Duke Energy Corp (DUK 0.73%) is one of the largest players in the U.S. utility industry. That's normally considered a pretty boring business, with government regulation largely dictating the outlook for the sector. While Duke isn't about to turn into a growth oriented business, it does have three important levers to pull to keep a slow and steady upward trajectory that will allow it to reward investors with continued dividend hikes. Here are the three biggest opportunities for Duke Energy.
1. Infrastructure spending
Utilities are monopolies with strings attached -- in the form of government regulation. Effectively the government gets to decide the rates that a utility can charge. That's a simplified version of a very complex issue, but it gets the idea across.
Image source: Getty Images.
One of the ways that utilities grow their businesses is by convincing regulators that they need to raise rates to cover capital spending. Regulators have been more willing to allow rate hikes for spending on infrastructure in recent years. For example, spending on upgrades that protect customers from the potential damage caused by extreme weather events.
At Duke that includes everything from replacing old power poles to installing smart meters. This spending isn't a one or two year thing, either. For example it recently started a 10-year upgrade project in North Carolina. Partially based on that spending it's asking regulators to provide it with a nearly 15% hike in delivery rates. (Electricity rates in this instance are handled separately.)
Duke isn't likely to get the full 15%. For example it was awarded only half of the 11% it asked for in 2012. But even if Duke gets a 7.5% boost, that's not bad in an industry known for slow and steady growth. For reference, Duke's earnings growth target over the next few years for its utility business is for between 4% and 5%. The type of infrastructure spending and rate case activity it's undertaking in North Carolina is going to be the foundation on which Duke grows its business for years to come. Note that the utility has plans to spend around $25 billion on electric infrastructure over the next decade.
2. Natural gas
Duke made a big business move in 2016 when it completed the purchase of Piedmont Natural Gas in early October. Duke already had a natural gas business serving around 500,000 customers, so this isn't exactly a new business to the utility. However, it changed the scale of the business in a big way by adding one million new customers. The deal also included ownership stakes in a number of large natural gas pipelines and pipeline projects.
Duke Energy's midstream assets. Image source: Duke Energy Corp.
Today that business makes up around 8% of adjusted earnings. The goal is to get that number to 15% over the next decade. Backing that up is a plan to spend $6 billion on capital projects over the next five years alone. It's worth noting that $3.3 billion of that spending is earmarked for the midstream business. Natural gas has been taking market share from coal in the utility industry, but the infrastructure to effectively move gas around the country is still underdeveloped. Pipelines like the ones Duke owns and is building are generally fee-based businesses that will support the continued industrial shift toward natural gas.
In other words, Duke has two levers in one on the natural gas side of the company. It will be spending money to grow its consumer natural gas distribution business, which will allow it to ask regulators for rate hikes. And it is expanding its midstream footprint, which allows it to meet increasing demand for these fee-based assets. Overall Duke expects its gas business to grow earnings between 10% and 12% over the next five years.
3. Renewable power
The last big growth driver for Duke is renewable power. Although it accounts for just 3% of earnings, making it Duke's smallest business segment, it's expected to grow earnings between 8% and 12% over the next five years. That's because of the increasing demand for clean power combined with this division's relatively small size.
Duke's renewable power business at a glance. Image Source: Duke Energy Corp.
The company has plans to spend $1 billion on renewable power over the next five years. It currently has around 3 gigawatts of capacity in wind and solar, with the opportunity to add another one gigawatt of wind alone in the future. And this business is largely driven by long-term contracts, making it roughly similar to the fee-based midstream business.
I would never expect the renewable power segment to become a huge part of Duke's operation, being that it's unregulated. But it should add notably to earnings in the future being that the growth rate is roughly twice what Duke expects on the regulated electricity side of things.
And the dividend...
Investors should be watching Duke's efforts to drive earnings by pulling each of these three levers. The goal is to achieve 4% to 6% earnings growth and 4% to 6% dividend growth. Note that the dividend growth rate expected to exceed the historical rate of inflation. With a yield of around 4%, conservative investors would be well served by doing a deep dive here.
That said, the company's PE of 22 is a little higher than its five-year average of 21 and its enterprise value to EBITDA is elevated, too. So it might be a better call to put Duke on your watch list for the moment, waiting for a yield closer to 4.5%.
