Utility CEO Talks Nuclear, Solar. Plus, Bonds and Inflation.

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As we look at a goal to get to net zero over time, nuclear is a part of that equation because I don't have a resource that I can replace nuclear with to deliver that low-carbon future.

Hello and welcome to the Barron Streetwise Podcast. I'm Jack Howe. The voice you just heard, that's Lynn Good. She's the CEO of Duke Energy. It's the second biggest utility in the US by stock market value. Duke stock recently had a dividend yield of 3.8%, and that's about triple the yield on the 10-year US Treasury. But is the outlook for utilities bright? And how should investors choose among them? Also, what should investors make of an activist recommendation that Duke split into multiple companies? Ahead, we'll hear from Lynn at Duke, and we'll talk with Sophie Karp, who covers utilities for KeyBanc Capital Markets, about 3 utility stocks she says to buy and another she doesn't like at all. We'll also make a few minutes for some listener questions about the stock market. Listening in is our audio producer Jackson. Hi Jackson. Hey Jack. So our power went out last weekend for the first time since I moved back in March, and it wasn't too bad. My family sat in the dark with flashlights and we took turns reading from a kid's book called Uncle Wiggly's Adventures. Jaxon, have you heard of Uncle Wiggily?

I've never heard of Uncle Wiggily.

No one ever has when I asked that. It was read to me every day when I was growing up. He has rheumatism, which today people call arthritis, and he sets off, he packs his valise, which is a bag, and I'm pretty sure it's pronounced valise, but I've been mispronouncing it to my children for so long, I have to stick with valise. Anyhow, my power company texted me to say it was working on the problem and it would have it fixed in 3 to 4 hours. And it did. And I think that's pretty responsive for a company that's just about 200 years old. The company's Consolidated Edison. It traces its roots back decades before the birth of Thomas Edison or even the electricity business to the New York Gas Light Company. And that was listed on the New York Stock Exchange in 1824, which makes ConEd the exchange's longest listed stock. Now, they say severe storms are growing more frequent, so ConEd emergency workers, I'd imagine, will stay busy. Also, I live an hour north of New York City, not too far from a nuclear power plant that was just shut down for good 3 months ago. Long term, there are plans to produce more power here from wind and solar, but in the near term, my power here could become less reliable and even less green since the lost nuclear generation will be made up with more natural gas. I definitely need a standby generator before winter and some solar panels might help too. So these themes, outages, aging nuclear infrastructure, the shift to renewable energy, what do they mean for the financial prospects of utilities? And should investors continue to regard utilities as a source of stable income. I had a chance recently to speak with the head of one of the biggest US utilities.

At no point in my life was I talking about running a power company. I wanted to be a ballet dancer. So the equivalent of your—

All due respect to ballet dancers, I think it worked out well for you. That's Lynn Goode, CEO of Duke Energy, and her childhood ballet interest gave way to a career in public accounting, and she ran a variety of businesses at Duke and worked as the company's chief financial officer before being named CEO in 2013. There are many kinds of investor-owned utilities. Some generate power, some distribute power, some also distribute natural gas, and some like Duke do all of these things. The power business is capital intensive, meaning you have to spend a lot of money to get into it. Businesses like that can lend themselves to monopoly control, and since power is a necessary good, many power companies like Duke are regulated by the government. They're told what return they're allowed to earn on the money they invest. That can make returns for utilities steady and predictable, but it also means you're probably not going to find the next Amazon in the utility sector. Investors look to the sector for its dividend income and its defensive characteristics, its ability to hold up relatively well when the economy turns weak. Duke serves the Carolinas and parts of Florida and the Midwest. Its goal is to grow earnings per share by 5% to 7% a year through 2025. Now, if you assume that stock prices will rise at that same pace, And if you add in the dividend yield, you can see a pretty feasible path to 10% yearly stock returns. I asked Lynn to describe her plan for growth.

It is not a viable strategy to continue increasing price. So we're looking for ways that we can drive efficiencies in our business, which we do at times from putting new technologies and capital in place that reduces labor costs, that makes us more efficient in our operation, because we want to accomplish all of this with an affordable price for customers.

