D - Dominion Energy: Dividend Pressures Expected Amid High-Cost Projects

Summary

• Dominion Energy had underperformed its peer group over the past year as the company faced downgrades due to elevated business uncertainties.
• Utility worker shortages, rising fuel costs, and other inflationary pressures remain a threat if more regulators shift to protect customers.
• Dominion is making massive investments in renewable energy projects that are not expected to produce nearly as much power as its core business today.
• Dominion Energy's investments are not necessarily shareholder or customer friendly and may be an effort to improve its political appearance.
• While Dominion's risks are elevated, it is around 20% cheaper than its peers, creating some peer outperformance potential.

Dominion Energy ( D ) is among the largest utility companies in the United States, with operations centered in the mid-Atlantic region and around 28GW total capacity . Like many utility companies, the sharp rise in fuel costs, blue-collar wages, maintenance overhead, and interest expenses have created strains on the firm's bottom line. Dominion's stock is currently resting at one of the lowest levels this decade, following large drawdowns late last year.

The last six months of 2022 were difficult for the firm as its CEO put the company under a "top to bottom" business review, leading to a wave of analyst downgrades. Utility investors historically do not like uncertainty, and since most utility margins are protected by rate regulation, managerial decisions are a significant factor influencing utility stock prices. At this point, it remains unclear what changes Dominion's business will face, but it is expected to create some strain on its cash flows in the short run.

The company faces other risks that may negatively impact its value in 2023. Macroeconomic conditions threaten energy fuel costs, and wages may continue to rise quickly enough that regulators push back against rate increases . However, the more problematic strain may come from Dominion's offshore wind project plan, which is expected to cost a great deal to produce relatively little power. Overall, while Dominion's valuation has compressed to a more attractive level, investors should consider the material risks and potential lack of shareholder (and customer) value focus, which may harm the firm's equity over the coming years.

Strategically Poor Investments

Historically, utility companies invest in energy production and grid projects that are expected to reduce consumer costs and improve power production and distribution. As such, Dominion can charge customers directly for the projects it pursues to increase power generation. However, problems have grown as Dominion seeks "green energy" solar and wind projects that are expensive for customers and the firm while creating little power. In 2020, the company also canceled the Atlantic Coast Pipeline natural gas project, which had already made significant investments and was expected to lower customer power costs.

Controversy has grown around Dominion's offshore wind project, " CVOW ." The project is expected to be completed around 2027, adding up to 2.6 GW (a <10% increase in Dominion's production), and cost around $21.5B - roughly half of which will come from the firm's CapEx budget. First, it is unclear if the project will cost as much as anticipated and if it will produce as much as Dominion hopes. On that note, Dominion was unwilling to guarantee the project has just 42% of the 2.6GW target.

After approving the project, the Virginia State Corporation Commission warned :

The magnitude of this project is so great that it will likely be the costliest project being undertaken by any regulated utility in the United States. And the electricity produced by this Project will be among the most expensive sources of power — on both a per kilowatt of firm capacity and a per megawatt-hour basis — in the entire United States, the order said.

Overall, I believe it is clear that investors should question Dominion's managerial focus. As a public company, it must make decisions expected to improve shareholder value. As a regulated utility, it must make decisions expected to enhance customer value. I believe its significant investments in these projects do not necessarily benefit either. While the firm argues that these investments will eventually reduce fossil fuel dependence (which helps both investors and customers), they come at an extreme cost for both investors and customers and, at this point, promise to produce minimal power. If these aims do not pan out, the company could jeopardize its financial position as cost overruns will come from the company's funds. When construction workers and equipment are in shortage, that risk seems very high. Additionally, these projects may eventually increase regulatory changes since they disproportionately increase customer costs to power production.

Growing Operating Costs and Debt Add Risk

Over the past decade, Dominion has seen significant growth in the portion of its revenue paying operating costs. At the same time, its gross margins have been under strain due to growing costs and difficulties in increasing rates. These trends are resulting in immense losses to the firm's cash-flow margins. See below:

Dominion's profit margins have experienced elevated volatility since the pandemic. Historically, utility companies have had steady margins due to their "regulated monopoly" position. That said, the rise in Dominion's operating costs could eventually create strain as regulators demand the company improve its efficiency before pushing costs onto customers. Further, Dominion's cash flows have declined dramatically, mainly due to deferred fuel costs associated with rising fuel prices.

Dominion also has slightly higher debt leverage and CapEx spending than its significant peers:

All utilities have large capital expense budgets, and most use high debt. However, as utility companies struggle with growing worker shortages and rising interest rates, I believe all will likely see an elevated strain on free cash flows. In other words, it will become more difficult for many utilities to grow or maintain dividends. While Dominion's metrics are similar to peers, they are on the high end, creating some elevated risks for the firm. As such, it is not a large surprise that Dominion still has a reduced dividend rate but does pay the highest yield. See below:

Dominion's yield is slightly above its peers and would be much higher than its peers if the company re-enacts its old dividend policy. I believe it will likely need to keep its dividend low to maintain cash flows, considering the company is ramping up capital investments into expensive renewable projects. Still, while Dominion appears slightly riskier than its peers, it is discounted accordingly, so it is not necessarily an overvalued company based solely on peer metrics.

The Bottom Line

Overall, Dominion Energy appears to offer a mix of positive and negative qualities for investors. Its positive quality is its elevated dividend yield and roughly 20% discount compared to other utility companies (based on an array of valuation metrics ). That said, Dominion's discount seems propositional to its elevated risk exposure. Company-specific risks include its high leverage, the "top-to-bottom" business review, and the various risks associated with its high-cost renewable projects.

To me, Dominion seems too focused on its outward appearance (ESG scores, political approval, etc.) compared to its core business of providing energy to customers inexpensively. While focusing on idealistic "outward appearances" may benefit the company, the practical issue of high capital costs and low power generation associated with these projects is enough that I would avoid investing in them. That said, these projects are long-term in nature and do not necessarily elevate the firms' short-term risks.

From a 2023-2024 standpoint, I believe Dominion is no riskier than most utility stocks. I do not think the firm is a strong long-term investment due to its own questionable long-term investments, but that means little for its profit outlook over the coming years. However, I am slightly bearish on the firm and believe it may decline over the coming year due to macroeconomic pressures facing all utility companies. Still, Dominion may outperform many of its peers over the coming year due to its lower valuation.

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