D - Dominion's 5% Yield: Is The Juice Worth The Squeeze?

2023-07-10 14:02:44 ET

Summary

• Dominion Energy, a utility giant with a market cap of $44 billion, is facing regulatory issues, a potential debt downgrade, and sector challenges. It has cut its dividend but still yields 5.1%.
• The company is undergoing a major business review to improve its operations and boost its stock price. However, its credit rating is currently BBB+, one step below the A-range, with a negative outlook from S&P.
• Despite operating in a growing market and having potential for improvement, Dominion Energy's history of underperformance and lack of significant discounts compared to peers may deter investors.

Introduction

If there's one thing I love, it's buying great companies when nobody else is willing to. The problem is that not every stock that is suffering offers buying opportunities. That's where Dominion Energy ( D ) comes in. This utility giant with a market cap of $44 billion has been struggling - big time.

While utilities, in general, aren't the best tools for capital gains, Dominion is currently more than 40% below its all-time high. It's down 15% year-to-date, and it has cut its dividend.

However, the company is still yielding 5.1%.

In this article, I'll assess the risk/reward of what looks like a dumpster fire that yields 5% but is dealing with regulatory issues, a potential debt downgrade, and the usual struggles in the utility sector.

So, let's get to it!

The Struggling Giant - With A 5% Yield

I own Duke Energy ( DUK ). It's my only utility investment. While I also like several other players that I regularly discuss on Seeking Alpha, I'm not a huge fan of the industry. Regulated utilities need to carefully deal with billions in additional costs related to the energy transition, rising input costs, and a ton of regulatory issues - all while maintaining affordable rates for their customers.

According to the company :

Dominion Energy is committed to safely delivering sustainable, reliable and affordable energy and achieving net zero carbon and methane emissions by 2050.

Essentially, this is a more fancy way of describing what I just wrote about balancing costs and prices.

The company operates in 15 states, serving roughly 7 million customers. Its asset portfolio includes significant electric generating capacity, transmission and distribution lines, and gas distribution mains.

Dominion Energy's strategic goal is to be a leading sustainable provider of electricity, natural gas, and related services in the eastern and Rocky Mountain regions of the US.

Around 90% of Dominion Energy's earnings from its primary operating segments are expected to come from state-regulated electric and natural gas utility businesses.

Furthermore:

• Dominion Energy's growth capital expenditure plan for 2022 through 2026 focuses on upgrading the electric system in Virginia. It includes investments in renewable generation facilities, such as utility-scale solar and offshore wind projects.
• The company also plans to extend the licenses for its regulated nuclear power stations in Virginia.
• Other growth drivers include renewable natural gas initiatives, gas distribution pipeline replacement and modernization, and upgrades to transmission and distribution networks to meet environmental requirements.

Last year, the company launched a major business review to improve its business and boost its stock price.

As reported by the Wall Street Journal :

Chief Executive Officer Bob Blue on Friday said that the Richmond, Va., energy company intends to review alternatives to its current business mix and capital allocation, and assess regulatory options to assist its customers with managing costs.

[...] "Like everyone, we are seeing inflation, supply chain limitations and higher fuel prices-all having an impact on customer rates and our balance-sheet strength," Mr. Blue said.

Unfortunately, the company's turnaround plan included cutting its dividend to achieve a more sustainable payout.

On November 4, 2020, the company cut its dividend by 33%. Since then, the company has hiked its dividend once, which was in December 2021, when the company hiked by 6%.

Now, D shares yield 5.1% with a 67% payout ratio, which is marginally above the sector median of 64%. In other words, for now, the dividend is safe - although a lot of investors have lost trust already.

Now What?

Things are slowly improving. For example, in Virginia, the company's largest service area, significant developments have taken place. As discussed in the company's 1Q23 earnings call , a new law, enacted in April and effective from July 1, addresses the need for near-term economic and customer bill relief while supporting long-term resiliency and decarbonization capital investments.