Reducing costs is different from growth in most industries, but in the utility business, the two are closely related. If a regulated utility wants to invest money and recoup a rate of return from its customers, it needs permission. Whether it gets permission depends in part on how good of a job it has done on holding down customer bills. Customer bills are affected in part by by the expenses of the utility. So utilities that can find ways to bring down their expenses also might be improving their growth outlooks. That's especially true if they can invest money to improve their efficiency and resiliency. Here's Lynn.

It's new technologies to isolate outages, try to minimize how many customers are affected, technologies that allow us to predict what's happening on our system, Drone technologies to review what's happening on our system, smart meters to give us better information on where and what's occurring. And so that ongoing investment really focused on improving reliability is something that we invest in year in, year out.

We talked on this podcast with the CEO of Sunrun, the biggest US solar installer, about how solar isn't just for homeowners looking to go green. Solar costs are competitive with grid electricity, and some homeowners view solar, especially paired with batteries to store solar power, as a way to diversify where their power comes from and protect against outages. But as more homeowners install solar, fewer are left to buy power from utilities and to absorb utility costs. Taken to the extreme, That could lead to utilities becoming less competitive, spurring more solar installations, and so on. There's a term for that, and it's not an encouraging one for utility investors. It's called the solar death spiral. But let's not overstate the case. The U.S. Department of Energy predicts that on-premises electricity generation, including from rooftop solar, will double as a percentage of overall power generation by 2050., but only to 7%. In other words, solar isn't going to replace the power company anytime soon. Lynn says that her job is to meet customer expectations and that rooftop solar is one of those expectations. But she also says that she can build large solar facilities that are cheaper per kilowatt than home installations. In some cases, she can offer customer subscriptions to those solar fields.

Typically, Jack, the larger-scale installations of both solar and battery are cheaper than the smaller ones. That's the economics today. So if I build a solar, 75-megawatt solar plant in a field versus you putting one on your roof, I can build it cheaper. But that doesn't mean the system is going to have just one. It will have both.

Duke has been closing its coal-fired power plants. Natural gas is an important power source today, but the company plans to triple its base of renewable power by 2030 and reduce its carbon output by then by more than half. So if coal is the past and natural gas is the present and renewables are the future, where does nuclear fit in? Here's Lynn.

At Duke, nuclear fits into the present and the future because we operate the largest fleet of regulated nuclear plants in in the US. And so if you live in the Carolinas, North and South Carolina, over 50% of your power comes from carbon-free nuclear. And as we look at a goal to get to 80% reduction and net zero over time, nuclear is a part of that equation for Duke Energy because I don't have a resource that I can replace nuclear with to deliver that low-carbon future. It runs 95% of the time. You turn it on and it runs. So we see it as very important. And we also are advocating for additional R&D investment in new nuclear technologies, advanced nuclear, small modular, because we think it could be part of the future in getting to net zero. We have never run the electric system with a single resource, Jack. I think wind will be part of it. Solar will be part of it. Battery storage will be part of it. Nuclear will be part of it. We see natural gas as a bridge fuel to new technologies. Because we think there'll be further innovation—hydrogen, maybe carbon capture, maybe longer duration storage, advanced nuclear.

Duke has a shareholder called Elliott Investment Management, which has pushed for the company to split into 3 companies. It's a pretty common practice for a so-called activist investor to take a big stock stake in a company and then publish a letter with recommendations on how to make the stock price go up. Sometimes just the presence of an activist will push the stock price higher. Some activist campaigns are more contentious than others. Duke has come out against Elliott's split-up plan, and Elliott recently published a new letter calling into question, among other things, management compensation. For the record, Duke stock has returned 118% since Lynn took over as chief. A SPDR exchange-traded fund that tracks a basket of utilities, ticker XLU, has done 11 points better over that period. And the S&P 500 index has done more than 100 points better. I asked Lynn, what's so wrong with breaking up?

