In my Dividend Growth Portfolio, I collect dividends in cash and reinvest them when the total reaches $1000.
Thinking in advance about what I might buy, I find that my thoughts have turned to utilities.
With that possibility in mind, I decided to analyze one of the country’s largest utilities: Dominion Energy (D).
Headquartered in Virginia and operating in several states, Dominion is the 4th largest domestic electricity and gas utility (ranked by market capitalization).
I want to see whether it might make a good addition to my portfolio, and at the same time provide Daily Trade Alert’s readers with a comprehensive analysis of the company for their own purposes.
Dominion’s Dividend Record
Dominion sports a solid dividend record. At 15 years, its dividend growth streak makes it a Dividend Contender on the Dividend Champions document (CCC). The graph below shows Dominion’s dividend payments since 1998. You can see the increase streak began in 2004 and has been steadily upward since then.
[Source of all yellow bar charts: Simply Safe Dividends]
With a 4.7% yield, Dominion is a mid-to-high-yield stock. Dominion yields 158% more than the S&P 500 and 74% more than the average CCC stock.
It is somewhat unusual for a stock yielding 4.7% to have a fast dividend growth rate, but Dominion does, including an 8.4% increase this year and a 5-year dividend growth rate of 9.6% per year.
Dominion gets a solid dividend safety score of 75 from Simply Safe Dividends. That rates as Safe on their rating scale as shown below. (For more insight into dividend safety, see Dividend Growth Investing Lesson 17.)
At its 1st -quarter earnings presentation in April, Dominion affirmed its expectation for 10% dividend growth in 2019 and 6-10% in 2020. The company’s next earnings presentation is scheduled for August 1.
Dominion’s Business Model and Quality
Dominion Energy is headquartered in Richmond, VA. Employing more than 16,000, it serves more than 6 million utility and retail energy customers in 19 states, principally along the Eastern seaboard and Western Rockies.
[Source of slides: Various presentations and reports by Dominion Energy]
Dominion is one of the nation’s largest producers and transporters of energy:
- Approximately 26,000 megawatts of electric generation;
- 14,800 miles of natural gas transmission pipeline;
- 51,800 miles of natural gas distribution pipeline;
- 6,600 miles of electric transmission lines;
- 57,900 miles of electric distribution lines
- Operates one of largest natural gas storage systems in the U.S. with 1 trillion cubic feet of capacity
Dominion has been shifting its business mix toward more regulated operations for years, reaching 90% in 2016. In 2010, it began moving away from businesses such as exploration and production and merchant energy plants and shifted its focus toward utility infrastructure.
As detailed on the slide below, Dominion operates in 3 groups:
- Power Delivery: regulated electric transmission in VA and NC (20% of earnings)
- Gas Infrastructure: natural gas transmission and storage (35%)
- Power Generation: serves electric utility customers in VA and NC (45%)
In its regulated businesses, Dominion enjoys guaranteed monopolies, and its regulators are considered to be business-friendly. Compared to utilities in general, it earns above-average ROE (return on equity) on the assets that ROE is applied to. That makes it more profitable.
Its customer base in VA is in a solid economy, with a low unemployment rate, strong data center demand, and significant governmental and military presence.
Dominion’s gas infrastructure segment operates a regulated natural gas distribution company in OH and WV, other transmission and storage operations, and an investment in a joint venture (Cove Point) that will gather, process, and transport gas from the Utica shale.
Dominion is in the midst of attempting to acquire SCANA (SCG, a SC-based utility), which would increase its service area in NC and grow it into SC. Dominion expects the acquisition – which it hopes to close by the end of the year – to immediately add to its earnings and earnings growth rate going forward.
The green area on the map below shows SCANA’s service area, and the map illustrates how the acquisition would be a natural extension of Dominion’s existing operations. The bar graphs show that the acquisition fits with Dominion’s desire to grow its proportion of regulated businesses.
The acquisition of SCANA is to be all-equity (no debt). As of this writing, the proposed merger has been approved by the Federal Energy Regulatory Commission. It still needs approval from SCANA’s shareholders, public service commissions in NC and SC, and the Nuclear Regulatory Commission. Dominion’s CEO stated in July, 2018 that he expects the deal to close by the end of this year.
