Market Doesn't Appreciate Dominion's Strategy Pivot

Tax reform, a surprise ruling on master limited partnerships, and the Scana merger required Dominion Energy D to rethink its financing plans, but we believe the underlying profitability of its businesses is intact.

Dominion Energy changed its name from Dominion Resources in 2017. More important for investors is that the company has also made a strategy pivot. Since 2010, the company has focused on developing new wide-moat projects with conservative strategies, exited the exploration and production business, sold no-moat businesses, and made significant investments in moaty utility infrastructure. We expect wide-moat businesses to generate roughly half of Dominion’s operating earnings by 2023.

Tax reform didn’t benefit Dominion’s regulated utility businesses, since rates are reduced to reflect lower income taxes. This lowered operating earnings for Dominion’s regulated utilities but is neutral to overall net income with the corresponding reduction in income taxes. However, Dominion did benefit from the tax reduction at its unregulated infrastructure businesses and its regulated gas transmission businesses with negotiated rates. Thus, these wide-moat businesses are now a larger share of consolidated pretax operating earnings.

In our opinion, the market has missed the strategy change that will result in almost 100% of operating earnings coming from regulated or wide-moat businesses in 2019. Revenue from these businesses is much less commodity-dependent and has significantly less variability than Dominion’s businesses 10 years ago. In addition, we believe these businesses will earn a material spread over our estimate of the cost of capital through the next decade.

Virginia Reregulates, Dominion Reacts A decade ago, the Virginia General Assembly passed legislation to reregulate the state's electric utilities and provide premium returns on equity for critical infrastructure investments. In our opinion, this was the catalyst for Dominion's pivot to a conservative strategy less dependent on commodity prices. In 2010, Dominion completed the sale of its exploration and production operations. Total proceeds from these transactions exceeded $14 billion and were used to offset equity needed for infrastructure development, pay down debt, buy back common stock, and raise the dividend.

In 2010, Dominion experienced a year-over-year operating earnings loss largely due to maintenance issues at its merchant plants combined with historically low commodity prices. Dominion began to scale down its exposure to the merchant generation business because of the earnings disappointment, its desire to reduce commodity exposure, and other investment opportunities in its regulated businesses. It started by selling its interest in the Morgantown Power Station in West Virginia in 2011. Over the next several years, it sold four coal-fired power plants and one gas-fired merchant plant. Finally, it closed the Kewaunee nuclear power plant in Wisconsin in 2013 after failing to find a buyer.

In December, Dominion completed the divestiture of the 1,240-megawatt Fairless Power plant in Pennsylvania, the 468 MW Manchester Street power station in Rhode Island, and its 25% interest in a 192 MW hydroelectric plant in Louisiana for approximately $1.3 billion. We didn’t believe that these facilities were moaty assets. Dominion also completed the sale of its 50% share of Blue Racer, a midstream joint venture with Caiman Energy, for $1.2 billion and a potential of $300 million in earn-out payments versus the $700 million investment balance in the joint venture at 2017 year-end. The no-moat joint venture formed in 2012 provides natural gas gathering, compression, processing, and NGL fractionation services in the Utica and Marcellus shales.

Dominion also owns wind and solar assets, most with long-term power sales agreements that give these merchant generation assets moaty fundamentals. The divestiture of Blue Racer and the merchant power plants increases the percentage of total operating earnings from Dominion’s wide-moat businesses.

Dominion’s only remaining major merchant power plant is the Millstone nuclear plant, which we consider to have a wide moat, in large part because of Connecticut’s dependence on this source of no-carbon power generation. Legislation passed in October 2017 allowed utilities purchasing power from Millstone to receive credit for the “zero carbon” electricity as part of their renewable requirement. In March, Millstone signed a 10-year agreement for over 50% of the plant’s capacity with Connecticut utilities Avangrid and Eversource Energy.

Equity Need Increases, but No Change to Underlying Operating Earnings The surprise tax ruling by the Federal Energy Regulatory Commission in March 2018 changed Dominion's strategy to drop down assets to Dominion Energy Midstream Partners, or DM, which would have pushed over $7 billion of cash to the parent for deleveraging. Instead, the company issued $3 billion of debt secured by the recently completed Cove Point liquefied natural gas export facility, with the proceeds to reduce parent debt. DM units were crushed following the FERC tax ruling, losing 50% of their value. In July, the FERC softened its tax policy and DM shares partially recovered but were still down 30% since the initial ruling in March.

