Duke Energy: Safe Returns?

08/24/2015 8:00 am EST

Focus: STOCKS

Josh Peters

Editor, Morningstar DividendInvestor

This featured recommendation merged with Progress Energy in 2013, becoming the largest utility in the United States, according to Josh Peters, editor of Morningstar DividendInvestor.

After a turbulent start, management at Duke Energy (DUK) has extracted significant cost savings, including fuel and dispatch savings promised to customers.

After the sale of its Midwest commercial generation fleet earlier this year, Duke’s regulated businesses make up about 90% of consolidated earnings.

In recent years, its utilities have been able to win rate increases from regulators, translating into higher profits.

Is the dividend safe? As with most regulated utilities, regulatory risk remains the key uncertainty for Duke, particularly given its aggressive investment plans over the next several years.

The company should benefit from favorable regulation in the Carolinas and Florida, partially offset by more challenging regulatory environments in Indiana and Ohio.

Even with its large capital-expenditure program, Duke maintains a strong balance sheet and an investment-grade credit rating. Debt has been about 50% of total capital historically and we expect this ratio to drift up only slightly over the next few years.

Dividend outlays are well covered by regulated profits; the payout ratio should be 70% this year at the midpoint of management’s earnings guidance.

Will the dividend grow? Including the dividends paid by 2007 spin-off Spectra Energy SE, Duke has raised its dividend each year since 2005. Increases averaged 2% a year in the five years through 2014 as management sought to trim the payout ratio and complete the Progress merger.

However, with the payout ratio reaching management’s 65%-70% target range last year, Duke announced a 3.8% dividend increase July 7.

The pace of dividend growth could improve a bit further in the next few years, as few, if any, new common shares will need to be issued to support Duke’s investment plans.

This, in turn, suggests dividend growth averaging 5%-6% a year through 2019, with 3%-4% a reasonable expectation thereafter.

What’s the return? With Duke offering a 4.5% current yield, we expect total returns of 8%-10% annually, which we find attractive in the context of Duke’s conservative, almost fully regulated portfolio of assets.

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