Morningstar awards Dominion a wide moat, its highest ranking. Among the factors its mentions in support of this ranking are:
- Constructive regulatory environment (VA)
- Operates in areas with attractive growth potential
- Advantages of scale
Beyond the SCANA acquisition, a couple of Dominion’s major growth initiatives should be mentioned.
The first is the Atlantic Coast Pipeline (ACP), a $5 billion natural gas transmission line that will transport natural gas from the Marcellus and Utica shale areas to utilities in Virginia and North Carolina, with possible later expansion to other states.
ACP is expected to be completed and in service by the end of 2019. It is a joint venture with two other major utilities, Southern (SO) and Duke (DU). Dominion is the majority partner, and it will construct, operate, and manage the ACP.
Another important growth initiative is Dominion’s $4 billion Cove Point liquid natural gas export facility, on the Chesapeake Bay in Maryland. Cove Point’s full capacity has been contracted for 20 years.
In addition to its major growth projects and the SCANA acquisition, Dominion has sizable ongoing capital growth and maintenance projects associated with its existing infrastructure. This slide illustrates them:
I use a company’s credit rating as one of the metrics for judging its quality. Dominion has a low “investment grade” rating from S&P of BBB+.
The company is focused on maintaining or improving its rating – this is one of strategic initiatives identified for the next few years.
Here is a summary of Dominion’s business quality rankings:
Value Line gives Dominion a middling Financial Strength Grade rating of B++. That is the 4th -highest of 9 levels in its rating system. Let’s take our own look. There are a lot of moving parts with Dominion, especially given how much it is spending on growth and expansion projects.
Return on Equity (ROE) is a measure of financial efficiency. ROE measures a firm’s efficiency at generating profits from each dollar of shareholders’ equity (also known as net assets or assets minus liabilities).
The average ROE among Dividend Champions is 22%, and for S&P 500 companies it is about 13%. The following chart shows Dominion’s ROE since 2008.
You can see that Dominion’s ROE tends to run in the mid-teens, or about average for a large corporation. ROEs often vary from year to year. It is important to look at ROE from a long-term perspective.
Debt-to-Capital (D/C) ratio measures how much the company depends on borrowed money to finance its activities. Most companies finance their operations through a mixture of debt and equity (shares sold on the open market or issued to pay for acquisitions) as well as their own cash flows.
High debt can “juice” the ROE number, so I like to check debt to see if that is happening. All else equal, the higher the D/C ratio, the riskier the company is. Debt must be paid back, so debt repayments create a constant draw on the company’s cash flows.
A typical D/C ratio for large companies is 50%. Let’s look at Dominion’s debt ratio.
As you can see, Dominion’s debt runs somewhat higher than the average large company.
That is not unusual for utility companies, especially one with so many large-scale expansion projects as Dominion.
We saw earlier that Dominion has adopted a strategic emphasis on reducing its leverage over time. Nevertheless, at 61%, Dominion’s debt just inches into the “poor” (meaning too high) range of my rating scale. Combined with its BBB+ credit rating, that means that Dominion has quite a bit of cash flowing to debt repayments every year, and that is a drag on the company’s financial performance.
Operating margin is a measure of profitability. It measures what percentage of revenue is turned into profit after subtracting cost of goods sold and operating expenses.
Per a report from Yardeni Research published earlier in 2018, the operating margin across S&P 500 companies is around 11%-12%, as shown in the following graph.
Dominion’s operating margin has been much higher than that average.
Dominion’s operating margins have been in the 20s and 30%+ range for the past decade, more than double the S&P 500 average. This is excellent performance.
Earnings per Share (EPS) – that is, a company’s officially reported profits per share outstanding – is always of interest. We want to see if a company has had years when it lost money, or if its earnings are steadily increasing or declining.
Dominion has a good earnings record. Its earnings have been consistently positive over the past 10 years, including during the recession years of 2008-09.