In September, Dominion announced a proposal to acquire the outstanding public units of DM. The proposed exchange ratio of 0.2468 Dominion share per DM unit represented an 8.2% premium to DM’s 30-day average unit price before the announcement. In November, Dominion announced a definitive agreement with DM that increased the exchange rate to 0.2492. The revised agreement resulted in Dominion issuing approximately 22 million shares, representing roughly $1.6 billion, to consolidate DM into Dominion. The merger closed in January 2019.

The announcement to eliminate the master limited partnership structure was not a big surprise following similar proposals by Enbridge, Williams, and other MLPs. Most of DM’s earnings are from Carolina Gas, Questar, and Iroquois pipelines with mostly cost-of-service rates. These rates would be subject to cuts eliminating income tax recovery if Dominion retained the MLP structure. Ownership by Dominion, a taxable entity, will allow rates to reflect income taxes and result in no change to the underlying operating earnings of these wide-moat businesses.

In December 2018, the South Carolina Public Service Commission conditionally approved Dominion’s merger agreement with Scana, which would require Dominion to make $2 billion of rate credits over a 20-year period and $2.5 billion in write-offs benefiting customers. Dominion increased the proposed rate cuts for customers twice since the original proposal in January 2018, but management reaffirmed at its March 25 investor day that it expects the transaction will be earnings accretive. We share management’s confidence as the South Carolina utility hasn’t had a base rate proceeding since 2011 and is currently earning below 8% versus an authorized return on equity of 10.25%. Dominion Energy South Carolina, the new name for the segment, will file a rate proceeding in 2019.

The all-stock merger closed in January 2019, providing Scana shareholders with 0.669 share of Dominion for each Scana share. The transaction, valued at $7.9 billion of equity when announced, required the issuance of approximately 96 million shares to Scana shareholders. The DM and Scana acquisitions combined with previous and planned equity issuances to address tax reform, ongoing capital expenditures, and the conversion of convertible units will require Dominion to issue roughly 178 million new common shares in 2018 and 2019, a 28% increase in basic shares outstanding. Although the increase in equity is a headwind, we estimate average annual EPS growth of 6% over the next five years.

Dividend Increases Should Moderate On Dec. 14, Dominion's board of directors established a 2019 dividend of $3.67 per share, a 10% increase over 2018. Annual dividend increases have averaged 9% over the past five years, but management indicated at the March investor day that future increases will be approximately 2.5% per year until the payout ratio declines to the low 70s. It will probably take until the middle of the next decade to achieve this target, but we are not too concerned, given the strong free cash flow from Cove Point and the diversity of Dominion's earnings and cash flow. The lower level of dividend increases should still provide an attractive dividend, and 2023 would represent 20 straight years of raises.

Dominion, the Only Wide-Moat Utility, Is Undervalued Our $84 fair value estimate is about 11% above the current stock price and 8% above the median consensus price target. Dominion Energy is the only diversified utility we cover with a wide-moat rating. We think the market is potentially not giving Dominion credit for this wide moat. We think some market participants are valuing Dominion like a narrow-moat company with a moat that lasts only 10-15 years, resulting in a fair value estimate between $72 and $78 per share. On the other hand, we think Dominion will continue to generate economic profits for at least the next 20 years, boosting its valuation.

Our valuation methodology also recognizes Dominion Energy’s lower risk profile. Our 7.5% cost of equity is lower than the 9% we expect investors will demand of a diversified equity portfolio. Our lower cost of equity is driven by the more conservative strategy that Dominion Energy has embarked on during the past 10 years. Our pretax cost of debt assumption is 5.8%, as we incorporate a normalized long-term real rate environment and normalized credit spreads. A 2.25% long-term inflation outlook underpins our cost of debt assumption.

Our weighted average cost of capital is 6.5% but would increase to 7.2% if we were to use a 9% cost of equity. Our fair value estimate is very sensitive to the increase in the cost of equity and would decrease by about $20 per share if we assumed a 9% cost of equity in our discounted cash flow analysis. We believe this is a significant factor in the stock’s undervaluation, as the market does not appreciate the pivot to a more conservative strategy and its impact on the cost of capital.

Dominion's Moat Sources We believe a regulated utility can establish a wide economic moat if it operates in a constructive regulatory environment and if it has a material share of earnings from nonutility businesses with sustainable competitive advantages. We believe Dominion meets these criteria with the completion of the Cove Point LNG export facility in 2018, the projected completion of the Atlantic Coast Pipeline in 2021, and the recent divestiture of remaining no-moat assets.

We estimate 39% of operating earnings were from wide-moat businesses in 2017 and expect this to climb to 50% by 2023 with the completion of Cove Point, ACP, and other ongoing wide-moat infrastructure investments. The balance will come from narrow-moat regulated gas and electric utilities with some of the most constructive regulation and attractive growth potential in the country.

