Duke Energy: Stability And Income In Volatile Times (NYSE:DUK)

Duke Energy (NYSE:DUK) has provided just the kind of defensive performance that one would hope for during the market decline of 2022. The trailing 12-month total return is 3.4%, as compared to -9.95% for the S&P 500 (SPY). DUK’s total return over the past year is almost identical to that of the Utilities Select Sector SPDR ETF (XLU), which had a total return of 3.36% (DUK is the 2nd-largest holding in XLU). Utilities in general, and DUK specifically, have benefitted from the broad rotation from growth to value during this market decline. It is somewhat remarkable that DUK’s 5-year annualized rate of total return, 9.49% per year, is currently higher than that of the S&P 500, 9.0% per year (DUK has lower total returns over the 3-, 10-, and 15-year periods, however).

12-Month price history and basic statistics for DUK (Source: Seeking Alpha)

DUK has been expanding its clean energy portfolio, most recently with 2 acquisitions. In November of 2022, the company announced that it was buying a 100 MW solar project (not yet built) in Mississippi. On January 18, 2023, Duke announced that it was buying a 175 MW solar project, also under construction, in Colorado. Duke is also part of a consortium of utilities that is pursuing government funding for a major Hydrogen hub in the southeast. Duke expects to see substantial benefits from the Inflation Reduction Act, largely in the form of production tax credits on nuclear and solar generation.

Duke’s increased focus on generation that does not use fossil fuels also reflects the trend for utilities to emulate NextEra Energy (NEE). The market has rewarded NEE’s focus on clean energy with a high valuation relative to earnings. NEE has a forward P/E of 29.05, as compared to DUK’s forward P/E of 19.3.

DUK’s earnings have been very reliable in recent years, albeit with essentially no growth. Q4 2022 EPS, which will be reported on February 9th, is expected to come in at $1.06 per share, as compared to $0.94 for Q4 of 2021 and $1.03 for Q4 of 2020. The consensus for expected EPS growth over the next 3 to 5 years is 5.77% per year.

Trailing (4 years) and estimated future quarterly EPS for DUK. Green (red) values are amounts by which EPS beat (missed) the consensus estimated value (Source: ETrade)

DUK’s 3.95% forward dividend yield, along with the trailing 3- and 5-year dividend growth rates of 2.05% and 2.66% per year, are solid but not especially compelling. Given the expected earnings growth rate, the company can easily support similar or somewhat higher dividend growth going forward.

I last wrote about DUK on September 27, 2022, about 3 ¾ months ago, when I reiterated a buy rating on the shares. At that time, DUK had sold off, along with the broader market, because of rising interest rates and increasing recession fears. In the period since this post, DUK has returned a total of 3.44%, albeit substantially lagging the S&P 500. At that time, the Wall Street consensus rating was a hold, but the consensus 12-month price target corresponded to a 20% expected total return over the next year. This high expected return was primarily due to the decline in the share price while the consensus price target remained quite stable. The market-implied outlook, a probabilistic price forecast that represents the consensus view from the options market, was bullish to the middle of 2023, with expected volatility of 25% to 26% (annualized). As a rule of thumb for a buy rating, I want to see an expected total return that is at least ½ the expected volatility. Using the consensus price target to estimate return, DUK was well above this threshold.

Previous post on DUK and subsequent performance vs. the S&P 500 (Source: Seeking Alpha)

For readers who are unfamiliar with the market-implied outlook, a brief explanation is needed. The price of an option on a stock reflects the market’s consensus estimate of the probability that the stock price will rise above (call option) or fall below (put option) a specific level (the option strike price) between now and when the option expires. By analyzing the prices of call and put options at a range of strike prices, all with the same expiration date, it is possible to calculate the probable price forecast that reconciles the options prices. This is the market-implied outlook. For a deeper discussion than is provided here and in the previous link, I recommend this outstanding monograph published by the CFA Institute.

I have calculated updated market-implied outlooks for DUK and I have compared these with the Wall Street consensus outlook in revisiting my rating.

Wall Street Consensus Outlook for DUK

Seeking Alpha calculates the Wall Street consensus outlook for DUK by aggregating the views of 19 analysts who have published ratings and price targets over the past 90 days. The consensus rating is a hold, with a consensus 12-month price target that is 3.99% above the current share price. Adding the dividend, the expected total return is 7.51% over the next year. The rating shifted from a buy to a hold on December 9, 2022.

Wall Street analyst consensus rating and 12-month price target for DUK (Source: Seeking Alpha)

For my analysis in late September, the consensus 12-month price target calculated by Seeking Alpha was $113.44, higher than the current value of $105.88. The decline in the price target is a large contributor to the lower expected return.

