Duke Energy Corp (DUK) — Q3 2016 Earnings Call Transcript

Thank you, Rachael. Good morning, everyone, and thank you for joining Duke Energy's third quarter 2016 earnings review and business update. Leading our call today is Lynn Good, Chairman, President and CEO, along with Steve Young, Executive Vice President and Chief Financial Officer. Today's discussion will include forward-looking information and the use of non-GAAP financial measures. Slide 2 presents the Safe Harbor statement, which accompanies our presentation materials. A reconciliation of non-GAAP financial measures can be found on duke-energy.com and in today's materials. Please note the appendix for today's presentation includes supplemental information and additional disclosures. As summarized on Slide 3, Lynn will cover the key milestones we reached in the quarter as we near the completion of our portfolio transition and provide a brief overview of our new business segments. She will also discuss our third quarter financial and operational highlights and provide an update on our growth initiatives. Steve will then provide an overview of our third quarter financial results, and lower growth trends as well as an update on regulatory activity. He will also provide insight into our expectations for 2017 before closing with our key investor considerations. With that, I'll turn the call over to Lynn.

Good morning, everyone, and thank you for joining us today. We had a strong third quarter at Duke Energy, delivering very solid financial results and demonstrating significant progress in the execution of our business portfolio transition. We closed the Piedmont Natural Gas acquisition and we also announced the sale of our Latin American assets. This transition of our business portfolio strengthens our franchise of high quality stable and growing energy infrastructure businesses. Starting on Slide 4, let me begin with our business portfolio transition. On October 3rd, we closed the Piedmont Natural Gas acquisition following approval by the North Carolina Utilities Commission. We’re delighted to bring Piedmont's industry-leading expertise into our company as we expand our natural gas platform in support of our transition to a lower carbon future and growing investments in important natural gas infrastructure. We've worked with and admired Piedmont for many years, and our post-closing integration efforts are well underway. In addition, on October 10th, we announced agreements with the China Three Gorges Corporation and I Squared Capital to sell our Latin American generation assets. China Three Gorges will buy our assets in Brazil for approximately $1.2 billion, including the assumption of debt. We expect to complete the transaction in 2 to 4 months once we’ve received the required approvals in Brazil and China. We’re making good progress. In fact, this morning the Brazilian antitrust agency preliminarily approved the transactions without any restrictions. This begins a 15-day statutory objection period, and if no objections are filed, the approval will become final. I Squared Capital will buy our remaining assets in South and Central America in a separate transaction, also valued at approximately $1.2 billion. We expect to close this transaction within the next three to five months. The proceeds will be used to reduce Duke Energy Holding Company debt. Steve will discuss additional implications from the transaction in a moment. Both of these announcements demonstrate our commitment to deliver more projectable growth in earnings and cash flows. I'm proud of our team for the extensive work on these transactions as well as the continued dedication of our employees at Duke Energy International, who have managed the business very well throughout the process. We look forward to a timely close as we exit our Latin American generation business and we're pleased to welcome the Piedmont employees to Duke Energy. Turning to Slide 5, consistent with the transition of our portfolio, today we are announcing the realignment of our financial reporting segment structure beginning with our fourth quarter results. Perspective-wise, we will discuss performance for three primary business segments: Electric Utilities and Infrastructure, Gas Utilities and Infrastructure, and Commercial Renewables. Electric Utilities and Infrastructure will be comprised of our regulated Electric Utilities in the Carolinas, Florida, and the Midwest. This segment will also include our commercial transmission investments. As previously noted, Frank Yoho will lead our Gas Utilities and Infrastructure Business, which will contain Piedmont, our local gas distribution companies in Ohio and Kentucky, and our gas pipeline investments such as Atlantic Coast Pipeline, Sabal Trail, Constitution, and Piedmont’s existing joint venture investments. With the realignment of our business, Commercial Renewables will become its own segment. Meanwhile, Other will continue to include holding company interest expense and our captive insurance results. Other will also begin to include our National Methanol equity investment in the fourth quarter. With the divestiture of the Latin American generation business, the balance of the international segment will be classified as discontinued operations starting in the fourth quarter of 2016. We will continue to report the earnings of this business in adjusted earnings per share until closing. Turning to Slide 6, let me update you on our strong financial results for the quarter. We announced third quarter 2016 adjusted earnings per share of $1.68, an increase of $0.21 from the prior year. We generated higher adjusted earnings with strong results at our regulated utilities due to warmer summer weather and our continued commitment across management and operational excellence. As a result of the strong results through the first three quarters of the year, we are trending towards the high end of our original 2016 adjusted diluted EPS guidance range of $4.50 to $4.70 per share, excluding costs associated with Hurricane Matthew. Turning to Slide 7, we are continuing to move forward and deliver strong results on our $30 billion growth capital plan. This plan aligns with our vision to invest capital in smarter energy solutions to generate cleaner energy and modernize the grid, creating value for customers and delivering earnings and dividend growth for our shareholders. Here are a few updates: site preparation activities are underway and are nearly $1 billion Western Carolinas Modernization Project