Dominion Energy (D -0.31%) is one of the largest utilities in the United States. Its generous 4.7% yield sits at the high end of the utility yield spectrum and well above the average yield of around 3%, as measured by the Vanguard Utilities ETF. But there's a big change taking shape on the dividend front at Dominion Energy that income investors need to know about, and it's important to understand why the company has made this tough dividend call.

A great record

Dominion Energy has increased its dividend annually for 16 consecutive years. Before you go any further, know that it has no intention of breaking that streak. Dividend growth over the past decade has averaged just under 8% a year. More recently, dividend growth has been roughly 10%. 

The word 'dividend' with a yellow line heading jaggedly higher underneath it

Image source: Getty Images.

That level of growth is over. Dominion is projecting that dividend growth will slow to around 2.5% in 2020 and remain at that level for at least a few years. To be fair, that's enough to keep up with the recent low rate of inflation growth. As long as inflation doesn't tick up to the historical average (closer to 3%) or higher, the buying power of Dominion's dividend will continue to expand over time. And with such a high yield relative to peers, it's hard to complain too much if you're looking to generate as much income as possible from your portfolio today.   

But you can't step in here, or stick around if you already own Dominion's stock, without asking: "Why the sudden deceleration in the dividend?" The answer isn't great, but it's not exactly bad, either.

Fixing a disconnect

Dominion has been shifting gears for a number of years, moving its business more and more toward assets with regulated businesses or fee-based structures. There has been a lot of movement in the portfolio, including asset sales and acquisitions. In fact, 2018 and 2019 were pretty active years, with Dominion buying smaller, financially troubled utility SCANA and acquiring its controlled midstream partnership (both were agreed to last year, but completed in 2019). 

At this point, in addition to a relatively high yield, Dominion also has relatively high leverage compared to peers. With debt to EBITDA of around 6.4 times at the end of the first quarter, it easily sits at the top end of the industry. That alone is something to worry about, but now add in the fact that Dominion's payout ratio has increased from the 70% range as recently as 2016 to what's expected to be nearly 90% in 2019. The average for the utility space, meanwhile, is roughly 70%. 

Leverage Is an Issue for Dominion Energy
D Financial Debt to EBITDA (TTM) Chart

D Financial Debt to EBITDA (TTM) data by YCharts.

Dominion is basically slowing its dividend growth to around 2.5% to create some financial breathing room (it wants to maintain its investment-grade credit rating) and bring the payout ratio back down into the 70% range. The latter target will take a few years to achieve, since dividend growth is expected to be roughly half the company's projected 5% earnings growth rate. Note that the utility has $26 billion in capital growth plans between 2019 and 2023 to back that growth, so 5% looks like a reasonable projection. However, pushing the dividend up by half that amount means getting to the 70% range will be a slow and steady process -- not an overnight success. (Getting this done overnight would mean a dividend cut, and investors generally prefer to avoid those.) 

In the end, Dominion is slowing dividend growth to ensure it remains a great income stock. Relatively high leverage combined with a high -- and still expanding -- payout ratio is a recipe for a dividend cut if something doesn't change. Management is proactively changing the dividend growth rate now so it can ensure income investors, who have come to rely on the utility's hefty yield, won't be disappointed later.

Not great news, but not bad

For investors who own Dominion specifically because of the swift dividend growth in recent years, the dividend growth slowdown means you need to reassess your investment. A different company with a higher growth rate, such as NextEra Energy, might be a better choice today. That said, for those interested in maximizing the income they generate from their portfolios, Dominion remains a solid option. The high yield, slow and steady growth projections (for dividends and earnings), and clear goal of solidifying its ability to pay dividends by lowering its payout ratio should be seen as long-term positives.