Duke Energy

Moat: 3/5

Understandability: 2/5

Balance Sheet Health: 3/5

Duke Energy is a large, regulated utility company that provides electricity and natural gas services to customers across several states in the U.S., focusing primarily on the Carolinas, Florida, and the Midwest.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Duke Energy operates in a regulated environment, which is both a blessing and a curse. This means they have a protected market and a guaranteed return on capital, but also that their profits are limited by government regulations.

Business Overview

Duke Energy operates in three core segments:

  1. Electric Utilities and Infrastructure: This segment, which forms the backbone of the company, engages in the generation, transmission, and distribution of electricity. The primary sources of power include nuclear, coal, gas, and renewables. The segment also handles operations in all their regulated states.
  2. Gas Utilities and Infrastructure: This segment focuses on the transportation and distribution of natural gas in the Carolinas. It manages an expansive system of pipelines and equipment that brings gas to residential, commercial, and industrial customers. This segment is regulated by the Public Utility Commissions of each state it serves.
  3. Commercial Renewables: This includes solar and wind power-generating assets, as well as battery storage. Although the name is “Commercial,” they are selling renewable power to other utilities and therefore the regulatory agreements. This is the smallest of the segments in terms of revenue and profitability.

Key points of revenue and profitability: Their electric segment and its regulatory agreements provide stable revenue streams, but these are tied to rates set by state regulators. Their growth is largely tied to growth in the population they serve and expansions, rather than price increases. Gas and Commercial Renewables have to fight to secure contracts and may have lower and more volatile revenue streams.

Industry Trends and Competitive Landscape:

The utility industry is undergoing a significant transformation, driven by several forces:

  • Shift towards Renewables: The increasing focus on sustainability and environmental consciousness has accelerated the transition from fossil fuels to renewable energy sources. Utilities are investing heavily in solar, wind, and battery storage to meet government mandates and consumer demand for clean energy.
  • Decentralized Generation: There is an increase in on-site power generation by residential and commercial consumers. The installation of solar panels, coupled with the development of battery storage, is reducing the amount of electricity that utilities sell to customers. This also gives more power to the customers and makes them more flexible on price.
  • Grid Modernization: Modernizing existing infrastructure with digital technologies, grid-scale batteries, and micro-grids is key to making the system more resilient. The power grid has been mostly unchanged since Edison time and has huge inefficiencies, which modernization tries to solve.
  • Regulatory Changes: The regulatory landscape is dynamic, with ever-changing federal and state policies about pricing, reliability, and renewable energy mandates. This requires utility companies to adapt their strategies, often with short notice.
  • Cost Pressures: Volatility in fuel costs, such as coal, natural gas, and oil, and rising construction costs for newer systems are putting pressure on utility margins. Utilities, therefore, have to be creative in how they manage their assets and liabilities.

This means that while regulated utilities like DUK may have stable revenues and predictable earnings in the short-run, there are risks from technology, policies, and volatility in input costs that may affect their earnings negatively in the long-run.

What Makes Duke Different:

  • Diverse Portfolio: Duke Energy possesses a diverse mix of generation resources-ranging from large nuclear plants to natural gas power plants to solar and wind farms. Its presence across many different geographical regions (primarily the Southeast) makes it geographically more diverse.
  • Investment in Innovation: The company invests in new, more-advanced technology, such as grid modernization and battery storage. It is one of the few utility companies doing so, to the extent that it is being done. The company has put a lot of importance on smart grid technologies that help in predicting and correcting outages.
  • Commitment to Sustainability: The company is trying to transition to a clean energy portfolio, with significant investments in renewable resources. The company’s carbon reduction plan calls for achieving a 50% carbon-reduction goal by 2030, and a 100% reduction goal by 2050. This is a significant step to make in modern times, as the younger generation will increasingly prioritize this aspect.
  • Strong Relationships with Regulatory Bodies: With most of its revenues regulated by state utility commissions, DUK has significant experience working and negotiating with regulators. This aspect allows them to predict, manage and get higher profits out of the regulated market.

Financial Analysis

Key takeaway: DUK’s financials can be hard to analyze because of the impact of regulations and special line items, such as fuel costs, purchased power, and other revenue items. One needs to look at the “core” financials, rather than the total revenue and the total earnings.