with plant construction anticipated to begin in early 2017. This project allows us to retire our Asheville coal units early, build cleaner natural gas units, and install renewable energy on the site. The project is on track to be completed by late 2019. In September, we worked with the Indiana office to be utility consumer counsel to develop a plan to modernize and upgrade the Markland Hydro Station. This multi-year effort will increase the output of the nearly 50-year facility, producing low-cost, carbon-free electricity for Indiana residents for years to come. For the agreement, the approximately $150 million investment and related expenses will be recovered through the recently approved renewable energy rider. Last week we issued an RFP for 400 megawatts of renewable energy in our Duke Energy Carolinas service territory. This furthers our efforts to provide renewable energy to our customers because the project must be in operation by December 31, 2018. Also in Carolina, we recently filed for a Certificate of Public Convenience and Necessity or CPCN for our Duke University combined heat-and-power projects. The projects will consist of natural gas-fired generators that also provide steam service to the campus and lower the University's carbon dioxide emissions by 25%. Combined heat-and-power projects represent an attractive energy solution that could benefit many of our universities and other larger industrial customers in the years to come. Shifting to our natural gas infrastructure investments, we continue to make investments in integrity management programs within our local distribution companies and advance construction of our pipeline projects. Let me briefly update you on Sabal Trail, Atlantic Coast Pipeline, and Constitution. Construction on the Sabal Trail pipeline began in August, and the project remains on track for June 2017 in-service dates. Since our last earnings call, we have received FERC's notices schedule for the Atlantic Coast Pipeline. Based on this schedule, we expect to receive the final FERC certificate and begin construction in the third or fourth quarter of 2017. This schedule moves our expected in-service date to the second half of 2019. In September the project partners announced the selection of Spring Bridge Constructors as the lead construction contractor representing a significant milestone for the pipeline. This firm is a joint venture, a leading U.S. natural gas pipeline construction company with extensive experience in similar projects. As you recall, we have now added Piedmont's 24% stake in the Constitution Pipeline to our portfolio. FERC approved this project in December of 2014. However, in April of 2016, the New York Department of Environmental Conservation (DEC) refused to grant the project’s water quality certificate. In response, the project filed lawsuits with the U.S. Court of Appeals for the second circuit and the U.S. District Court of Northern New York seeking to overturn DEC's actions. Both of these lawsuits continue to progress with oral arguments before the U.S. Court of Appeals scheduled for November 16th, and we expect a decision in this case by mid-2017. We continue to believe that the business case for this pipeline is compelling, as the northeast lacks adequate access to lower-cost supplies of natural gas that this pipeline provides. Before I turn it over to Steve, I'd like to highlight on Slide 8 several of our recent operational accomplishments made possible by the dedication of our employees. As many of you know, we managed through two major hurricanes this fall. After Hurricane Hermine hit the Southeast in early September, our team restored power quickly and safely for more than 200,000 Florida customers and 150,000 Carolinas customers. Then Hurricane Matthew, a historic storm stuck to our Florida and Carolinas service territories in October. The storm tragically resulted in multiple fatalities and widespread flooding, impacting many of our customers across the Carolinas. The flooding, wind, and rain caused extensive damage to our energy system, leaving more than 1.7 million customers without power. Piedmont’s infrastructure experienced minimal damage. In terms of customer outages, Hurricane Matthew is the fifth worst storm to hit the combined Duke Energy Carolinas-Duke Energy Progress service area, with damage similar in scale to Hurricane Floyd in 1999 and Hurricane Hugo in 1989. In response, we mobilized more than 10,000 workers to rebuild the system and restore power for our customers. We continue to work with the hardest-hit areas as they look to recover and rebuild. I'm extremely proud of our employees and our unwavering commitment to serving our communities. Given the magnitude of the storm, we intend to request a deferral of incremental costs and will ask that they be considered as part of our next base rate cases for Duke Energy Progress for the majority of damage that occurred. Our current estimate of incremental costs is approximately $200 million. We are still in the process of refining these preliminary cost estimates. Moving to our generation fleet results in the quarter, our fleet responded well to the hot summer weather. Our nuclear units at Catawba and McGuire set new generation records, and our Edwardsport plant set a new station record for generation in the quarter. Also, in the third quarter Duke Energy was named to the Dow Jones Sustainability North America Index for the 11th consecutive year. This consistent run demonstrates the effectiveness of our sustainability, economic, and environmental and social efforts. This is a significant achievement earned by the entire company. In addition, we were named as Site Selection Magazine's annual list of the Top 10 utilities in economic development for the 12th consecutive year. Another example of our focus on developing our communities and growing our customer base. Through September, our economic development efforts have yielded almost $3 billion of investments and more than 10,000 jobs across our service territories. In conclusion, I am very pleased with our progress on the transition of the portfolio and in delivering strong financial results in the quarter and building momentum for a strong finish to 2016. We are advancing our strategic capital investments and maintaining our focus on operational excellence and value to our customers. Our portfolio of businesses is well-positioned to deliver strong predictable earnings and cash flows to our investors. Now let me turn the call over to Steve.

