Dominion Energy Could Cut Its Dividend

Investors may be interested to shop for value in Dominion Energy (NYSE:D), which has underperformed the utility sector (using the Utilities Select Sector SPDR Fund (XLU) as a proxy) and the stock market (using SPDR S&P 500 ETF Trust (SPY) as a proxy).

On a closer look, though, it has underperformed both over the last 1-, 3-, 5-, and 10-year periods. Therefore, investors should proceed with extra caution.

The graph below illustrates the 10-year total returns. Dominion Energy is the 8th largest holding in XLU. The ETF has a weighting of about 4.3% in the utility.

This graph suggests Dominion Energy is a stock to avoid, as it has significantly underperformed. Many investors buy utility stocks for the dividend. Let’s use XLU as a proxy again. The ETF has a recent distribution yield of 3.45%. Dominion’s dividend yield is 5.71% at writing. The market pricing the stock at a much higher yield than the sector suggests it’s a stock with relatively high risk.

As a predominantly regulated utility, Dominion Energy’s earnings should be quite resilient. However, because of supposedly strategic moves by the company to make asset sales, lowered earnings have resulted in dividend cuts in the past.

A Flat Dividend for Now

A growing dividend is safer than a stagnant one. Surely enough, the utility stock has maintained the same dividend per share for 8 consecutive quarters, including the one that was declared on November 2, has an ex-dividend date of November 30, and a payment date of December 20. The higher yield is entirely a consequence of a depressed stock price.

In Dominion Energy Upholds Big Dividend, Shares Pop, SA analyst Ray Merola wrote that “The current dividend is secure.” with the following snippets as support for his argument.

CEO Bob Blue

We’ve been and continue to be 100% committed to our current dividend. Earnings growth combined with a period of low to no dividend growth will restore our payout ratio to a peer appropriate range over time.

During the Q&A session, Mr. Blue reiterated himself. He didn’t stutter:

Jeremy Tonet – Analyst

Appreciate the commentary just laid out there with regards to how you’re talking about the review, but just wanted to go to the dividend, if I could, and just wanted to see if the dividend policy remains intact, even if for some reason you keep all of wind [CVOW]. Is there any scenario where, keeping the dividend at these levels [$2.67 annualized] just wouldn’t make sense?

CEO Bob Blue

We’re committed to the dividend, Jeremy. As we said, we’re 100% committed to the dividend. Trying to talk about scenarios that people could imagine, I don’t think is terribly productive. We’ve been committed to the dividend since the beginning. We haven’t wavered in that. We’re not wavering on it today.

(Quotes from Ray Merola’s article ends)

Why Dominion Energy Stock Might Cut Its Dividend

Despite management’s seemingly strong commitment to the dividend, please allow me to provide a friendly reminder that as recently as Q4 2020, Dominion Energy “cut” its dividend by a third. This is in quotes because the cut was due to the sale of gas transmission and storage assets, which were worth an enterprise value of $9.7 billion, to Berkshire Hathaway (BRK.A) (BRK.B).

When a company sells a meaningful amount of assets, it would also see a corresponding reduction in its earnings and cash flow. So, it’s logical for a dividend cut, which lowers the payout ratio. Asset sales done during favourable economic times may even result in the payout of a special, one-time dividend.

This time around Dominion Energy is waiting for the pending sale of the remaining interest in Cove Point LNG facility and natural gas distribution utilities. A portion of the proceeds will be used for paying down debt. Even though some of the proceeds will also go into investing for future growth, these projects will take time to complete before they can start contributing to earnings and cash flow.

Dominion Energy’s 2023 operating EPS guidance is $2.10, which accounts for the pending asset sales, suggests a payout ratio of about 127%. Management noted that interest savings from the announced asset sales would otherwise have pushed the EPS guidance to $2.90, reducing this year’s payout ratio to about 92%.

In the short term, the utility could choose to maintain its dividend. However, the stretched payout ratio implies that it’s not a stock for conservative investors, especially if you’re looking for income from utility stocks that are typically viewed as defensive through the economic cycle.

Investor Takeaway

Other than the questionability of its dividend safety, there are also other uncertainties in Dominion Energy. The regulated utility is under a strategic review – the final step could bring in a non-controlling equity financing partner. It expects a decision by early 2024. In the meantime, its growth outlook is highly uncertain, especially in a higher interest rate environment.

Since earnings in the near term are lower than expected from asset sales and debt reduction, investors should, at a minimum, expect no dividend increases in the short term.

The weakness in Dominion Energy stock over the last year has more or less priced in these uncertainties.

Dominion Energy enjoys an investment-grade S&P credit rating of BBB+. It would be smart for it to further improve its balance sheet by paying down debt in the current higher interest rate environment to reduce interest expense.

A turnaround in the company could result in a reasonable rate of return for an investment over, say, the next five years. However, in the near term, investors should not be overly trusting about its dividend. We rate the higher-risk utility stock as a “hold” at best.

For other utility stock ideas, check out XLU’s larger holdings, including NextEra Energy (NEE) and Southern (SO).