Here’s a deeper dive into the key financial performance metrics:

  • Revenue Composition: Electric power sales represent a bulk of DUK’s revenues. Gas and commercial renewables add to the rest. Revenue is very dependent on government regulations and prices set, based on long-term contractual agreements. There are differences in regulation in each state.
  • Margins: While net margins have been high, they are highly variable. Net profit margins are quite high when the company doesn’t have to pay for additional fuel costs, while those margins can be hit very hard by increases in fuel costs. Gross profit margins show a better representation of the company’s ability to reduce the cost of goods. The average gross profit margin for DUK has been quite similar to the median gross margin in its peer group but can vary across years. A better representation of the margin is found when the operating income is taken as a percentage of the total assets.
  • Profitability: Return on equity (ROE) and return on invested capital (ROIC) are quite high. This indicates that DUK is efficient in managing and generating returns for shareholders. However, most utility companies are able to provide this due to the nature of their operations. In the last few years, DUK’s ROIC has remained mostly around the 8% range. This is not very good considering the fact that, traditionally, utility companies have low but stable ROICs. Most of the peers generate similar ROIC results. The debt-to-equity ratio is at the median of the utility space, which implies that the assets are leveraged quite a bit with debt.
  • Cash Flow: The cash-flow performance has also been volatile. There are periods where operating cash flows have decreased despite increased revenue, mostly due to large swings in fuel costs and lower regulatory collections. The total capital expenditure continues to be large at roughly $6 Billion a year.

Moat Rating: 3/5

  • Barriers to Entry: The regulatory aspect, along with their vast infrastructure and huge capital requirements, is a major barrier to entry in the utility sector. These are usually regulated monopolistic entities with predictable income. The large capital needed to build and upgrade the infrastructure makes it very hard for new competitors to enter their core market. This earns a 3/5 moat rating.
  • Brand and Customer Loyalty: Most customers are price-sensitive, but their needs are so basic that customers would not likely move from one provider to another. Customers’ brand loyalty to the utility brand is also typically low. They could care less who is providing the energy. These factors diminish the moat.
  • Economies of Scale: DUK has a wide geographic area and a large customer base, which gives it economies of scale when it comes to servicing customers and managing operations. Because the cost of electricity distribution goes down as the company becomes bigger, DUK is more profitable as a larger entity. However, the effect is not that pronounced and the same may be accomplished by any other similar energy utility, thereby diminishing this aspect of a moat.
  • Switching Costs: Utility companies can benefit from switching costs, as customers usually do not like the hassle of changing their services. However, the switching costs in this industry are low, as regulators can often quickly permit changes. The ease of moving to other energy sources makes switching costs relatively low.
  • Intangible Assets: The ownership of transmission lines, power plants, and other necessary resources are valuable intangible assets. The fact that DUK needs to be a recognized entity to serve most customers, creates a sort of license-like protection that’s inherent to DUK’s operation.

Risks To the Moat and Business Resilience

  • Regulatory Risks: Duke Energy is subject to regulatory oversight, which can greatly impact profitability. Changes to regulations regarding carbon emissions, fuel prices, and rate structures can significantly affect earnings and competitiveness.
  • Technological Disruption: The shift toward renewable energy and decentralized power generation poses a threat to Duke Energy’s traditional business model. New technological innovations from competitors may take away DUK’s business or reduce the cost of renewable energy, making their offerings more desirable than those of DUK.
  • Economic Factors: Recessions can cause consumption to drop, which reduces the demand for power. The need to reduce interest rates may also impact DUK’s profitability. If there is another credit crunch, or there is a rise in interest rates that may also affect the stock negatively.
  • Operational Risks: Natural disasters, such as hurricanes, can damage DUK’s infrastructure and operations, leading to increased expenses and reduced revenues. The high reliance on nuclear plants can also be a risk, given the high risk of failure and the high capital cost of those facilities.
  • Commodity Prices: The cost of fuels (both gas and other types) has a very high impact on the company’s margins and profits. If DUK is not able to hedge against price volatility from those resources, it can drastically alter the profits of the company.
  • Management Decisions: Miscalculations in acquisitions, investments and regulatory actions can hamper the company. The management has a huge role in controlling operations, planning growth, and maintaining a sustainable balance sheet.

Despite all the structural advantages, it’s good to remember that DUK shares have been very volatile in the past, given the financial crisis and the recent recession. It’s also important to see how the management tackles all of these new regulations and risks.

Understandability: 2/5

While the basic business of delivering power is easily understood, a lot of the company’s financials are very complex to fully comprehend. This is due to the many nuances related to a regulated utility and all the different rules and regulations they are obligated by. The impact of government policies and market forces in emerging technologies also makes the analysis more difficult.

Balance Sheet Health: 3/5

  • Moderate Leverage: While not excessively leveraged, the company’s debt-to-equity is quite high, which is typical for most large utility companies. The company has significant amounts of debt, but most of that debt has a reasonably low interest rate, and is not exposed to high-risk changes in interest rates.
  • Stable Assets: Most of their assets are tangible property and plants, and not any high-risk speculative investments. This makes their balance sheet quite robust and predictable.
  • Regulatory Liabilities: A large portion of their liability is related to regulatory assets, liabilities, and deferrals. While they may be negative as of the current time, these are usually collected in the near-future and therefore are not as dangerous as normal liabilities. This is an accounting trick, but a legitimate way to recognize how much the company owes.

While not the highest, the balance sheet is sufficiently strong and capable of meeting the company’s obligations. Overall, it has high risk associated with debt, but has managed it in a satisfactory way, and therefore can be deemed as somewhat healthy.