Earnings rose in 4 of the last 9 years. The consensus forecast for earnings growth over the next 3-5 years is 6% per year.
Free Cash Flow (FCF) is the cash a company has left after paying its expenses, including capital expenditures that maintain or expand its asset base. Excess FCF allows a company to pursue investment opportunities, make acquisitions, repurchase shares, and pay/increase dividends.
As with earnings, the significant number to examine is the per-share amount, and again we look for trends.
At first glance, Dominion’s FCF record looks awful. All the annual number are negative. It is hard to look at the chart and see how Dominion can pay any dividends at all, let alone raise them each year. But that’s what it has been doing.
Let’s look deeper. It turns out that negative FCF is common among utilities.
[Image source: Market Realist]
The reason is the companies’ enormous expansion projects. Utilities routinely spend a great deal of money for capital expenses, both to maintain current assets as well as to build new infrastructure. Improving the energy grid can cost billions of dollars upfront, which can take years to recoup.
The funding gap is manageable, because regulators allow a healthy rate of return on both maintenance and growth projects, which allows the eventual recovery of the utility’s capital outlay.The result is that many regulated utility companies can register negative FCF for years without jeopardizing their dividends.
Here is Dominion’s record of operating cash flow and capital expenditures as displayed on Morningstar.
As you can see, Dominion generates billions of dollars of operating cash flow each year. But when its capital expenditures are subtracted out, free cash flow is negative every year. It’s the result of Dominion’s growth trajectory, which is ultimately good for the company.
Whereas normally I would consider a series of years with negative FCF as a disqualifying factor, for a growing utility company it is a common and acceptable situation.
Here is a summary of the items above:
Overall, this is a middling financial picture. Lots of categories are in the yellow range, and the level of debt is high.
The level of debt is a concern, but it is ameliorated somewhat by the financing characteristics of all growing utility companies.
As stated earlier, Simply Safe Dividends accords Dominion’s dividend a “safe” rating. Dominion’s Stock Valuation
My 4-step process for valuing companies is described in Dividend Growth Investing Lesson 11: Valuation.
Step 1: FASTGraphs Basic. The first step is to compare the stock’s current price to FASTGraphs’ basic estimate of its fair value.
The basic valuation estimate uses a price-to-earnings (P/E) ratio of 15 (the historical long-term P/E of the stock market) as a baseline “fair value” reference. That’s shown by the orange line on the following chart. The black line shows Dominion’s actual price.
Dominion’s actual P/E is 18.4 (circled), so this valuation method suggests that the stock is overvalued by quite a bit. Dominion’s price is above the orange fair-value reference line.
To calculate the degree of overvaluation, we make a ratio out of the P/Es: 18.4 / 15 = 1.23. In other words, Dominion’s current price is 23% above the fair price as estimated by this first method.
The fair price is calculated by dividing the actual price by the valuation ratio of 1.23. We get $71 / 1.23 = $58 for a fair price.
Note that I round all dollar amounts to the nearest dollar. That’s one way to avoid creating a false sense of precision in making valuation assessments.
Step 2: FASTGraphs Normalized. The second valuation step is to compare Dominion’s price to its own long-term average P/E ratio. This gives us a valuation estimate based on the stock’s own long-term valuation instead of the market’s long-term valuation that was used in Step 1.
Using Dominion’s 5-year average valuation changes the picture, because its 5-year average P/E ratio is 20.5 (circled).
Therefore, the blue fair-value reference line shifts upwards from its position when 15 was used in the first step. Price, of course, stays the same. Now Dominion looks undervalued, because its price is below the fair-value reference line.
The degree of undervaluation is calculated the same as in the first step: Make a ratio out of the P/Es. We get 18.4 / 20.5 = 0.90. So when viewed from this perspective, Dominion is 10% undervalued.
The fair price suggested by this 2 nd approach is $71 / 0.90 = $79.
Step 3: Morningstar Star Rating. Morningstar approaches valuation differently. They use a discounted cash flow (DCF) model for valuation. Many investors consider DCF to be the best method of assessing stock valuations.