The legislation has received nearly unanimous bipartisan support and provides several benefits.

• It reduces the monthly bill for a typical residential customer by nearly $7 through a combination of existing riders and allows for the securitization of deferred fuel costs, potentially providing an additional $7 a month in savings.
• These savings, if approved, would result in a 10% reduction in the current typical residential customer bill and position the company around 21% below the national average.
• The law also simplifies the rate-making process for the base business, reinstating base rate reviews on a biannual schedule and improving the timeliness of expense and investment recovery.

• Regulatory parameters are set for the next few years, including an authorized return on equity ("ROE") of 9.7% for the 2023 biennial review and directives regarding the common equity ratio and rider recovery.

So, what does this mean?

According to the company, the legislation allows Dominion Energy Virginia to make necessary investments to ensure stable and reliable service in line with resiliency and decarbonization public policy goals.

The company faces substantial and increasing demand growth, with PJM's 2023 forecast projecting peak summer load growth of approximately 5% per year for the next ten years.

• This forecast indicates a significant increase in peak load by 2033.
• Dominion Energy Virginia has observed strong sales growth over the last 12 months, with an expectation of moderate growth of around 5% for the full year 2023.

Unfortunately, because of the company's ongoing business review, it did not issue full-year guidance.

However, the company told us about its credit, which isn't looking so great at the moment. For now, the company has a BBB+ credit rating, which is one step below the A-range. That's not bad at all.

The problem is the trend.

Earlier this year, S&P revised the debt outlook from stable to negative for the Dominion family of issuers.

Essentially, this outlook typically indicates a 1/3 probability of a rating change over the next 12 to 24 months, meaning S&P could lower the rating from BBB+ to BBB.

While S&P maintained VEPCO's stand-alone credit profile at A and Dominion's business risk profile as excellent, they suggested that countermeasures were likely needed to strengthen the company's future credit metrics.

This is one of the reasons why the company is busy working on a comprehensive business review.

Valuation

What's interesting is that Dominion shares aren't trading at a discount versus its major peers. While potential business improvements will enhance EBITDA well beyond the next 12 months, Dominion Energy is trading at 11.4x NTM EBITDA. While this is the lowest valuation among the largest electric utility companies, it's not a major outlier.

The current consensus price forecast is $59, which is 13% above the current price.

However, there is a steep downtrend in the consensus, as analysts aren't willing to price in a rebound at this point. I cannot disagree with that.

I believe that the company might be able to outperform its peers if it presents a comprehensive business improvement plan and executes it well.

However, I do not expect Dominion to turn into a fast-growing utility with a very attractive long-term risk/reward.

It also needs to be said that Dominion started to underperform its peers well before its recent issues. While I expect the ratio to normalize a bit, I cannot make the case that the D-ticker is a must-buy.

While I also cannot make the case that Dominion Energy is a waste of money, I'm not a buyer at current levels and do not suggest that income-seeking investors are better off by buying its 5.1% yield.

I think other opportunities with less risk and a better long-term risk/reward are more promising.

Takeaway

Dominion Energy may seem like a tempting investment with its current 5.1% yield, but the risks associated with the company should not be ignored. As a struggling utility giant facing regulatory issues, potential debt downgrades, and the challenges of the utility sector, Dominion Energy's future is uncertain.

While the company has taken steps to improve its business and reduce costs, such as cutting its dividend and reviewing its operations, there are still concerns about its credit rating and overall financial health. The recent negative outlook from S&P suggests that countermeasures may be needed to strengthen Dominion's credit metrics.

Although Dominion Energy operates in a growing market and has the potential for improvement, it's important to consider the company's history of underperformance and the fact that it's not trading at a significant discount compared to its peers.

Considering the risks involved, income-seeking investors may find better opportunities with lower risk and a more favorable long-term risk/reward profile than Dominion Energy is currently offering.

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