In addition to Cove Point and ACP, Dominion’s other wide-moat businesses include 3,900 miles of natural gas transmission pipeline in the Marcellus and Utica shale regions, a 1,500-mile natural gas pipeline in South Carolina and Georgia, a 2,700-mile gas transmission pipeline in Utah, Wyoming, and Colorado, 6,600 miles of high-voltage interstate electric transmission system regulated by the FERC, and a large, two-unit nuclear plant in Connecticut. When completed, the 48%-owned ACP and 100%-owned Supply Header Project will add over 600 miles of natural gas transmission pipeline.

Interstate Natural Gas Transmission Pipelines: Efficient Scale Dominion's transportation system is an interstate highway for natural gas that moves the product from producing regions to where it will be primarily consumed by utilities for electric production or by consumers for heating and cooking. The portfolio has 15,000 miles of natural gas transmission, gathering, and storage pipeline. We award a wide moat to Dominion's interstate pipelines because of the strong efficient scale, attractive adjacent expansion opportunities, favorable FERC regulatory framework, and little commodity exposure.

Dominion’s natural gas pipelines have a broad mix of customers including local gas distribution utilities, electric power utilities, marketers, and other interstate and intrastate pipelines. These customers, many investment-grade regulated businesses, are mostly users of natural gas rather than exploration and production companies subject to the vagaries of commodity prices. Revenue is derived primarily from reservation charges for firm transportation and storage services with a meaningful portion of capacity under longer-term contracts. Despite varied contract lengths, these assets have demonstrated resilient financial returns through recent commodity cycles.

Interstate Electric Transmission: Efficient Scale High-voltage electric transmission regulated by the FERC is estimated to contribute approximately 11% of operating earnings in 2019. We expect it to remain at roughly this level as investments in electric transmission total over $800 million per year through 2023, resulting in average annual earnings growth of approximately 7%.

We believe electric transmission is a wide-moat business due to its efficient scale competitive advantage. Competitors have little incentive to build competing transmission lines if one that Vepco owns already is serving a market’s full capacity. Capital costs for new transmission lines are too high and incremental benefits too low to offer sufficient returns on invested capital for two competing transmission owners. In addition, Vepco benefits from regulatory protection. The FERC approves new transmission lines only if there is a demonstrated need for new capacity. And if there is a need, many times it is more economical to increase the capacity of an existing transmission line than to build one in a new right of way. Electric transmission also has a favorable regulatory framework under the FERC.

Cove Point LNG Export Facility: Intangible Asset and Efficient Scale The Cove Point LNG import/regasification and export facility on the Chesapeake Bay near Lusby, Maryland, loaded its first cargo tanker in March 2018. Cove Point had been an import-only facility, but the dramatic increase in gas production in the Marcellus and Utica shale formations has provided opportunity to export natural gas. Liquefaction is the process by which natural gas is converted to LNG, which can be loaded into oceangoing LNG vessels for worldwide transportation. U.S. exports of LNG are expected to dramatically increase over the next decade, driven by the supply of shale gas and projected growth in worldwide demand. Cove Point also owns 136 miles of natural gas pipeline that connects the facility to interstate natural gas pipelines.

Dominion spent approximately $4 billion to provide Cove Point the capability to export approximately 4.6 million metric tons per annum (0.66 billion cubic feet equivalent per day). Half of Cove Point’s capacity has been contracted with a joint venture of Sumitomo and Tokyo Gas, the largest natural gas utility in Japan. The remaining 50% is contracted with a wholly owned indirect U.S. subsidiary of GAIL, one of the largest government-linked natural gas companies in India. The 20-year agreement with each of these creditworthy counterparties has a fixed fee that covers all operating and capital costs, including profit. Natural gas is supplied by the counterparties. Thus, Dominion takes no commodity or volume risk.

Cove Point is operating at 105% of design capacity after one year of operation and producing $525 million-$545 million of free cash flow, or a free cash flow yield of over 13% on the $4 billion investment. Since the facility requires only modest maintenance capital, the project can provide substantial dividends to the parent. We estimate that Cove Point will contribute over 6% of operating earnings in 2019, its first full year in operation. Since its output is fixed and the restricted site can’t be expanded, we estimate its contribution to consolidated operating earnings will decline to approximately 5% by 2023.

We believe the contract structure--eliminating price and volume risk--is an intangible asset that is one source of the facility’s wide moat. In addition, a competitor would find it difficult to justify the billions of dollars to develop another site on the East Coast and obtain government approval, also providing an efficient scale moat source. Thus, we believe the wide moat could last beyond the initial 20-year export agreements.