I would start the conversation by saying we remain open to ideas and have been in discussions and dialogue with this investor for over a year. And each of the ideas we take really seriously and we look at it closely and frankly have not seen that three-way breakup as creating long-term value. And it really centers on the fact that the credit metrics, the scale of those companies, the cost to put corporate center and a DC office and an environmental health and safety and a cybersecurity operation in those individual companies would be substantial. And so to take Duke and break it into small pieces, we just frankly don't see the ability to create long-term value.

Sophie Karp is a utility analyst at KeyBanc Capital Markets, and that gives her a good overview of whether the industry as a whole is attractive right now. She says utilities have enjoyed a long bull market, thanks in part to falling expenses.

It's much cheaper to run newer gas plants versus older coal plants in terms of efficiencies and labor. Then you would have lower interest costs, right? Because debt was cheap and getting cheaper. And then you would have a tax reform where the tax rates got cut. So when all of these operating costs are coming down, that relieves the pressure on customer bills. And it's only so much a customer bill can increase before there's a political blowback.

The pandemic wasn't so bad for utilities, financially speaking. Demand for power shifted from commercial customers to residential ones. Because workers left their offices for their homes. But residential power tends to have higher profit margins than commercial power. Now, however, is a tricky moment to invest in utilities, Sophie says, in part because it's unclear whether higher inflation will stick. And if it does, it could increase costs for utilities. Many companies can simply pass higher inflation along to customers as price hikes, but for regulated utilities, raising prices is more complicated. I asked Sophie if homes are trending toward greater electrification by, for example, adding outlets to charge electric vehicles, and if homeowners are installing more solar, how do those two trends offset each other and what does it mean for utility investors? She says it's too early to say, but to the extent that solar will affect utilities, it'll have the largest impact on ones that both generate and distribute power. Sophie is bullish on Duke, but she recently downgraded ConEd, my power company, to underweight. Part of her reasoning had to do with the contrast in the two companies' relationships with regulators.

The whole political dialogue around the utility and the role of the utility in the green transitioning is a lot more constructive down there in the Carolinas, right? So this is where you have other political players, legislature, the governors recognize the significance of the role of the utility. And there's not so much of the utility bashing that goes on down there as it is in New York routinely. They also experience population growth, which is quite meaningful in those jurisdictions. And that again helps to keep the customer bills in check.

Sophie says New York, where I live, doesn't have enough population growth, which is important because it affects the ability of my power company to spread out its costs.

The more customers you have to spread those costs over, the lower your ultimate bills will be. And so when you have population growth, that alleviates a lot of bill pressures. And then in New York, a large part of the business in New York is natural gas. It's a gas utility, and that situation has been very difficult, quite honestly. Recently, there's been moratoriums on new gas hookups and there's significant fear among investors that ultimately the gas utility in New York will be a stranded asset because the political establishment doesn't want gas.

Sophie says that there is plenty of talk among investors about how companies rank on environmental practices, but that utility investors might not be paying enough attention to which companies are most exposed to destruction from climate change.

So if you're in a flood zone, if you're in a desert, if you're in a wildfire-prone territory, you're going to suffer disproportionately because your infrastructure is continuously at risk. We are seeing that the market reflects that, but I don't see people connecting the dots a lot. And we would publish extensive research on this particular topic, but California utilities are trading at a discount because of wildfires, but wildfires are happening because of climate change. So ultimately what you're looking for is how climate change impacts these different regions differently. And nothing they can do in California alone is going to fix that. California utilities can go zero carbon and they're going to still have wildfires.

Duke, ticker DUK, isn't the only utility stock Sophie likes. She calls New Jersey's Public Service Enterprise Group, ticker PEG, underloved. It's shifting away from the merchant power business where companies generate power and sell it to the highest bidder and where returns on investment haven't been great, and it's focusing more on being a regulated utility with plenty of nuclear generation and growing offshore wind assets. Sophie says companies with similar profiles tend to trade at higher valuations than where Public Service trades today. She also likes Ohio-based FirstEnergy, ticker FE. It sold off on a bribery scandal related to legislation to bail out power plants The company announced a $230 million settlement this past week. Sophie says the stock can recover. Public Service, the first company, has a 3.4% dividend yield, and FirstEnergy, the second one, yields 4%. What about the activist proposal facing Duke? Sophie calls Duke's response spot on, and she calls some of the criticism of management outdated. Duke was a partner in something called the Atlantic Coast Pipeline that was supposed to increase natural gas supplies, both for Duke's gas distribution business and for generating electricity from gas. But there were cost overruns and legal challenges, and Duke canceled the plan last year and booked a loss and said it will divert some of the investment dollars to more renewables. Finally, I asked Sophie about nuclear power. Lynette Duke sounded like she thought there might be a future in nuclear, not just for Duke's current assets, but for new projects or new technologies. Sophie from KeyBank isn't so sure.