Thanks, Lynn. Today, I’ll walk you through the key drivers from the third quarter as well as provide updates on the current retail volume trends within our service territories and regulatory activity underway in our jurisdictions. I’ll close with a look ahead to 2017 and our key investor considerations. I'll start with the quarterly results on Slide 9 and discuss our adjusted earnings per share variances compared to the prior year quarter. For more detailed information on segment variances versus last year and the reconciliation of reported results to adjusted results, please refer to the supporting materials that accompany today's press release and presentation. As a reminder, this is the last quarter for the existing segment structure. We began managing the business under new segments at the beginning of the fourth quarter upon the completion of the Piedmont acquisition. On a reported or GAAP basis, 2016 third quarter earnings per share were $1.70 compared to $1.35 last year. Third quarter adjusted diluted earnings per share were $1.68 compared to $1.47 in the third quarter of 2015. Regulated Utilities quarterly adjusted results increased by $0.34 per share quarter-over-quarter. This strong performance was primarily driven by warmer weather across all of our service territories, which added $0.14. We also recognized a lower effective tax rate primarily due to prior year tax adjustments, which contributed to an $0.08 increase. Higher revenues from energy efficiency riders in the Carolinas and grid investment riders in Ohio continue to be favorable drivers of earnings, adding $0.05 to results for the quarter. Weather-normal retail volumes also added $0.04 with growth primarily in the Carolinas and Florida, I’ll discuss those details in a moment. Finally, our cost management efforts across the business provided the $0.02 uplift, despite additional storm costs in the third quarter. Our ongoing commitment to managing O&M costs and finding efficiencies throughout our business positions us to achieve our goal of maintaining a flat O&M cost structure through 2020. Commercial portfolio results increased by $0.02 per share in the third quarter, with higher results largely driven by additional wind and solar facilities placed online this year and more favorable wind resources throughout the summer months. Moving on, Other was down $0.14 for the quarter, largely driven by our higher effective tax rate due to prior year tax benefits and current year unfavorable audit settlements. These unfavorable tax items offset the favorable tax variance in the regulated utilities segment. For the year, we continue to expect a total company adjusted effective tax rate of approximately 31%, compared to our original expectation of 32% to 33%. This is primarily due to the favorable tax benefit realized at international in the first quarter. Our first three quarters have been strong reflecting favorable weather and strong execution on the part of our team. As we look to the fourth quarter, I would like to share a few considerations. First, Piedmont will contribute $0.03 to $0.05 in the fourth quarter. In regulated utilities, we have taken the opportunity to re-plan some of our O&M work including advancing a fossil plant outage and some distribution projects into the fourth quarter. In addition, the prior year results included a favorable Ohio regulatory settlement. Meanwhile, at commercial renewables, we expect a relatively flat quarter compared to the prior year and for the segment to finish below original expectations for the full year. Market returns continue to decline and we remain disciplined on renewables capital deployment. With our strong year-to-date results through the third quarter and our expectations for the fourth quarter, we are trending for the high end of our original guidance range, excluding costs associated with Hurricane Matthew. Moving on to Slide 10, let's review our retail customer volume trends. On a rolling 12-month basis, weather-normalized retail load was 0.6% through the third quarter and continues to track our long-term expectations of approximately 0.5% load growth. Overall, we are pleased with the strength of our residential volumes, which continued to grow at 1.1% over the last 12 months. A strong 1.4% annual increase in the number of new customers drives this growth. Utility-sponsored energy efficiency programs and more efficient building codes and standards continue to partially offset this customer growth. Recently we have seen a decline in usage per customer beginning to level out. Looking forward, positive trends in new