Millstone Nuclear Plant: Efficient Scale and Cost Advantage We believe the two-unit 2.1-gigawatt Millstone nuclear plant is a wide-moat asset that is estimated to contribute approximately 4% of operating earnings in 2023 and should provide returns above its cost of capital for the next 20 years. Recently, we have seen merchant nuclear plants subject to financial stress, but due in large part to its size, location, and support from public officials, we believe this will not be the case for Millstone. Unlike other merchant nuclear plants in regions with good access to cheap shale gas, Millstone is in a constrained area along the East Coast with higher power prices. It is the only nuclear plant in Connecticut, supplying almost 50% of the electricity used by the state and almost all of its carbon emission-free energy.

In part because of Connecticut legislation and the long-term contract for over 50% of its capacity, we believe Millstone has wide-moat characteristics, with estimated returns on capital above its cost of capital for at least the next 20 years. Nuclear generation’s wide-moat economics are also driven by two primary competitive advantages: (1) Nuclear plants take as long as 10 years to site and build, cost billions of dollars, and typically face significant community opposition. These are significant barriers to entry, giving Millstone an effective low-cost monopoly in Connecticut and efficient scale moat source. (2) No other reliable base-load power generation source can match the cost or scale of a nuclear plant, giving nuclear a cost advantage moat source.

Vepco: Efficient Scale Vepco generates and distributes electricity in Virginia and North Carolina; however, the majority of customers and rate base are in Virginia. In 2018, Vepco's regulated distribution and generation contributed 39% of Dominion's pretax operating earnings excluding corporate and other. Although we estimate operating earnings growth over 4% per year, by 2023 the contribution to total operating earnings is likely to decline to roughly 29% because of the increasing contributions from Dominion's wide-moat growth projects and the Scana acquisition.

Service territory monopolies and efficient scale advantages are the primary moat sources for regulated utilities such as Vepco. Rates for electric transmission, regulated by the FERC, are added to the cost of generation and distribution in the total electricity charge for Vepco customers.

These regulated rates are the foundation for Vepco to earn a fair return on and return of the capital it invests to build, operate, and maintain its infrastructure. This implicit contract between regulators and Vepco should, on balance, allow the company to earn greater than its cost of capital, though observable returns might vary in the short run based on demand trends, investment cycles, operating costs, and access to financing.

We also consider the ability of Vepco to achieve and sustain a positive spread between earned returns on capital and costs of capital in the long run. In our view, the regulatory environment, operating history, and forecast shareholder return give us confidence that this positive spread can be maintained, supporting our narrow moat and stable moat trend ratings for this business.

Scana Merger Modestly Dilutes Wide Moat, but Accretive In January 2018, Dominion and Scana announced a merger agreement that would effectively help Scana escape the backlash from abandoning the construction of two new units at the V.C. Summer nuclear power plant in mid-2017. The project was almost $5 billion over budget and several years behind schedule. Scana's plan to collect rates from customers to pay for the half-built project per the 2007 Baseload Review Act created a political, legal and regulatory firestorm. Without the Dominion deal, it could have taken years to reach a resolution.

We think the merger offered the one thing that everyone agreed on from the beginning: an opportunity to put this debacle to rest as quickly as possible. Public statements from regulators and politicians suggested no one wanted a drawn-out legal circus or a Scana bankruptcy. Regulators agreed, and the merger closed in January 2019.

The agreement requires Dominion to make $2 billion of rate credits over a 20-year period and $2.5 billion in write-offs benefiting customers. Dominion increased the proposed rate cuts for customers twice since the original proposal, but management reaffirmed the transaction will still be earnings accretive. We also expect Dominion Energy South Carolina to file for a base rate increase in 2019, the first since 2011.

Utility mergers do provide synergies with reductions in senior management, call center consolidation, and other operations and maintenance benefits, and we believe this will be the case with this merger due to the proximity of the service territories. We expect South Carolina regulators to monitor synergy savings during the coming years and claw back some of those for customers. Thus, we are not including significant synergy savings in our estimates for now. However, these merger savings give us additional confidence in our estimated five-year average annual EPS growth rate of 6%.

Excluding the nuclear issues, Scana is a healthy utility with attractive core demand growth and investment potential to drive earnings in line with its regional peers. However, Scana’s integrated electric utility and natural gas distribution businesses are narrow-moat businesses that will modestly dilute Dominion’s share of earnings from wide-moat businesses. A full year of operation of wide-moat Cove Point in 2019 and other wide-moat investments will partially offset this impact, but we still expect wide-moat businesses to contribute 43% of earnings in 2019.

We forecast that the completion of the ACP in 2021 and continuing wide-moat infrastructure investment will more than offset the impact of the narrow-moat Scana acquisition, resulting in wide-moat businesses contributing about half of operating earnings by 2023.