Dominion Energy: Yield Plus Capital Appreciation in an Undervalued Sector

Summary

• Utility Sector Exposure: Dominion Energy is seen as a way to increase exposure to the utilities sector, which has underperformed compared to the S&P 500 since 2022 but is expected to gain traction with the anticipation of interest rate cuts by the Fed.
• High Dividend Yield: Dominion Energy offers a stable and high dividend yield, which has been consistent since March 2022. Despite a reduction in the dividend per share since December 2022, its yield has remained attractive due to the decline in stock price.
• Revenue Mix Shift in Virginia: There is a projected shift in revenue from residential to commercial, particularly due to the growth of data centers. Dominion Energy Virginia contributes over 60% of total revenue, and commercial sales are expected to increase from 47% to 59% by 2033, driven by the demand for electricity from data centers.
• Price Appreciation Potential: Analysts have a moderate target price for Dominion Energy, but the thesis posits a more aggressive target based on the assumption of a recovery in valuation ratios to levels seen in 2017 and 2018.
• Risk Factors: There are high risks related to continued inflation and the potential delay in rate cuts, which could affect the utilities sector’s performance. Additionally, if Dominion Energy fails to meet its growth targets or if the bond market offers better “safe” income options, there could be downward pressure on the stock. There are also medium risks associated with the company’s ability to redirect funds from divestitures effectively.
• Price as of March 7: $48. 12-month Price Target: $61 (+27% upside)

Investment Thesis

#1: The main investment reason into Dominion Energy is to increase our exposure in the utilities sector.

• Utilities have been an outlier since the end of 2022. Most of the sectors within the S&P 500 have recovered the lows of 2022, but utilities have struggled to recover.
• The trend however isn’t surprising, since investments into utilities comes from a demand for steady income and low volatility which occurs during expectations of market downturns
• 3 pivotal macroeconomic insights emerged in early 2022: (1) Peak inflation %, (2) Peak interest rates (3) Sentiment signals a recovery vs. a recession

• All these macroeconomic points to a risk-on environment which came true. Investors piled their capital into tech, widening the returns gap between safe and growth investments.

• The result is that since 2023, XLK (Tech) had a return of +68%, SPX (S&P 500) had a return of +33%, and XLU (Utilities) had a return of -8%. This is an underperformance of 41% vs. SPX and 76% vs. Tech.
• But as of March 6, 2024,  Powell said the Fed remains attentive to inflation risks, but rate cuts are likely “at some point” this year which now reverses the narrative, providing the utilities sector a tailwind to grow from.
• So why invest now? We believe the utilities sector is undervalued as a whole and will remain so until we start to see a decline in interest rates. On the flip side, we’re starting to see growth and tech becoming overvalued and our bet is a rebalancing in the months to come.
• To reduce our risk exposure, we have chosen D because of investment point #2: a steady and high potential for cashflow through dividends

#2: Dominion Energy has a stable and high dividend yield relative to the rest of the utilities sector in the S&P 500.

• Dominion Energy ranks 1st in terms of yield % within the utilities sector. This represents $0.67 per share and has been consistent since March 2022. Most notably, D has decreased its dividend payment per share since Dec 2022 from $0.94 per share, but the decline in price has kept it’s yield % above 4%.
• In the March 2024 Investor Day Presentation, the guidance is that management will maintain the current dividend of $2.67 per share until a target payout ratio of 60% is achieved.
• Dividend payout totals $2.1B ($2.67 * 0.8B Shares) while Net Income currently sits at $2B representing a payout ratio > 100%. To achieve a 60% payout ratio, Net Income will need to total $3.5B, representing a growth of 75%.
• We think achieving a 60% payout ratio is unlikely, but an EPS CAGR guidance of 6% combined with a scenario where D can reduce it’s interest expense back to pre-interest rate hike level ($1.6b current to $1b historical), that’s $758M added back to the bottom line. Forward looking, this brings the payout ratio to 76%.

#3: Dominion Energy, similar to the rest of the utilities sector has a degree of price appreciation in the next 12 months.

• Analysts have set a target at $52, with a upside of 10% from the current price
• We’ve set a price target at $61, with a upside of 30% from the current price. Our valuation are calculated using a price to total asset valuation ($109B total assets * 0.45 Ratio / 0.8B shares)
• Our price target is set quite aggressive we assume that the ratios will recover back to 2017 and 2018 levels and that the price appreciation will mainly come from it’s ratio growth, not it’s fundamental growth.
• Adding in the dividend, D is expected to return between 15% – 35% within the next 12 months.

#4: Projected Change in Revenue Mix in the Virginia Market from Residential to Commerical (Data Centers).

• Dominion Energy Virginia accounts for over 60% of the total revenue for 2023
• On the right, the bar chart breaks down Dominion Energy’s electric sales by revenue class for the year 2023 (actual) and projections for 2033. It shows that while residential sales are expected to decrease from 33% to 26%, and government/other from 14% to 10%, there’s a substantial increase expected in the commercial segment, especially from data centers. The commercial sales are predicted to rise from 47% to 59%

• Management forecasts that demand of electricity from data centres will outgrow it’s contracted capacity by 2031
• The growth of the data center industry in Virginia is poised to continue, with the total capacity of data centers in Northern Virginia having more than doubled from 2018 to 2021

Risk Assessment

• High Risk: Inflation continues to stay above 3% prompting the Feds to delay rate-cuts until mid to late 2025. In this scenario, the gains will be delayed for a year with increased price volatility in the utilities sector.
• High Risk: In addition, the bonds market is inversely related to XLU. As interest rates remain high, bonds are the more attractive “safe” income option putting downward pressure on the utilities sector. See below on the relationship between XLU (Utilities) and US10Y (US 10Y Gov Bond).

• Med Risk: D does not meet it’s 6% CAGR target and continues to have it’s payout ratio over 100%. In this scenario, there is a risk of D lowering it’s dividend payout.
• Med Risk: Restructure risk due to D low/zero carbon goals. Divestures already happened in 2023 with the sale of the non-controlling interest in Cove Point and it’s gas operations to Enbridge. The risk here is that with restructures is the long-term view. Can D successfully redirect the funds from the divestures to grow it’s existing business? Are the terms of the divestures favourable to D?
• Low Risk: The growing competitiveness of renewable energy sources and the rise of distributed generation (e.g., rooftop solar) could pose challenges to Dominion Energy’s traditional utility model. This shift could affect demand for Dominion’s energy supply and impact its revenue mix more broadly than just the shift from residential to commercial.

News and Events

1. May 5, 2023: Q1 Non-GAAP EPS of $0.99 beats by $0.02. Revenue of $5.25B (+22.7% Y/Y) beats by $790M. Company initiates second quarter 2023 operating earnings guidance of $0.58 to $0.68 per share vs. consensus of $0.79.
2. July 7, 2023: Entered into two separate 364-day term loan facilities of $600M each. Berkshire Hathaway Energy said Monday it agreed to acquire Dominion Energy’s 50% stake in the Cove Point LNG plant in Maryland in a deal valued at $3.3B.
3. Sept 5, 2023: Enbridge reached three deals with Dominion Energy to buy several natural-gas utilities for a combined value of $14 billion. The agreements will create the biggest natural-gas utility in North America. The terms include $9.4 billion of cash and $4.6 billion of assumed debt.
4. Sept 2023 – Nov 2023: In September, inflation hit 5.6%, fed rates were at 2.56% and were aggressively increasing. The rates increased until it peaked Aug 2023 at 5.3% and plateaued in the following months.