Duke Worth $70 On Merger Synergies, Improving Margins

-2.70%
Downside
96.71
Market
94.10
Trefis
DUK: Duke Energy logo
DUK
Duke Energy

Duke Energy (NYSE:DUK) has had a difficult time dealing with investor response to its after-hours CEO change following the completion of its merger with Progress Energy. The move triggered investigations by North Carolina regulators, which are yet to be settled. However, that aside, the company has turned into a solid, enlarged unit with the merger. The high barriers to entry in the utility industry will also help fend off any additional competition. The company is now well-placed to ramp up its expenses for marketing to lure more customers and spend on research to make its energy production more efficient. Duke Energy is in a sector where customer growth opportunities are modest and the only way to grow is through acquisitions. In that respect, Duke’s move to merge with Progress will help it harness tremendous value in the future. The two drivers that are critical to Duke’s performance going forward are success in rate cases and improvement in margins. Below we look at these two factors in more detail to understand their impact on the company’s value.

We have a $70 price estimate for Duke, nearly 5% ahead of the current market price. We recently updated our analysis to account for the merger and subsequent reverse stock split.

Relevant Articles
  1. Duke Energy Jumps 10% On Takeover Rebuff News – What’s Going To Happen Now?
  2. Duke Energy Could Have 20% Upside. What Are The Catalysts?
  3. Duke, Southern, Dominion: Utility Stocks Continue To Underperform. Time To Buy?
  4. Is Ameren’s 2x Price Rise Compared To Duke Energy Justified?
  5. Why NextEra’s 5x Price Rise Versus Duke Energy Is Not Justified
  6. Duke, NextEra, Southern: Are Big Utilities Riskier Through This Downturn?

See our complete analysis for Duke Energy here

Rate increases to drive growth

Duke Energy Ohio applied for electricity and natural gas distribution rate hikes with the Public Utilities Commission of Ohio (PUCO) in July 2012. The enactment of the rate increases is likely to happen in early 2013, after which electric rates are expected to increase by an average of 5.1% and natural gas rates by 6.6%. The rate hikes are designed to recover costs incurred by the company for grid modernization, upgrades in distribution systems, and manufacturing natural gas plants. Earlier in January 2012, Duke’s rate cases got approval in the Carolinas. The North Carolina Utilities Commission (NCUC) and the Public Service Commission of South Carolina (PSCSC) approved rate hikes for residential customers by approximately 7.2% and 6.0%, respectively.

With the completion of the Progress Energy merger, Duke’s customer base has expanded from 4 million to 7.1 million. However, after the merger, the company filed with the NCUC and the PSCSC to reduce electricity rates in order to give back $650 million in savings from the merger to its customers over the next five years. [1] This may have a significant impact on the overall average revenue per MWh for its U.S. Franchised Electric & Gas division and is another potential risk to our estimates. As rate increases are to be negotiated with the regulators with justification, a rejection or delay in rate renewals can’t be ruled out, in which case our estimates will see a downside.

Margin improvement and merger synergies

The integration process after the merger will take several months and should unlock value for the company in terms of expense reductions. Apart from that, the company is continually phasing out coal-fired power plants and replacing them with gas-fired or nuclear power plants. This offers a significant cost saving opportunity from reduced carbon emissions, which will require much less spending on carbon trapping upgrades. The company is also spending on upgrades to improve plant efficiency, which will result in increased electricity production. Moreover, gas prices are not likely to recover in the near term, which will lead to savings in fuel costs as well. Duke is also moving its production toward renewable energy fuel sources, which are more sustainable, cheaper and environmentally friendly. While we expect Duke to keep expanding its margins in the near term, they will likely start to decline in the long term as fuel prices increase and merger synergies exhaust. Our estimates could see a downside if fuel prices rise materially above anticipated levels.

Improving economy

There is a correlation between electricity usage and the economic environment of a country. Electricity consumption tends to rise in an improving economy due to an uptick in industrial and commercial consumption. We believe as the U.S. economy improves further, Duke’s MWh per customer will rise, though at a very gradual pace.

U.S. Franchised Electric & Gas is the largest division of Duke Energy, contributing nearly 87% value to the company’s value, so the factors impacting this division have a significant impact on the stock. The other divisions – Commercial Power and International Power – are significantly smaller and are clearly not the focus areas for the company, so any changes in the drivers for these divisions will not have a material impact on our price estimate.

Understand How a Company’s Products Impact its Stock Price at Trefis

Notes:
  1. Duke Energy Merger Benefits Begin Flowing to Carolinas Customers, marketwatch.com, August 1, 2012 []