The only nuclear plant under construction in the US right now is Plant Vogtle that's being built by Southern Company. After seeing how much Southern struggled with this plant, and a lot of that had to do with, you know, developer-contractor issues, I don't think there's any appetite among regulated utilities to build nuclear plants at this point.

Jackson, do we have time for a listener question if I keep the answer short? I think we could do two. That's a bold claim. Who do we have?

Yeah, we have also Jack with a question about inflation. Let's hear it.

I wanted to ask a question about inflation, which I've been reading a lot about recently, but of which I don't have any real-world understanding, as the inflation rate in the US has hardly exceeded 3% since I was born in 1999. I know that the government usually fights inflation with contractionary policies like raising rates, but what would a market environment like that mean for investors? What new areas would they probably look to for appreciation, yield, or safety?

Thank you, Jack. What we know is that the U.S. Consumer Price Index rose 5.4% in May versus the year before. That's the fastest inflation in 13 years, and it's well above the Federal Reserve's target. What we don't know is whether higher inflation will stick or pass. That is certainly what the bond market is saying. If bond investors thought that higher inflation was a big risk, they would surely be selling bonds, causing prices to fall and yields to rise. But just the opposite is happening. In fact, for my tastes, the bond market doesn't look cranky enough. Bond investors seem so supremely confident that inflation will recede that it makes me wonder if they expect a weak economy next year. As to what higher inflation would mean for investors, UBS published a report recently breaking the past 45 years of stock market returns into long periods, some with high inflation and others with low inflation, and stocks did well through both environments. That makes sense. Stocks aren't static things like bonds. They represent businesses run by clever people who can respond to changing conditions, including inflation. As for what to favor, if you expect inflation, to the extent higher inflation would bring higher interest rates and would correspond with healthy economic growth, it would probably favor banks, which would see strong loan demand and higher spreads on their lending. But again, faster inflation might not be here to stay, at least not yet. How am I doing on time, Jackson?

We still have time for that one more. Here's Mike. My question's about risk and returns. Many investors that are closer to retirement typically would move their portfolios to holding more fixed income, you know, to lower the risk in the market, but with interest rates so low, many of them have their portfolios more into equities than they typically would. I believe that investors should build their portfolios around diversification and their risk profile, but advisors are basing it on returns today, and with the markets being so frothy these days, I feel like if the bubble pops, this could create a problem not seen since the Great Depression. Let me know your thoughts. Thanks.

Thank you, Mike. I think you're right, bonds stink right now, but you still need them. They can earn their place in a pinch. Like this past Monday when the stock market tumbled, bonds held up well. But what do you do to make up for low portfolio income due to stingy bond yields? What you don't do, I think, is reach for riskier bonds. Even junk bonds don't pay that much right now. You can favor stocks that pay dividends like utilities, I wouldn't shift money from bonds to stocks wholesale just to make up income. In fact, rather than reach for anything too risky, I'd sooner just make peace with lower investment income. If you need more money to live on than bond yields or stock dividends are providing, better to keep your principles safe and just do some selling from time to time. Thank you, Jack and Mike, for sending in your questions. And if anyone else out there has questions about the stock market, inflation, the economy, Uncle Wiggly, what have you, you, just tape on your phone, use the voice memo app and send it to jack.hough@barons.com. Thank you for listening. Jackson Cantrell is our producer. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. If you listen on Apple, write us a review. And if you want to find out about new stories and new podcast episodes, you can follow me on Twitter. That's @jackhowe, H-O-U-G-H. See you next week.

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