The expected return implied by the consensus price target is fairly normal for DUK, given that the trailing 3-year annualized total return is 6.60% per year, the 10-year annualized total return is 7.46% per year, and the 15-year annualized total return is 6.68% per year.

Market-Implied Outlook for DUK

I have calculated the market-implied outlook for DUK for the 4.7-month period from now until June 16, 2023 and for the 11.8-month period from now until January 19, 2024, using the prices of call and put options that expire on these dates. I selected these specific expiration dates to provide a view to the middle of 2023 and through the entire year.

The standard presentation of the market-implied outlook is a probability distribution of price return, with probability on the vertical axis and return on the horizontal.

Market-implied price return probabilities for DUK for the 4.7-month period from now until June 16, 2023 (Source: Author’s calculations using options quotes from ETrade)

The market-implied outlook to the middle of 2023 shows a pronounced tilt that favors positive returns. The peak in probability corresponds to a price return of about 3.3%. The expected volatility calculated from this distribution is 21.7%, lower than the expected volatility calculated in late September (25% to 26%).

To make it easier to compare the relative probabilities of positive and negative returns, I rotate the negative return side of the distribution about the vertical axis (see chart below).

Market-implied price return probabilities for DUK for the 4.7-month period from now until June 16, 2023. The negative return side of the distribution has been rotated about the vertical axis (Source: Author’s calculations using options quotes from ETrade)

This view really highlights the asymmetry in probabilities between positive and negative returns. The probabilities of positive returns are consistently higher than the probabilities of negative returns, across a wide range of the most-probable outcomes (the solid blue line is above the dashed red line over the left ⅔ of the chart above). This is a bullish outlook.

Theory indicates that the market-implied outlook is expected to have a negative bias because investors, in aggregate, are risk averse and thus tend to pay more than fair value for downside protection. There is no way to measure the magnitude of this bias, or whether it is even present, however. The expectation of a negative bias reinforces the bullishness of the market-implied outlook to the middle of 2023.

The market-implied outlook to January 19, 2024 is similar to the shorter-term view, although with less a bullish spread between the probabilities of positive and negative returns (the vertical distance between the solid blue line and the dashed red line). This is still clearly a bullish tilt for 2023 as a whole. The expected volatility is 21.7% (annualized).

Market-implied price return probabilities for DUK for the 11.8-month period from now until January 19, 2024. The negative return side of the distribution has been rotated about the vertical axis (Source: Author’s calculations using options quotes from ETrade)

The market-implied outlooks for DUK to the middle of 2023 and into January of 2024 are bullish, with low expected volatility. The market-implied outlook was neutral with a bullish tilt in my analysis in March of 2021, was slightly bullish in January of 2022, was solidly bullish in June of 2022 and September of 2022, and continues to be bullish today. The expected volatility in the current analysis is lower than in September (26%-27%), June (24%), and January (23%) of 2022, but slightly higher than in March of 2021 (20%).

Especially due to the bullish tilt, selling covered calls options on DUK looks quite attractive. At the time that I pulled up the options quotes for this analysis, DUK was trading at $101.82. The bid price of a call option with a strike of $105, expiring on January 19, 2024, was $6.80. Buying DUK and selling this call option provides an income yield of 10.6% over the next 11.8 months ($6.80 in option premium + $4.02 in expected dividends, with the sum divided by $101.82). This position can also provide up to 3.1% in price appreciation (if the share price rises up to, or above, the option strike price). For a stock with expected volatility of 21.7%, this total income yield is quite attractive. If the shares rally, this covered call position will provide 13.7% in total return (10.6% income + 3.1% in price appreciation), assuming that the options are not exercised early. If the options are exercised before expiration, this will also tend to be favorable because the option buyer sacrifices the remaining time value of the options.

Summary

The market decline that started in 2022 has provided a vivid reminder of the benefits of owning low-beta stocks like DUK. The current valuation is reasonable, but the shares certainly don’t look undervalued and expected growth is modest. DUK’s ongoing investments in clean energy have the potential to convince the market that a higher valuation is justified, however. The Wall Street consensus rating on DUK is a hold, with a consensus price target that corresponds to a total return of 7.5% over the next year. This is not a compelling total return for a stock with this risk level, but DUK’s low-beta is an additional benefit that partially offsets the fairly low expected return. The market-implied outlook for DUK is bullish to the middle of 2023 and for the year as a whole, with low expected volatility. With a hold rating from the Wall Street analysts, the bullish market-implied outlooks, and the company’s solid execution and strategy, I am maintaining a buy rating on the shares. DUK’s 3.95% forward yield is attractive for income investors, and selling covered calls looks favorable in the current conditions.