I'm a sucker for a big dividend, so I have to be careful that I'm not getting into a yield trap when I buy stocks. Which is why I had to step back and carefully think about my decision before purchasing Dominion Energy Inc. (NYSE:D). While I was clearly attracted by the giant diversified utility's big 5% yield, there were other important facts that really led to the purchase. Here's why I bought this high-yield energy stock.
A big yield, relatively speaking
I would be lying if I said Dominion Energy popped onto my radar for any reason other than its 5% yield. But a large yield alone is a terrible reason to buy a stock. So I also make sure to look at a company's yield relative to its own history. Doing this can help you spot when investors are, potentially, being overly pessimistic.
Right now, Dominion's yield is toward the high end of its historical range. In fact, the dividend hasn't been this high since the 2007 to 2009 recession. That was an important signal to me that this utility was worth a deeper dive. A closer look revealed that the dividend yield is backed by 15 years of annual dividend increases. The payout ratio is a bit high today, in the mid-80% range, but management is comfortable with that level based on the stable nature of its revenue. A clear focus on returning value to investors via regular dividend hikes is another factor to which I pay close attention.
While regular increases are nice to see, the size of the hikes is also important. On that score, Dominion has rewarded investors with dividends that have grown at a compound annual rate of around 8% over the past decade. That's nearly three times the historical rate of inflation growth, which is roughly 3%. Dominion has notably increased its shareholders' buying power over time, yet another reason to like the stock.
That, however, is the past. You also have to look to the future. With a large regulated utility business at the core of Dominion, it has a solid foundation. As it spends money to upgrade its asset base, it can request rate hikes from regulators. It also has a sizable fee-based infrastructure business, in which it is expanding its portfolio via construction. A larger portfolio of fee-based assets leads to a larger income stream.
And, across its portfolio, it has been executing well on large projects. Spending is currently pegged at as much as $4.2 billion a year, which Dominion expects to result in 10% dividend growth in 2018 and 2019, with growth between 6% and 10% in 2020. Note that the investment plans that are driving earnings and dividend growth are one of the reasons the payout ratio is on the high side; over the longer term, management expects to get that number down into the mid-70% range.
Why the high yield?
So far, Dominion sounds like a great dividend stock, which I think it will end up being. However, there are some good reasons for the high dividend yield. One key reason today is tax reform. Regulators set utility rates so that utilities can make a reasonable return on their investments, which includes an expectation for taxes. With taxes lower, regulators could make customer-friendly (and utility-unfriendly) rate changes.
At the same time, Dominion is dealing with headwinds to its plan to use Dominion Energy Midstream Partners LP (NYSE: DM) as a funding source. The original plan was to sell, or drop down, midstream infrastructure like the recently completed Cove Point liquified natural gas facility to this controlled partnership. The cash would then be used to raise dividends and support Dominion's investment plans. However, a steep drop in the prices of midstream limited partnerships has made this a nonstarter.
Dominion has been reworking its funding plans because of these two issues. That's included issuing stock and reducing its capital spending budget. Also on tap: taking on more debt at select assets (notably Cove Point), and selling non-core assets (such as its Blue Racer Midstream business and carbon-powered merchant power plants). It's well on the way to dealing with these issues, which I believe will soon prove to be temporary. Once it has adjusted to the new environment, investor concerns should subside.
While all of this is going on, Dominion has also announced plans to buy financially struggling peer SCANA Corp. (NYSE:SCG). This utility got into trouble when it canceled a nuclear construction project midstream after its contractor declared bankruptcy. Regulators, customers, and politicians have been less than pleased, with demands for rate and dividend cuts (a dividend cut was just announced).
That said, SCANA has a desirable footprint in growing markets, which would be a net positive for Dominion. And Dominion claims its acquisition plan is set in stone, with any notable changes requested by regulators likely to lead it to drop its bid. While buying SCANA increases uncertainty at Dominion, I believe the acquisition will be more positive than negative, if it goes through. And if it doesn't, Dominion is still an attractive opportunity as is.
There's a lot going on
At the end of the day, I expect Dominion to work through the current list of issues while continuing to reward investors well via a large dividend and sizable dividend increases. The worst-case scenario appears to be that it muddles through a difficult period and has to pull back on its dividend growth to ease any financing issues it's facing. I don't foresee a dividend cut.
Once it's through this rough patch, which could last a few years, it should be much smoother sailing. I don't think investors are wrong to be worried about the uncertainty at Dominion today, but I'm willing to collect a 5% yield while I wait for management to solve the current round of issues -- all of which it appears to have a good handle on. Which is why Dominion and its 5% dividend yield are now in my portfolio.