In my continuing quest for long term reliable dividend paying stocks that are currently yielding at least 4% and that will sustain and grow their dividend at least at the rate of inflation, I recently happened upon Duke Energy (DUK), providing about 4.2% in current yield and at first glance, a good looking dividend history. But is the recently increased dividend sustainable?
There are a couple of recent articles on DUK that look at such things as solar panels and coal ash and predicted EPS growth and so on. I take a somewhat different approach to evaluating a company’s dividend paying ability and commitment to dividend growth. I’m not concerned very much by what management or retail analysts say about this or say about that. Management is concerned about showing their better half and ‘analysts’ have their own interests (that don’t represent my interests). There are simply too many variables only management is aware of, and even if I could see all important management variables, and there are probably dozens of them, I’m not a CEO and I really don’t know how everything fits together to provide sustainable growth and unless one is a full-time CFA analyst focusing only on regulated electric and gas utilities, I doubt anyone else does either. Although arm-chair quarterbacking a company feels good, I don’t consider it of any real value. So I stick with objective measures of how well/poorly management has actually done. And the most reliable measure of this is the corporate checkbook.
But first things first….what does DUK’s history of dividend payments look like, particularly during the thin times of recession?
(note: these dividend data are from YahooFinance that adjusted pre 2Q12 dividends for the 1:3 stock split that occurred then)
Although this dividend history looks a bit alarming with such a long flat dividend that lasted for 8 years, comparatively, this dividend history is quite favorable for a regulated utility. It seems that during the 1990s, deregulation of power transmission and the ability to purchase power from more than a single source caught many power generation utilities unprepared for low-cost competition to their relatively higher cost power, leading to a sharp reduction in cash flows and for most, including Alliant Energy (LNT), Xcel Energy (XEL), WEC Energy Group (WEC), and American Electric Power (AEP), to name a few, had to sharply cut their dividend in the late 90s or early 2000s. But DUK did not. This is in part attributable to DUKs management and is a favorable indicator to the income investor.
Now, how well has DUK been able to support and grow the dividend over recent periods?
I sorted David Fish’s most recent list of Dividend Champions for the 10 gas/electric utilities it contains and calculated the average dividend growth rate of this group for comparison with the annual dividend growth rate of DUK, assuming the Q4 17 dividend for DUK will remain unchanged. From this chart, it would seem DUK went into a dividend slowing between 2011 and 2014 that have lagged the Dividend Champion utilities in each year since 2009, although DUK has shown positive dividend growth over the previous four Q4 periods.
Cash Flow Measures
I measure 4 cash flows over the trailing 16 quarters that I feel are the best measures of management’s effectiveness. All data points are consecutive rolling 4 quarter totals, which helps to stabilize the quarterly fluctuations that often occur in any 12 month period:
- The trend in the percentage of Cash Flow From Operations (CFFO) used to pay the interest on debt.
- The trend in per-share Revenue, CFFO and Dividends
- The trend in the dividend-to-CFFO payout ratio
- The trend in the percent of Consolidated Funds used For Investing Activities (or CFFI) paid with CFFO AFTER paying the dividend
So let’s look at these individually.
(note: all CF data I’ve obtained from Morningstar and Mergent Online)
The percent CFFO that is consumed by the interest expense is a measure of how effective management is at converting a borrowed dollar into profit.
Since the 4Q ending 2Q15, this ratio has been steadily increasing, suggesting DUK is not getting the return on its borrowed dollars it should be getting. At nearly 23% over the trailing 4Q, this is very high for a regulated utility, which is usually in the 15% to 18% range. Over the past 24 months, DUK has borrowed a net of $8.326B and issued $.733B in stock = $9.06B in raised capital. Over this same time period, the changes in total Revenues and CFFO are as follows
This is perhaps the most disturbing metric of DUK I have found. With over $9B spent on all investing activities, the Revenue has declined by -3.2% while CFFO has declined further by -6.2% over this period.
Per-Share metrics will show the trend in how effective management is in real growth of revenues and company operating cash. Without growth here, the dividend ultimately cannot grow.
Although a bit hard to discern here, the CFFO per share showed slow growth from 2Q14 through 2Q16, but it has been on a decline over the past 3 quarter 4Q periods. The overall 16Q change has been essentially flat. Revenue per share has shown a declining trend, going from the high $8.90’s in 2013 down to $8.23 over the past 4Q. These are unfavorable CF trends.
The Dividend-to-CFFO payout ratio measures how much ‘headroom’ the dividend has in the total of CFFO.
Most regulated utilities will payout between 25% and 40% of Net Operating Cash as a dividend, and at just under 37%, DUK’s dividend is well covered and although on the high side of its peers, this payout ratio has existed in a narrow range of 33% to 37% over the past 16Q. However, the sharp jump up of this payout ratio over the past two 4Q periods is of concern.
The trend in the percentage of CFFI that is covered by the CFFO AFTER the dividend is paid, is always a strong indicator of financial health. The ability to fully fund company investments without having to borrow or add to equity (thus increasing the amount of CFFO required to fund the dividend) is an important indicator.
In my travels, regulated utilities will be able to fund most of their investing expenses, usually at least 70% to 80%, with CFFO after paying the dividend, with some such as OGE Energy Corp and WEC able to exceed 100% over most 4Q periods. The trend shown by DUK is of concern, dropping each 4Q period since 2Q15, except 3Q16, down to 33% for the trailing 4Q. This means DUK is having to issue more debt, sell more equity, or go off balance sheet and form financing relationships with non-controlling interests. Over the past 10Q, just over 13% of DUK’s financing activities have been ‘other’. Generally, the higher this percentage, the higher the cost of capital.
As is often the case, digging into the CF metrics provides me with a constant flow of surprises I did not expect to find. At first run-through, DUK looks like a no-brainer. Great looking dividend history per the quick screening of The Dividend Channel’s dividend charts and a recent 4.7% annualized dividend increase. The question that remained at the initial screen is why DUK’s current yield has climbed to 4.2% when its peers are yielding in the low 3% range. The answer to this, I believe, is what is found in digging through the company’s cash flows. Clearly, DUK management is having a tough time getting a return on their invested dollars. The dividend is still well covered with net operational cash, but at some point, DUK’s Revenues and CFFO per share are going to have to improve, or the trend in dividend coverage will continue to grow until the dividend is at risk of being cut.
I’m going to pass on DUK for now, at least until I can see an up-tick in some of these declining CF metrics. Were I holding DUK, I would put it into my “Red Zone” and monitor its CF metrics each quarter. If I saw no improvement over the next 2 quarters, I’d do what the Senate seems unable to do: repeal and replace it.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.