Duke Energy- Investors Do Not Like The Piedmont Deal, Nor Do I
Summary Duke Energy is expanding its natural gas operations in the Carolinas by acquiring Piedmont. Investors doubt the steep premium being offered for Piedmont, as do I. Duke has failed to quantify the anticipated earnings accretion as I think that the company´s acquisition track record is mediocre at best. The only real appeal comes from the dividend yield as earnings multiples are inflated due to the low interest rate environment. The increase in leverage makes me very cautious amidst the historical and relative steep multiples at which Duke is trading as the future of the industry is becoming more uncertain. Duke Energy ( DUK ) announced a sizable deal as the company is looking to acquire Piedmont Natural Gas ( PNY ) in a $4.9 billion cash deal. Investors in Duke balk at the high premium being offered for Piedmont´s shares, as I fail to see real appeal as well. Add to that the poor acquisition track record of Duke, an increase in leverage, and increasingly uncertain future for the regulated industry, and I am very cautious. For these reasons, shares remain a no go in my eyes as the dividend is the only appealing factor for the shares. Amidst risks to the valuation in case interest rates rise and non-compelling dividend growth, I would be very cautious. A Strategic Deal.. Duke is looking to expand its operations in the Carolinas and Tennessee as ownership of Piedmont will give the company access to a million customers in those states. Roughly 90% of these customers are residential and customer growth has averaged roughly 1.5-2% per year. These are fairly attractive growth rates in comparison to Duke which is reporting customer growth rates of around 1% per year. The increased scale and expansion of Duke´s natural gas platform are not the only reasons behind the deal. Both companies have been working together in the $5 billion Atlantic Coast Pipeline project. Piedmont has a lot of interests in other joint ventures as well including Hardy Storage, Pine Needle LNG Storage, the Cardinal pipeline and Southstar Energy Services, among others. It must be said that the vast majority of both earnings and assets are generated through Piedmont´s regulated utility business however. Besides increasing Duke´s scale, the deal allows for the expansion of its gas infrastructure platform and the transformation towards becoming a highly regulated business. Ahead of the deal, Duke generated 85% of its earnings from regulated utility operations in the Midwest, Carolinas and Florida. Roughly 10% of the earnings are generated from the international operations in Latin America as commercial wind and solar project generate the remainder of the profits. This latest deal will only increase the relative profit share of the regulated business. The company has not discussed cost or revenue synergies from the deal besides the strategic benefits. On the deal conference call , management actually admits that no synergies have been considered in the decision to pursue this deal. It must be stated that Duke has the ability to borrow cheaply. Additionally, Duke is making a large bet on continued oversupply of natural gas in North America, keeping prices low for a long time to come. This should make natural gas the preferred energy option for decades to come, at least in Duke´s opinion. This shifts the company away from coal based generation as the electricity business is suffering from lower long term demand for electricity following increased efficiency of usage. ..Comes At A Price To obtain ownership of Piedmont, Duke is willing to pay a roughly 40% premium for Piedmont´s shares. This translates into a purchase price of $60 per share. Including the $1.8 billion in debt, the deal price comes in at $6.7 billion. While this is a sizable amount, Duke expects to finance just $500 to $750 million in the form of newly issued equity with the remainder coming from additional debt. Despite the fact that the board of both companies have already agreed in favor of the deal, and Piedmont´s shareholders are likely to do the same given the fat premium offered, closing is only anticipated late in 2016. Regulatory approval is always a tedious issue in this industry, which makes that it takes more time before deals finally close. Despite the fact that Duke is paying a 40% premium, the company anticipated accretion to adjusted earnings per share in 2017. Unfortunately Duke does not quantify this anticipated accretion although it cites that the cheap cost of debt of 4% alone is sufficient to result in accretion. This is even the case if no synergies are being realized. Adding To The Long Term Targets The vast majority of Piedmont´s business is a regulated business which is allowed to earn a return on equity of 10-10.2% from its operations. Duke anticipates that the faster growth rate of Piedmont will improve the overall growth profile as it reinforces its position as the largest US utility business. The company previously anticipated that earnings will come in at $4.55 to $4.75 per share in 2015. The deal are complementing the company´s plans to grow earnings per share by 4-6% per year through 2017. Investors should like the sound of this as the company sticks to its 65-70% payout ratio, having paid dividends for 89 years in a row now. The deal actually allows the company to make a big step with its investments plans for the years 2015-2019. The company outlined a $23-$26 billion spending plan for these four years with respect to new power generation, infrastructure investments as well as compliance and other investments. By acquiring Piedmont, Duke will complete a major step with regards to its infrastructure investments. With the deal, Duke is pulling a lot of its investments forwards in time. This does have an impact, namely that the leverage position will continue to increase in the short to medium term. Duke itself operated with a net debt load of roughly $40 billion ahead of the deal as the purchase of Piedmont will increase this number to roughly $46 billion. This corresponds to pro-forma EBITDA of some $9.7 billion, for a 4.7 times leverage ratio. The Market Is Not Buying It Shares of Duke Energy have fallen some 2.5% in response to the deal, wiping out roughly $1.2 billion in shareholder value. This wealth destruction is pretty much equivalent to the $1.4 billion premium being offered for Piedmont. The skepticism of investors can be understood, even as the deal is relatively small compared to Duke´s enterprise valuation of roughly $84 billion. The negative reaction is driven by the large premium and the fact that the deal will face some uncertainty, given that Duke already has a large presence in the Carolinas. This could potentially raise some anti-trust issues down the road. Other concerns include the mediocre track record with regards to large strategic deals which Duke has made in the past. This mostly relates to the $26 billion purchase of Progress Energy back in 2012. This deal has created some problems for Duke in recent years as it made the company an owner of nuclear plants, as Duke ended up paying multi-million dollar settlements in the years following as well. Back in 2007, Duke Energy has actually spun-off gas assets into Spectra Energy (NYSE: SE ) . Ironically, it are similar kind of assets which the company is now aiming to buy back through the purchase of Piedmont. All these deals have not really paid off for investors. While pro-forma revenues of $25 billion have increased by two-thirds over the past decade, the outstanding share base has increased by 70% as well. As a matter of fact, the book value of the company and earnings per share have only moved down, so have dividends. Of course investors have received a stake in Spectrum, although that does not make up for the disappointing results. This makes that Duke´s prime attraction is the 4.6% dividend yield amidst a very modest track record. The trouble is that this yield is very attractive on a relative basis, as those looking for income have pushed up shares of ¨yield¨ plays in recent years. As a result, Duke is now trading at similar multiples as the general market. This makes shares very risky in case the interest rate environment will change and trend upwards. Add to that the increasing leverage and an increase in the uncertainty faced by the still regulated industry, and you understand why current levels do not look appealing for long term investors. This is based on my assumption that the regulated industry model will come under pressure as advancements in notably wind and energy power generation have the potential to undermine the regulated industry business model. If you combine everything you will note that this is a very dangerous situation for long term holders of the stock. While the strategic rationale behind the increased focus on gas makes sense, the premium seems very steep as much more infrastructure has gone for sale in the form of limited partnerships in the last year. The high valuation, increasing leverage, pricey deal and the long term uncertainty for the industry all outweigh the appeal of the current dividend.