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Utilities Beyond California Also Struggle to Maintain Infrastructure

Utilities Beyond California Also Struggle to Maintain Infrastructure

News stories are focused on California as wildfires spotlight the problem of the state’s utilities to maintain and upgrade infrastructure to ensure safety. But the problem is not confined to California.

The Charlotte Business Journal reported,

Duke Energy Corp. (NYSE: DUK) has changed its construction and financing plans for the still-stalled Atlantic Coast Pipeline, pushing off any operations to 2022 and issuing $2.5 billion in additional stock by the end of next year to cover costs.

Duke has been saying for some time that it did not anticipate issuing additional stock for the project. The sudden reversal, announced in conjunction with Duke’s earnings [and] came as a surprise to investors, said analyst Andy Smith at Edward Jones.

He suspects that it is the major contributor to a drop in Duke’s stock price.

DUK daily chart

CEO Lynn Good and CFO Steve Young explained the decision as largely resulting from two factors. The first is Duke’s long-held commitment to maintaining its strong credit rating, combined with the recognition that delaying the any operation of the project into 2022 creates a cash-flow question.

Duke and its partners had been looking at operating a part of the pipeline starting in 2021. But by giving up on that partial operation, Duke loses expected revenue from the project in 2021 and 2022.

“So, we thought it was appropriate in light of the events that occurred this quarter, … to derisk our plan, get the balance sheet in good shape, move forward as we have said on Atlantic Coast Pipeline,” Good said during [the] earnings call.

“(We) really feel like the plan itself is a solid one that represents good growth for investors.”

Young said, in an effort to maintain ratings from Standard & Poor’s and Moody’s, Duke is targeting 15% to 16% in funds from operations.

“A delay of a project of this magnitude has a lot of cash-flow implications, and so, we want to be mindful of that and be proactive,” he said. “And I think this will give us flexibility on the back end of things as well.”

Duke owns 47% of the proposed $7.8 billion project, which is currently on hold due to court challenges by environmental groups. Dominion Energy Inc. (NYSE: D), which owns 48% of the project, made no similar announcement about issuing stock to cover its costs.

The stock issue occasioned the first question from analysts on the call and at least six follow-up questions as analysts worked to understand the change in strategy and the impact it will have on diluting earnings per share going forward.

Good said Duke is looking at issuing the additional shares opportunistically, with the majority coming at the end of 2020. So, there would not be any dilution until 2021 and 2022.

Young said at least some of that would be offset from higher earnings, because the delay means that Duke will make additional returns on funds used during construction.

Smith said a lot of questions remain. He said that investors never like to see large stock offerings, and that they would probably prefer to see Duke sell some assets. The most likely candidate for that, he said, would be the commercial renewables business, since most of Duke’s other segments relate directly to its core utilities.

There are also some remaining questions about the math. Duke says it has $2 billion on the pipeline to date and plans to raise $2.4 billion more.

That adds up to roughly $4.5 billion. But Duke’s share of the project at the current high figure of $7.8 billion would be about $3.7 billion.

That raises the possibility that Duke may be seeking additional capital from equity for other purposes, particularly when you consider that the company has a $37 billion plan for capital over the next several years.

But Duke says the money is earmarked only for costs related to pipeline project. What appears to be additional money is there simply to cover cash-flow issues caused by the delay in pipeline operations.

Good and Young said on the call:

that once Duke gets past that issue, the company should be able to reduce plans to issue about $500 million annually through at the market sales and dividend reinvestment plans for shareholders.

The 600-mile pipeline faces two major hurdles occasioned by the federal courts right now. Construction on the pipeline has been halted by a U.S. 4th Circuit Court of Appeals ruling that invalidated an environmental finding issued by the U.S. Fish and Wildlife Service.

That finding is needed before the Federal Energy Regulatory Commission can allow construction on any portion of the project.

The service is now working on issuing a new finding in that case, which relates to the protection of endangered species.

Another issue is heading to the Supreme Court early next year.

The 4th Circuit ruled that a permit to allow the pipeline to go under the Appalachian Trail was improperly granted by the U.S. Forest Service. And it ruled that essentially no permission could be granted without approval by Congress.

Good said that Duke is encouraged by the developments in the project, including the Supreme Court’s decision to take up the case. She said the pipeline now has a path that can lead to the resolution of all the issues. And with the greater clarity, she said, Duke has been better able to determine how to structure its finances to handle the expected timelines for completing the project.

This news could all lead to a short term down trend in the stock.

DUK weekly chart

A Trading Strategy To Benefit From Weakness

A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.

In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.

Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.

One strategy that traders can consider is the bear call spread. This is a trade that uses two calls with the same expiration date but different exercise prices.

Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call. The call is sold to limit the risk of the trade. So, this strategy will always generate a credit when it is opened and will always have limited risk.

The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.

bear call spread

A Bear Call Spread in DUK

For DUK, we could sell a December 20 $90 call for about $1.35 and buy a December 20 $92.50 call for about $0.56. This trade generates a credit of $0.79, which is the difference in the amount of premium for the call that is sold and the call.

Remember that each contract covers 100 shares, opening this position results in immediate income of $79. The credit received when the trade is opened, $79 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade in DUK is about $171. The risk can be found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($79).

This trade in DUK, offers a potential return of about 46% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if DUK is below $90 when the options expire, a likely event given the stock’s trend.

Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $171 for this trade in DUK.