job and wage growth as well as a recovery in housing are positive signs for continued residential growth. Moving to the customer class, we experienced an increase of 0.4% over the rolling 12 months and improvement compared to last quarter. Commercial usage is slowly improving across our jurisdictions as non-manufacturing employment improves and office vacancies continue to decline, even with new office space being added. These improvements were somewhat offset by commercial businesses supporting manufacturing. In addition, we continue to see declines in the government and education sectors, especially in the Midwest. In the industrial class, we see growth of 0.2% on a rolling 12-month basis. Industries that support construction and automotive continue to show resilience, however the metals industry is once again experiencing declines. We will closely monitor economic conditions and our customer usage patterns throughout the remainder of the year and into 2017. Moving to Slide 11, let me take a moment to discuss the status of the DET's South Carolina rate case. In October, we reached a constructive settlement with the office of regulatory staff and other key intervening parties. The settlement was reviewed by the Public Service Commission and Staff Carolina during a hearing earlier this week. The major components of the settlement were largely consistent with our initial filing, we requested a $79 million increase with an allowed ROE of 10.75% and an equity structure of 53% and a rate base of $1.3 billion. Our significant energy infrastructure investments were the key drivers for the proposed increase. The settlement provides for a $56 million revenue increase and an allowed ROE of 10.1%. We also agreed to a 53% equity structure and a $1.3 billion rate base. If the settlement is approved as filed, new rates are expected to be effective in January 2017. Customer rates would be implemented over a two-year period; in year one, customer bills will increase by $38 million, then step up to $56 million in year two. DEP will reduce its cost to removal liability by $18 million in year one to provide a neutral earnings impact to the company in the first year of rate implementation. Based on the settlement, coal ash costs that have incurred will be recovered with a return over a 15-year amortization period and we agreed to defer any future rate cases until 2019. This settlement is an important milestone, and we are expecting an order from the commission in the coming weeks. With the transition in our business portfolio, I want to provide you some broad parameters for 2017 on Slide 12. Consistent with past practice, we will provide guidance for 2017 including a five-year capital plan during our February earnings call. We anticipate growth in the core businesses: electric and gas infrastructure and commercial renewables of about 5% off of the $4.30 midpoint of our 2016 adjusted earnings per share guidance range. Accretion from Piedmont is expected to be $0.08 to $0.10 per share in 2017, a strong first year reflecting the benefits of early integration. We will provide additional perspective on growth capital in all of our segments in February. International results through closing use of sales proceeds and National Methanol are expected to contribute between $0.10 and $0.15 per share in 2017. National Methanol will move to other and contribute $0.05 per share based on prevalent Brent crude oil prices in our ongoing ownership percentage, which is expected to decrease in 2017. The use of proceeds from the sale of our Latin American generation assets of $1.7 billion to $1.9 billion will displace future financing at the holding company and will also contribute about $0.05 per share based on current interest rates. We estimate first quarter operating results from our international business could also add up to $0.05 per share of earnings depending upon the timing of the close. We look forward to further discussions of 2017 and beyond in February. I’ll close with Slide 13: Duke Energy has tremendous scale offering an attractive investor value proposition, which includes balanced growth in earnings and reliable dividends over time. Within months, we expect to complete our multi-year portfolio transition, affirming our commitment to provide low risk, high quality earnings and cash flows, and supporting our long-term growth projections. We will continue to invest in cleaner energy resources, modernize the energy grid, and build our natural gas platform while providing enhanced services for our customers. With that, let's open the line for your questions.

