Duke Energy Is Worth $70 Rates Outlook And Merger Synergies

Duke Energy‘s (NYSE:DUK) has not participated in the broader rally seen by the market following the QE3 announcement though it is in reach of our $70 price estimate for Duke. Short-term performance aside, we believe that the company is well positioned following the Progress Energy (Read Duke Is Worth $70 As Progress Merger Unlocks Value), and there are several factors such as rate increases, cost cutting and streamlining operations that will contribute to Duke’s performance going forward. Below, we look at rate cases and margins impact on the company’s value.

See our complete analysis for Duke Energy here

1) Rate increases to drive growth

In July 2012, Duke Energy Ohio applied for electricity and natural gas distribution rate hikes with the Public Utilities Commission of Ohio (PUCO). 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.

However, there is one potential risk to our estimates. With the completion of the Progress Energy merger, Duke’s customer base has expanded from 4 million to 7.1 million. 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. As the 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 could see downside. This may have a significant impact on the overall average revenue per MWh for its U.S. Franchised Electric & Gas division.

2) Margin improvement and merger synergies

The integration process after the merger will take several months or years and should unlock value for the company in terms of expense reductions. Apart from that, the company is continually phasing out older coal-fired power plants and replacing their production with power from cleaner coal burning plants, 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 or scrubbing upgrades.

The company is also spending on upgrades to improve plant efficiency, which will result in increased electricity production. Moreover, natural gas prices are not likely to recover fully 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  downside if fuel prices rise materially above anticipated levels.

Duke Energy is in a sector where customer growth opportunities are modest and one of the best ways 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 company has turned into a solid, enlarged unit with the merger. 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. The high barriers to entry in the utility industry will also help fend off any additional competition in its core markets.

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