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Duke Energy
My Take

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By andyz151
May 5, 2003

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I too read the Street.com's Duke bashing and have to say it was somewhat bleak. Unfortunately, I was not able to totally discount it as I would have liked. Forbes ran an article recently [not the present issue but the one before] and unlike Cramer and Street.com, Forbes is anything but Liberal. Also Bank of America recently issued a sell rating saying there are better risk/reward plays out there. BoA also believes that the risk of a rating cut is high.

OK that is the bad news, here is the good - as I see it. Roger Conrad - who is editor of Utility Forecaster believes Duke is risky but will be an ultimate winner long term. He is very clear that there are many short-term risks here. He cites the possibility of a dividend cut, an equity offering and a rating cut as potential negatives that could push Duke below $10. But he also believes they have quality assets that will make them a leader when the economy recovers. He also is of the belief that the "power glut" is going to end a lot sooner then later. He points to the 4% increase in power usage last year despite a weak economy. Also the new power plant building is being cancelled and several older plants - manly coal and oil - are being taken out of service, as they are too inefficient or uneconomical to run. This will soak up the "glut" real fast.

Now let me look at what Duke owns. For a more detailed summary go to Duke's website and review the 2003 annual report where they break out their business lines with revenue and profit numbers.

Regulated power in NC and SC - no need to do much more then say they run one of the cheapest power suppliers in the country. they make plenty of money here and it is very stable and predictable. When the economy heats up some, these will make even more money.

NG assets. Again, stable, reliable cash cow business. These are their pipeline, gas gathering and NG reserves. These are only going to do better when the economy picks up.

These last two are what generate most of Duke's earnings right now. They are stable and predictable and are growing internally modestly.

Then there are their remaining businesses. Merchant power generating and trading and what I call other.

Merchant trading and generating is what is killing Duke. They built lots of new plants in the last 5 years, almost all of which are NG fired and they are not getting back enough to pay the debt. This is not in my mind a permanent condition. Most of Duke's new plants are in the west. Everyone but the analysts seems to be saying that California and the west is fast becoming short on power despite the so called glut. When the summer heat wave hits, I am willing to bet we are going to see a rash of reports talking about the shortage out west and need for new power and for new plants to be built. If that happens, Duke's stock should increase.


Trading: Duke said they are only going to trade what they generate power wise and what they can transport NG wise. I doubt this is permanent either. Once this business is less taboo, they will probably dip their toe back into the power trading business since they will have the infrastructure in place. But for now they won't trade solely as a means to generate earnings. They will only trade as a function of their generating and transporting business.

The one problem many people raise for Duke is their reliance on their real estate arm. To be honest I don't really understand what this business does, so if anyone else can help me out I would be obliged. From what I gather, they buy and sell land and buildings. Here is what their websites says:

Through Crescent Resources, LLC, we develop and manage real estate throughout the southeastern and southwestern United States. Crescent creates award-winning country club communities, neighborhoods, apartment and condominium communities, Class A office space, business/industrial parks and shopping centers.

Clearly this is not a utility or energy business line, so I am not sure how to value its worth to Duke as a whole other then to say they make money. Right now there is a mini boom in real estate, which could burst at any time. Reliance on this business line is no more stable then on trading and I think this is where analysts see a problem. I am not sure I buy the whole bubble idea but I can say that this business is surely going to suffer when interest rates go up. It won't be so easier for a buyer to finance the property at rates which ensure a profit. That is one reason commercial real estate is hot. You can finance the property are 6-7% or so and make a decent profit from the rents. But when rates go up, profits margins will shrink, reducing the potential buyers. There have been many discussions on this sort of topic on the REIT board and would suggest folks go there for more insight.

Finally, my opinion for what it is worth, is that I am still buying. I recognize there are risks to Duke from the economy, but I think a) the power market will firm up, which will strengthen Duke's balance sheet. This would limit the likelihood of a dividend cut or a big dilutive equity offering and probably the ratings cut; b) even if there is a dividend cut, equity offering and ratings cut, the long term effect is not going to drive Duke to bankruptcy or into such dire straights as say Aquila or Mirant. Duke has too many quality assets that generate steady cash flow to remain down. Duke's regulated assets will continue to generate earnings and once the cyclical unregulated business recovers, so will the growth to Duke's earnings. I believe management is trying to hold the dividend until the economy recovers. Psychologically, a cut would do a lot to shake investor confidence, especially the individual investors who seek income. If Duke can make it to the recovery without a dividend cut, the stock will soar as it will have increasing earnings growth potential and a decent yield. But if they need to issue a substantial amount of equity - say 1.2 billion then I suspect a dividend cut will also happen. Too generate $1.2B they would need to sell about 75 million new shares [ at $16 a share.] This would dilute earnings about 8.5%. Right now if Duke makes the low end of its projected earnings of 1.35-1.60 per share, the dividend coverage ratio is 80%. If they issue 75 million shares, the coverage ratio increases to 90% [meaning it takes 90% of earnings to pay the dividend] That is simply too high to maintain the dividend.

But again, I am still buying and holding. Just not doing it blindly - I hope.


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