Could you discuss in a little more detail the results from commercial renewables, which I believe were not as expected? I'm interested in understanding some of the issues surrounding that.

Michael, I would direct you to Slide 16 of the deck which gives you a comparison of where we are for year-to-date results against original expectations. Can you see commercial has delivered about $65 million of net income against our original expectations of $140 million. We are not expecting that will deliver $140 million for ’16. Some of that shortfall will be the result of lesser capital deployment as Steve mentioned, returns have been very market-driven, so break for customers but load for investors. And then we continue to expect to be slightly behind on wind and solar resources as a result of what we've seen in weather patterns. So those are the two things that I would point to.

Is it that the market for investment has become more competitive than you expected, let's say, a year ago, that returns on acquisitions are just smaller than you thought? Or is this more of a weather issue?

I think returns are lower, Michael, and I think the other thing to consider for Duke as an investor is we are in an NOL position as a result of bonus depreciation and so as we look at returns we consider that the monetization of tax credits needs to reflect when we will be a cash taxpayer, so the DCF of that can challenge our returns. So that's something that we'll continue to monitor. As time progresses, we understand the market well, we have great expertise in both wind and solar based on the business that we've built, we still like the business, but we are declining in the way we deploy the capital based on the returns we’re seeing in the market.

How long does that NOL position go out to? What do you expect?

As currently we are expecting, assuming there are no further extensions of bonus, that we would come out of the NOL position in 2019. We would then begin using tax credits ITC production tax credits, so we would still not be a significant cash taxpayer for a few years after that.

But that, in theory, could make the renewables business a little more competitive for you, right?

I think as we get closer to that period of tax where we burn off the NOL, that will impact our view of returns, Michael, because the relative value of the tax credits will be greater.

Alright, understood. Thank you.

First question, Steve, the proceeds from the international sale, as you mentioned, you are going to use to pay off parent debt. Can you remind me, on average, what's the average interest rate on the debt that you are paying off?

When we did the calculation, we came up with roughly $0.05. We’re looking at long-term holding company rates, might be in the 3.5% to 4% type range of that nature. So that's the basis of what we’re looking at and we've baked that into our financing plans anticipating that to happen; we’ll initially take down some bridge facilities of shorter term with the proceeds.

Okay. But is there sufficient high-cost debt available to achieve those kinds of savings?

Well, what I'm speaking about is, we’ve anticipated this and baked it into our financing plans to avoid issuances of hold co. at that higher level.

So, Ali, if you think about it, as $1.7 billion to $1.9 billion of proceeds coming into the holding company. So the average rate, as Steve referenced, is consistent with that.

I see. Then second, regarding the commercial results you're reporting, $65 million year-to-date or $140 million for the year, it's a bit lower now. How much of that is approximately due to the recognition of tax credits?

Tax credits are going to be a significant part of the renewable return. Ali, I don’t have an exact number in front of me; we do have a modest amount of contribution in commercial fund of pipelines at this point to the third quarter, we’ll move that to the gas infrastructure segment in the fourth quarter.

That’s correct. The results for the commercial portfolio reflect small amounts of AFUDC on the pipelines that will be growing. But right now it is primarily from the renewables business, and that is heavily driven by the recognition of the tax benefits.

Got it. Last question. Lynn, as you look at this portfolio now, post the international sale, and you look at your utility footprint, is everything essentially core as far as Duke is concerned? And related to that, as you are looking at growth over at least the next three, four years, does M&A come back into the mix for you as you are looking to deliver growth for shareholders?

So Ali, the businesses that we earned coming out of the transition are all core and I think the strength of the franchises we own in the Southeast, both Gas and Electric, and then a strong position in the Midwest are core businesses. And we’ll be looking to drive growth for investment that builds on cleaner forms of generation and strengthening our grid and driving growth and providing value to customers - that will be job one at Duke. I believe M&A represents something that we will continue to look at as opportunity for rise, and I think we’ve demonstrated a track record of successful integration of M&A candidates, but job one, as I said, is growing core businesses that we own.

Thank you.

So maybe just jumping back to your renewable portfolio, when you are underwriting these investments, do you generally assume that the PPA cash flows are going to cover the full investment cost? Or do you assume some residual value, post-PPA, in order to recover that investment?

We will typically assign some terminal value beyond the contract period.

Okay, got it. As a follow-up, can you provide any guidance on how you think about valuation after the PPA? Do you make some assumptions regarding re-contracting or do you use a dollar per kilowatt multiple or some other method?

We look at a variety of things as we think about terminal value, including forward curves as well as market experience. Our contracts are the majority of the value that we are looking at, and so terminal is something and we look at a range of possible outcomes.

Got it, thanks.

Thank you, everyone, for your interest and investment in Duke Energy. We have made tremendous progress this quarter and look forward to see many of you in the coming months and at the EDI Financial Conference next week. Thank you.