Duke merger with Progress unlocks value
Economies of scale will likely help increase profits.
The primary factors affecting the results for its largest division, U.S. Franchised Electricity & Gas, included revised electricity tariffs in the Carolinas, which were partially undone by lower electricity consumption due to unfavorable weather conditions.
Overall revenue increased marginally, while revenue in international and commercial energy declined. The results in international energy were affected by lower earnings in Central America and unfavorable foreign exchange rates, which overtook improved tariffs in Brazil and Peru. While the growth in residential customers continues to be sluggish, the company ought to look for periodical tariff raises to harness value. The recent merger with Progress Energy will benefit significantly, as strengthening pricing power and reducing costs due to economies of scale are likely to increase profits.
We have recently revised our model for Duke Energy to accommodate the merger with Progress Energy and the Q2 results. We now have a price estimate of $70.
The Progress Energy operations will now be part of U.S. Franchised division of Duke. We have revised our forecasts for international energy and commercial energy divisions lower, and we have increased our revenue per MWh estimate for its franchised business, as it has several pending rate cases that are likely to turn out positive.
In January, both the North Carolina Utilities Commission and the Public Service Commission of South Carolina approved rate hikes for residential customers by approximately 7.2% and 6.0%, respectively. Other noteworthy changes include reduction in discount rate from 8.5% to 8% due to increased stability after the merger, updated share count and total capitalization.
If we were to break down the results of Q2 for Duke Energy, we would highlight these trends: an increase in tariffs, a decline in GWh sales and a negligible increase in customers. Average number of industrial customers dropped, which was more prominent in the Carolinas, where it fell by 3.3%. In its entire operating territory, the loss in GWh sales was driven primarily by residential customers, who tend to use much less electricity when climatic conditions are more favorable. During Q2, GWh used by residential customers fell by 5.6% and 8.2% in Midwest and Carolinas, respectively.
Duke Energy merged with Progress Energy on July 1 and reported Progress's Q2 results separately. The earnings reported by Progress Energy were affected primarily by outages caused by nuclear refueling in the Carolinas. This increased the operations and maintenance charge by a whopping 15% for the first six months of 2012, which stood at $1.15 billion. While revenues saw a marginal incline of less than 1%, EBITDA increased by 11% on reduced purchased power expenses. The other trends are more or less congruent to the ones observed for Duke.
The outlook of the company has become more stable after the merger with Progress Energy, but one will need to keep an eye on the consolidation process over the next year to ascertain positive outcomes from the merger. The company plans to reduce its non-fuel operations and maintenance expenses by 5% to 7% per year. It will also execute fuel savings by coal-blending and coal-purchasing efficiencies. Duke has pending rate cases in Ohio likely to be in effect by 2013 Q2. However, its fuel and joint dispatch savings plan could partially reduce recent tariff gains in Carolinas, according to which it will offer $89 million reduction in sales to Carolina customers over next 12 months.
Progress Energy generates 43% of total power through nuclear fuels, which will change the fuel production profile drastically for the consolidated entity as Duke's maximum share of electricity generation came from coal. Progress's operations and maintenance expenses went up abruptly in Q2 on refueling outages. Hence, much of the company's fate now lies on how it rolls over across plants for maintenance. Several of Duke and Progress's plants are being phased out, and will be replaced by new plants. In its earnings call, it reaffirmed that Edwardsport IGCC project startup will happen in early 2013 instead of September 2012. The capital structure of the company is likely to change as it plans to take $2 billion of additional funding over the $1.3 billion it already planned for its Carolina and Florida utilities.
Overall, we believe the company's ability to charge higher tariffs and contain costs will help unlock value for it going forward. However, a changing fuel consumption profile could affect the company as it now has an increased reliance on nuclear fuels. We are looking forward to seeing how the company manages its power generation fleet to keep outages to as low as possible. The company is likely to perform better in the future largely because of its enlarged scale.
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Duke is also under investigation by the North Carolina. Utilities Commission.
From the Raleigh Neww & Observer:
"The investigations stem from Duke’s decision to remove CEO Bill Johnson shortly after the merger was completed. Johnson had been CEO at Progress and it was understood by the N.C. Utilities Commission that he was to be CEO of the combined Duke after the merger."
So future unknown legal expenses and consequences should be considered.
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