Shedding Brazilian Assets Puts Duke Energy in a Stronger Position

The sale of Duke's 2.1 gigawatt Brazilian generation fleet is in line with our $2.3 billion enterprise value for Duke's international segment, which includes 2.3 GW of additional generation facilities in Chile and Peru. We expect management to announce plans for the rest of Duke's international fleet by year-end, and we continue to see strong strategic rationale for divesting the noncore, no-moat assets, which have no long-term competitive advantages as a result of their exposure to commodity markets. After divesting its international portfolio, Duke will have completed its transition to a fully regulated utility.

Duke Energy, the second-largest U.S. utility, with regulated utilities in the Carolinas, Indiana, Florida, Ohio, and Kentucky that deliver electricity and gas to about 7.1 million customers, remains our most undervalued regulated utility, trading at a 9% discount to our fair value estimate and sporting a healthy 4.5% dividend yield.

Duke continues to move toward being a fully regulated utility. Management's $6.7 billion acquisition of gas distribution utility Piedmont Natural Gas, including assumed debt, in 2016 has strong strategic rationale with demographic overlap and significant growth potential but came at what we consider a rich price.

Duke's regulated distribution businesses make up about 90% of consolidated earnings. In recent years, Duke's utilities have been able to win higher customer rates from regulators, translating into higher profits. In 2016-20, we anticipate cumulative capital expenditures of $42 billion. These investments include new power generation, infrastructure, and environmental upgrades supporting our 5.5% earnings growth estimate in line with management's 4%-6% guidance. We anticipate that Duke will be able to recover these costs through constructive regulatory outcomes, particularly in the Carolinas and Florida.

How Do Utilities Build Moats? Monopolies in their service territories and efficient scale are the primary moat sources for regulated utilities such as Duke. State and federal regulators typically grant regulated utilities exclusive rights to charge customers rates that allow the utilities to earn a fair return on and return of the capital they invest to build, operate, and maintain their distribution networks. In exchange for regulated utilities' territory monopolies, state and federal regulators limit returns to minimize customer costs while offering fair returns for capital providers.

This implicit contract between regulators and capital providers should, on balance, allow regulated utilities to earn positive economic profits, though short-term returns might vary based on demand trends, investment cycles, operating costs, and access to financing. The risk of adverse regulatory decisions prevents regulated utilities from earning wide moats (and is the primary uncertainty regarding Duke’s moat), but the threat of material value destruction is low, and returns exceed costs of capital in most cases, leaving us comfortable assigning narrow moats to many regulated utilities. In addition, Duke’s narrow moat has been strengthened recently when it acquired Piedmont Natural Gas, a fully regulated domestic gas distribution company that benefits from the same advantages as Duke's other regulated subsidiaries.

We think Duke has strong corporate governance, constructive regulatory relationships, and an astute leadership team. We like that management has refocused on integrating Progress Energy and regulated growth initiatives, moving away from power generation and international investments. And we think management's move toward a fully regulated earnings mix is a positive for shareholders in the current market environment.

We have been impressed by management's ability to reach favorable settlements in rate cases and secure above-average returns on equity at its operating subsidiaries (though we think management might have paid too much for Piedmont).

Overall, CEO Lynn Good has proved quite capable of mending and maintaining regulatory relationships, refocusing the business on regulated operations, dealing with operational challenges, and lining up an industry-leading pipeline of growth opportunities.