Danger Lurking in Duke Energy Stock's Dividend Payout Ratio?

Source: Duke Energy.

Dividend investors rely on the stocks they own to pay reliable and consistent streams of income to provide them with the cash they need. Whenever anything threatens a dividend stock's continued ability to make payouts, those investors get nervous and often seek out healthier alternatives for the income-producing portions of their portfolios. One thing that can raise concerns is when a company's earnings are too high compared to what it's paying out in dividends, and Duke Energy (DUK 0.07%) is one example of how sometimes, companies end up paying more to shareholders than they actually earn. Is that a danger sign that Duke Energy shareholders should heed? Let's take a closer look at Duke Energy by doing a dividend payout ratio analysis to see if its high dividend yield is sustainable.

A look at Duke Energy

Source: Yahoo! Finance.

Should Duke Energy dividend investors worry?
Looking solely at the utility company's earnings and dividend information, Duke Energy seems to be in the danger zone when it comes to payout sustainability. After the company raised its dividend by about 2% in August, Duke Energy is now on target to pay out more in dividends over the next year than it has made in earnings per share over the past year.

Source: Duke Energy.

Yet the very fact that Duke Energy was willing to make that dividend increase in the first place is the first clue that you need to look beyond a simple earnings-based payout ratio. In many industries, earnings according to generally accepted accounting principles can look vastly different from the actual cash flowing into a company's coffers.

Sure enough, when you look at the operating cash flow that Duke Energy has, it paints a much different picture from its GAAP net income. The utility industry is extremely capital intensive, and over the past 12 months, Duke Energy has had almost $3.2 billion in depreciation and amortization charges related to its capital base. In addition, having made asset writedowns of $1.4 billion over the past year, Duke Energy ends up with actual operating cash flow of $6.16 billion -- within breathing distance of triple its net income figure for the same period.

Nevertheless, even with all that operating cash available, Duke Energy has aggressively spent it on capital expenditures. With $5.2 billion in capital spending since this time last year, Duke Energy weighs in with free cash flow of only $947 million. That's less than half the company's reported net income, and when you consider Duke Energy's total dividend-related expenditures of $2.21 billion over the past year, you get a payout ratio based on free cash flow that's even uglier: 233%.

Retired coal-fired power plant. Source: Duke Energy.

Where Duke's dividends are coming from
Without enough money to finance its needed improvements to its power plants and pay dividends, Duke Energy has followed the same course that many of its peers have: Use new debt to bridge the gap. The utility has done a good job of paying off some of its debt, but mostly it has refinanced its debt obligations, with new debt issuance of $3.7 billion in 2013 going to repay $2.76 billion of existing debt and leaving enough in reserve to finance almost half of Duke Energy's dividend obligations.

Nevertheless, Duke Energy itself has a much rosier view of its financial condition. Instead of using GAAP accounting figures, Duke focuses on adjusted earnings per share as its target metric, with the expectation of paying between 65%-70% of its adjusted EPS to shareholders as dividends. Based on those adjusted EPS figures over the past year, Duke Energy's payouts add up to about a 67% adjusted payout ratio -- well within the utility's target range.

Going forward, investors need to watch Duke Energy's debt situation closely to ensure that it can continue to afford the interest costs of borrowing to help cover dividend payments. As long as interest rates stay low, though, taking on more leverage will likely improve Duke Energy's profit picture by taking advantage of financing that might never be available again.