Dividend Investing: Duke Energy Corporation (DUK)

Investing in stocks that pay high dividends is an effective way for the conservative investor whose concern is mainly with the preservation of capital. When investing for a high dividend yield, the most important consideration for the investor is the sustainability of such dividends. Hence research into the underlying dividend payer is crucial.

Previously I highlighted communications company CenturyTel in this article.

Another company that is selling for a high dividend yield is Duke Energy Corporation (DUK). At the current stock price of $16.33, the company is yielding 5.88% in dividends.

Duke is an energy company that provides its services through three business segments, namely U.S. Franchised Electric and Gas, Commercial Power and International Energy. In June 2009, Duke Energy completed the buyout of a Peruvian energy project called Aguaytia Integrated Energy. In that same month, the company acquired North Allegheny Wind located in Western Pennsylvania. The company merged with Cinergy in 2005.

The company trades on a PE of 19.6 times which is in line with the industry average. Duke however trades at close to book value and had a price to sales ratio in line with the industry, if not fractionally lower. A lower price to sales ratio means investors obtain more revenue at less cost.

The low return on equity at just under 5% explains why the company is paying out such large dividends. Clearly there are few if any projects that yield returns greater than the company’s cost of capital. As such a prudent board will usually distribute extra cash to shareholders either in the form of dividends or through share-buybacks. With a current ratio (current assets divided by current liabilities) in the region of 1.5 times and net cash (cash minus short-term debt) on the balance sheet of around $600 million, Duke is in a pretty decent financial position. For the last five years the company has generated an average of over $3 billion in cash from operations.

However upon closer inspection cash is not really flowing through to shareholders. Free cash flow is a method used by value investors to determine what is left over after all costs associated with upkeep and maintenance of the business have been deducted, and non-cash costs like depreciation have been added back. Free cash flow is basically calculated as net income plus depreciation, less working capital changes and capital expenditure related to business maintenance excluding expansion. On this measure, the company actually lost about $1.4 billion in cash. Added to that, the firm’s most recent 10-K filing (or annual report) says, “During the three year period from 2010 to 2012, Duke Energy anticipates cumulative capital expenditures of approximately $14 billion to $15 billion of which approximately $11 billion”. Such large capital expenditure is related largely to the modernization of energy generating equipment but does also include expenditure on new energy technologies.

Another caveat investors must be aware of is described in the same 10-K filing: “Duke Energy’s wholly-owned public utility operating companies have restrictions on the amount of funds that can be transferred to Duke Energy via dividend, advance or loan as a result of conditions imposed by various regulators in conjunction with Duke Energy’s merger with Cinergy. Additionally, certain other Duke Energy subsidiaries have other restrictions, such as minimum working capital and tangible net worth requirements pursuant to debt and other agreements that limit the amount of funds that can be transferred to Duke Energy. At December 31, 2009, the amount of restricted net assets of wholly-owned subsidiaries of Duke Energy that may not be distributed to Duke Energy in the form of a loan or dividend is approximately $10.5 billion. However, Duke Energy does not have any legal or other restrictions on paying common stock dividends to shareholders out of its consolidated Retained Earnings account. Although these restrictions cap the amount of funding the various operating subsidiaries can provide to Duke Energy, management does not believe these restrictions will have any significant impact on Duke Energy’s ability to access cash to meet its payment of dividends on common stock and other future funding obligations.”

The company does also state that it intends to keep its current dividend policy. The company has paid out $0.94, $0.90 and $0.86 in dividends for the past three years, respectively.

I would caution against investing in this company for a “safe” dividend yield as I feel there are better options offering a similar yield where I would estimate the dividend is more secure.