Morningstar’s approach is comprehensive and detailed; that’s one of the reasons I like it. Morningstar ignores P/E ratios. Instead, they make a detailed projection of all the company’s future profits. The sum of all those profits is discounted back to the present to reflect the time value of money. The resulting net present value of all future earnings is considered to be the fair price for the stock today.
Morningstar gives Dominion 4 stars on their 5-star scale, meaning that they consider Dominion to be undervalued.
Morningstar calculates the degree of undervaluation at 15% and computes Dominion’s fair price as $84.
Step 4: Current Yield vs. Historical Yield. My last step is to compare the stock’s current yield to its historical yield.
This way of calculating fair value is based on the idea that if a stock’s yield is higher than usual, it may indicate that its price is undervalued (and vice-versa).
[Image source: Simply Safe Dividends]
Dominion’s 5-year average yield is 3.75%, while its current yield is 4.7%. Current yield higher than historical average suggests undervaluation.
Again, we use a ratio to compute the degree of undervaluation: 3.75% / 4.7% = 0.80, or 20% undervalued.
Dominion’s fair price computes to $71 / 0.80 = $89.
Now let’s average the 4 valuation methods.
Thus, I conclude that Dominion’s current price is about 9% below the stock’s fair price. I call anything within +/- 10% of fair value “fairly valued.” Nevetheless, the numbers suggest that Dominion is selling at a 9% discount to its true value.
As a comparison point, CFRA has a 12-month price target of $71 on Dominion, which is its current price.
Beta measures a stock’s price volatility relative to the S&P 500. I like to own stocks with low volatility for 2 reasons:
- They present fewer occasions to react emotionally to rapid price changes,
especially sudden price drops that can induce a sense of fear.
- There is industry research that suggests that low-volatility stocks outperform the market over long time periods.
Dominion has a very low 5-year beta of 0.3 compared to the market as a whole (defined as 1.0). That means that its price has been 70% less volatile than the index. This is a positive factor.
In their report on Dominion, CFRA shows the recommendations of 14 analysts who cover the company. Their average recommendation is 3.5 on a scale of 5, where 5 means “buy.” The rating of 3.5 translates to “buy/hold.” There are no “sell” or “strong sell” recommendations. This is a neutral factor.
Share Count Trend
I like declining share counts, because the annual dividend pool is spread across fewer shares each year. That makes it easier for a company to maintain and increase its dividend. By buying back its own shares, the company is essentially investing in itself and expanding each remaining share into a larger piece of the pie.
As might be expected with a company that is making so many capital expenditures to expand, Dominion’s share count is rising. It issues new shares to help finance its capital needs. The share count will rise more if the SCANA acquisition is completed, because that deal is being financed entirely with stock.
Overall, I consider Dominion’s rising share-count to be a slightly negative factor.
What’s the Bottom Line on Dominion Energy?
Here are Dominion’s positives:
- Relatively high yield at 4.7%.
- Good dividend resume on other factors: 15-year dividend growth streak; good dividend safety; surprisingly strong dividend growth for such a high-yield stock.
- Stock is around 9% undervalued.
- Solid quality company with a strong growth vision. Operates in regulator-friendly environment and fast-growth markets. Non-regulated businesses have high demand.
- Decent financials, although high debt levels (helping to fuel expansion) are a concern. Management is focused long-term on improving its debt situation and maintaining the company’s investment-grade credit rating.
- Very low-volatility stock.
And here are Dominion’s drawbacks:
- High debt coupled with low-investment-grade credit rating.
- Growing (through projects and acquisitions) at upper edge of “safe” rate. Lots of growth projects being managed at the same time.
Overall, I see Dominion as a pretty attractive investment opportunity at this time. When my next dividend reinvestment opportunity comes in August, Dominion will definitely be on the short list of candidates to add to my Dividend Growth Portfolio.
That said, this is not a recommendation to buy, hold, or sell Dominion. Any investment requires your own due diligence. Think not only about any company’s quality, dividend, and business prospects, but also about how and whether it fits your personal financial goals.
— Dave Van Knapp
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