This Just In: Upgrades and Downgrades

It's been nearly two months now since Swiss megabanker UBS cut its price target on Duke Energy (DUK 0.18%), punishing the company for the cardinal sin of cutting guidance (by a whole nickel!) in its Nov. 5 third-quarter earnings report. Since then, however, Duke shares have only gone up, rising from sub $67 prices to recently pass $70.

And so today, with Duke shares up 5% since UBS cut its target, the analyst is throwing in the towel and announcing an official rethink: It's upgrading Duke Energy shares to buy.

What's changed?
When last we heard from UBS on the subject of Duke Energy, the analyst was panning the utility for cutting its guidance to "$4.55-$4.65," a range UBS observed was below consensus "by a nickel."

Looking forward into 2016, UBS opined that with Duke showing "little to no improvement" in international operations, and "core regulated and commercial businesses" in the U.S. growing only "4%-6% into 2016," the most Duke could be expected to earn in the coming year is $4.65 -- $0.25 less than UBS had been hoping to see previously. This, in UBS' view, was too little, too late.

Since then, Duke has announced it's building 75 megawatts' worth of solar plans in North Carolina and 200 megawatts of wind power in Oklahoma, and that it's trying to extract $1.8 billion in ratepayer-supported capital improvement projects in Indiana -- projects Duke expects to result in annual 1% increases in its revenue, while reducing the amount of power it must produce for those ratepayers by another 1%. As Duke has not made any announcements directly affecting guidance, it's presumably these projects that now have UBS feeling more optimistic about the utility's growth prospects.

But is UBS right?

Let's go to the tape
Unfortunately, the answer to that question is most likely "No, UBS is not right about Duke Energy." The reason we say this rests squarely on UBS' poor record picking electric utilities stocks:

Mind you, in many respects, UBS is a fine stock picker. According to our data on Motley Fool CAPS, where we've been monitoring the performance of UBS' stock picks since mid-2006, UBS ranks in the top 10% of investors. It's just not very good at picking electric utilities stocks in particular. There, the banker scores just 36% for accuracy across its several recommendations. And its average pick underperforms the stock market, to boot.

I expect much the same will happen with today's recommendation of Duke Energy. Here's why:

Valuing Duke Energy
Priced at more than 20 times earnings today, analysts expect Duke to grow its earnings at no more than 3.3% annually over the next five years -- basically the inflation rate. Granted, Duke's generous 4.7% dividend yield should give its owners a better-than-inflation return on their investment -- but only if the stock price doesn't shrink.

Personally, I think it will shrink, and for three reasons:

First, Duke costs too much relative to its competitors. Exelon shares, for example, have a half-point growth lead over Duke (3.8% to 3.3%). The company's debt load is more manageable and its dividend yield is nearly indistinguishable from Duke's at 4.6%. Best of all, Exelon sells for the most reasonable P/E ratio of the bunch -- a relative bargain at 12 times earnings.

PPL Corp, also mentioned above, sells for 23 times earnings and pays a 4.5% dividend yield -- both numbers that look inferior to Duke's at first glance. But analysts who follow the company (rated higher on CAPS, by the way -- five stars to Duke's four) expect PPL to outgrow Duke by nearly 2 full percentage points at 5.2% annualized, and PPL boasts a lighter debt load than its rival as well.

Second -- speaking of debt, let's speak about debt. Valued at about $48 billion in market cap, Duke carries more than $41 billion worth of debt, net of cash on hand. In case you missed it, though, the Federal Reserve just raised interest rates ... which will raise the cost of Duke's debt ... which will decrease Duke's profits. That's going to crimp earnings growth over time, and with Duke only pegged for 3%-ish growth already, there wasn't a whole lot of growth there to begin with.

Third and finally, when interest rates go up, bonds pay more interest. And because bonds are viewed as "safer" than stocks, those higher bond interest rates will draw investors away from dividend-paying stocks like Duke. This, too, is a factor that will tend to sap Duke Energy stock's strength over time.

The upshot for investors
When you get right down to it, my main reason for being pessimistic about Duke Energy stock is as simple as this: 20 times earnings is an awful lot to pay for a stock growing at 3%. But debt plays a role in this thesis, too. It seems to me, in reversing course and recommending Duke despite rising interest rates, UBS has made a seriously bad call.

I think Duke is going down.