XLU - Why Dominion Energy Is Seriously Undervalued Right Now

2023-10-12 08:05:00 ET

Summary

• Utility company Dominion Energy has reached a 10+ year low in its stock price, presenting a potential opportunity for contrarian investors.
• Dominion has made commitments to transition towards renewable energy, selling off assets to fund renewable energy projects.
• While the market doesn't like near-term uncertainty related to asset sales, the sell-off creates an attractive entry point with a high yield.

Investing doesn't always have to be a popularity contest, and going against the grain, or otherwise called contrarian investing, can potentially lead to outsized returns. Such may be the case right now with utility companies, which appear to have bottomed as of late.

This brings me to Dominion Energy ( D ) which I last visited here back in June with a 'Buy' rating, noting its relative undervaluation and progress towards renewable energy. The stock has traded down by 19% since then, as higher interest rates have pressured D and the utility segment in general.

As shown below, D now trades at a 10+ year low not seen since 2010. In this piece, I discuss why the market may be overly bearish on the stock and why value investors may want to look into the stock for income and capital appreciation potential, so let's dive in!

Why Dominion?

Dominion Energy is a large public utility that serves 7 million customers 16 U.S. states. Like other utilities across the country, D has made commitments to pivot its business towards renewable energy and it has a goal of achieving Net Zero emissions by 2050.

To achieve this goal, D has had to sell off some assets, such as its natural gas pipelines in 2020 to Berkshire Hathaway Energy ( BRK.A )( BRK.B ), and its remaining interest in Cove Point facility also to Berkshire Hathaway in July of this year for $3.5 billion. Its biggest sale was the one recently announced last month for the sale of three natural gas utilities to Canadian midstream giant, Enbridge ( ENB ) for after tax proceeds of $8.7 billion.

This gives D the funding capacity it needs to pursue renewable energy projects, such as its proposal announced earlier this month to build more than a dozen new solar projects in Virginia, which if approved would generate 772 MW of carbon-free electricity. This is estimated to power around 200K homes at peak output. This would add to D's existing portfolio of solar projects, bringing the combined total to 4,600 MW of solar in Virginia, which is enough to power 1.1 million homes.

Renewable energy obviously comes with upfront costs but can save the utility company money down the line due to far lower input costs compared to traditional fossil fuels. However, there are execution risks related to the renewable transition, and asset dispositions such as the ones above are near-term dilutive to earnings.

Markets dislike uncertainty, and this is reflected by D's significant underperformance compared to the SPDR Select Utilities ETF ( XLU ). As shown below, D has returned -48% over the past 12 months compared to the 7% decline in XLU over the same timeframe.

In the meantime, milder than normal weather, along with planned and unplanned outages at D's Millstone facility resulted in an earnings decline in the latest quarter. Additional headwinds include higher interest expense and the near-term dilutive impact the loss of Cove Point and natural gas utilities (through the aforementioned sales) result in a lower forward earnings outlook.

While the headwinds and execution risks for the company are real, its business is nonetheless supported by regulated utilities that generate a steady income stream. Plus, management sees opportunities for rate growth down the line, as its residential rates are 22% below the national average. Dominion's aforementioned solar and battery storage projects would add value over time, and it also has 6 projects producing negative-carbon renewable natural gas, including its joint venture with Smithfield Foods, which captures methane from hog farms.

Moreover, data center growth in D's key markets should fuel electric demand and it's seeing attractive customer growth in Virginia and South Carolina. As shown below, D saw 4% electric sales growth over the last 12 reported months, driven by commercial customer growth.

Proceeds from the recent sale of gas utilities also strengthened D's balance sheet, which carried a net debt to EBITDA ratio of 5.8x. Applying the full proceeds from Cove Point and the natural gas utilities would bring the leverage ratio down to a much lower 4.3x.

Lastly, D is trading at an attractive entry point at the current price of $42.96 with forward PE of 12.7, trading below its normal PE of 17.2, as shown below.

Its 6.2% dividend yield is also covered by a 79% payout ratio, based on its reset forward EPS of $3.36. This payout ratio is positioned to decline with analysts expecting 4% to 10% annual EPS growth over the next 4 years.

Based on my fair value analysis below, I believe D has a fair value of $64.81 per share, based on the current year EPS estimate, and a modest 5% growth rate combined with a 2.5% discount rate, sitting above the 2% long-term inflation target set by the Federal Reserve. While I wouldn't expect for the market to reward D with this fair value anytime soon, I believe it's a reasonable target for those with a long-term horizon.

Investor Takeaway

Dominion Energy's recent underperformance has created an attractive entry point for investors looking for income and value. While there are headwinds in the near-term, management's execution of its renewable energy transition along with a stronger balance sheet supports long-term income and capital appreciation potential. With D trading at a material discount to my fair value estimate and a strong dividend yield, it could be a long-term winner for patient value-seeking investors.

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