to the combined Health Care and Biotechnology sectors. Outside of that we have one spot each for REITs, high yield bonds, TIPS, emerging market consumer staples, domestic consumer staples, foreign large capitalization firms, and long term bonds. The first thing I want to point out about these allocations are that for any older investor, running only 30% in bonds with 10% of that being high yield bonds is putting yourself in a fairly dangerous position. I will be highlighting the individual ETFs, but I would not endorse this portfolio as a whole. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. Because a substantial portion of the yield from this portfolio comes from REITs and interest, I would favor this portfolio as a tax exempt strategy even if the investor was frequently rebalancing by adding new capital. The portfolio allocations can be seen below along with the dividend yields from each investment. Name Ticker Portfolio Weight Yield SPDR S&P 500 Trust ETF SPY 10.00% 2.11% Health Care Select Sect SPDR ETF XLV 10.00% 1.40% SPDR Biotech ETF XBI 10.00% 1.54% iShares U.S. Real Estate ETF IYR 10.00% 3.83% PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB 10.00% 4.51% FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT 10.00% 0.16% EGShares Emerging Markets Consumer ETF ECON 10.00% 1.34% Fidelity MSCI Consumer Staples Index ETF FSTA 10.00% 2.99% iShares MSCI EAFE ETF EFA 10.00% 2.89% Vanguard Long-Term Bond ETF BLV 10.00% 4.02% Portfolio 100.00% 2.48% The next chart shows the annualized volatility and beta of the portfolio since October of 2013. (click to enlarge) Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. You can see immediately since this is a simple “equal weight” portfolio that XBI is by far the most risky ETF from the perspective of what it does to the portfolio’s volatility. You can also see that BLV has a negative total risk impact on the portfolio. When you see negative risk contributions in this kind of assessment it generally means that there will be significantly negative correlations with other asset classes in the portfolio. The position in TDTT is also unique for having a risk contribution of almost nothing. Unfortunately, it also provides a weak yield and weak return with little opportunity for that to change unless yields on TIPS improve substantially. If that happened, it would create a significant loss before the position would start generating meaningful levels of income. A quick rundown of the portfolio I put together the following chart that really simplifies the role of each investment: Name Ticker Role in Portfolio SPDR S&P 500 Trust ETF SPY Core of Portfolio Health Care Select Sect SPDR ETF XLV Hedge Risk of Higher Costs SPDR Biotech ETF XBI Increase Expected Return iShares U.S. Real Estate ETF IYR Diversify Domestic Risk PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB Strong Yields on Bond Investments FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT Very Low Volatility EGShares Emerging Markets Consumer ETF ECON Enhance Foreign Exposure Fidelity MSCI Consumer Staples Index ETF FSTA Reduce Portfolio Risk iShares MSCI EAFE ETF EFA Enhance Foreign Exposure Vanguard Long-Term Bond ETF BLV Negative Correlation, Strong Yield Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio. Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. (click to enlarge) Conclusion BLV offers a clear negative correlation with each asset except for short term TIPS (no surprise, high credit quality) and equity REITs. The equity REITs in IYR have a slight positive correlation with BLV which is caused at least in part by the fact that BLV is holding some high credit quality non-Agency debt. Since a substantial portion of the debt is still corporate in origin, it has a higher correlation with equity REITs than it would if it were pure treasuries. Despite that, the ETF still has a very clear negative correlation with other equity assets classes. Normally that kind of negative correlation requires midterm or longer treasury securities, but most of those funds have very limited yields. That isn’t any surprise either since the demand for extremely high quality debt (treasury securities) has pushed the yields to extremely low levels. By incorporating investment grade corporate debt the total portfolio for BLV is able to offer a respectable return so that the fund offers investors a material amount of income along with a negative correlation that results in total portfolio risk being materially reduced. This is what a bond fund should look like. Vanguard is known for high quality and low cost funds, but this fund is downright exceptional.