In early July, giant U.S. utility Dominion Energy (D -2.02%) announced that it was making a big change: By the end of the year, it plans to cut its dividend by 28%. That's a significant reduction, and dividend-focused investors have a right to be displeased. But before dumping the stock or putting it on the verboten list, step back and examine why the cut is being made. The truth is, this decision might actually be good for long-term investors.
Getting regular
Dominion Energy is one the largest utilities in the United States. However, what it looks like today is vastly different from what it looked like just a decade or so ago. Over that span, it has been shifting away from more volatile businesses so it can focus more on regulated utility assets. The biggest move was the sale of its oil exploration and production business. However, it has also been acquiring utilities, most recently SCANA, to build up its regulated utility operations.
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The long-term goal has been to create more stable top- and bottom-line performance so that investors can be more sure of what to expect from the company over time. That goal includes the dividend as well. But the recently announced dividend cut appears to contradict that messaging...or does it?
Today, Dominion is really three businesses in one. The largest piece of what it does is own and operate regulated utilities. These are boring businesses that would be appropriate for widows and orphans, to use an old Wall Street cliche for the most risk-averse investors one can imagine. Then it has a small segment selling power to other companies, largely derived from renewable sources. And lastly, it owns midstream energy assets. These are the pipelines and other facilities that help move oil and natural gas from where they are drilled to where they eventually get used. The key here is that the pipes Dominion owns are largely fee-based and regulated by the federal government, so they aren't as risky as they may seem.
For the most part, Dominion has been a fairly consistent performer since it got rid of its far more volatile exploration business. But the midstream sector has started to change lately, and not in a good way.
Shifting with the times
The headwinds that Dominion faces in the midstream space started in 2018, when a tax law change altered the benefit of the master limited partnership model. At that time, Dominion controlled a partnership that it had intended to use as a funding vehicle. This was a common approach at the time, with companies selling midstream assets to a partnership (also known as dropdowns) and using the cash generated from the transaction to invest in growth projects. The tax law change killed the benefit of this for Dominion, and it bought the controlled partnership, opting instead to sell assets and take on more debt in its effort to raise capital.
Following that move, the company started to face increasing headwinds in its effort to build a key pipeline project it had in the works, known as the Atlantic Coast Pipeline. It wasn't the only company facing material pushback, however, as the entire pipeline industry was seeing the same kind of trouble. One legal case regarding the Atlantic Coast Pipeline actually went all the way up to the Supreme Court. Dominion eventually won the case, but the experience and what it was seeing in the rest of the pipeline space led it to drop the project. It believed that there was too much risk of further delays (including the potential that the project wouldn't get completed) and cost increases to keep going.
At the same time it announced the decision on the Atlantic Coast project, it also said that it was basically exiting the midstream space. The reason was essentially the same one that led it to stop work on the Atlantic Coast Pipeline. Most of the business would be sold to Berkshire Hathaway. The bad news is that Dominion's midstream segment was expected to account for around a quarter of its earnings in 2020. Pull that out, and there's no way it could afford to keep paying its dividend at the same level as before. Dominion basically has no choice but to cut its dividend if it sells its pipelines.
But at this point, it has completed the transformation into a boring utility. In fact, now that it has ripped the Band-Aid off, Dominion believes that it will be able to grow its earnings at around 6.5% a year for the foreseeable future. That's a strong number in the utility space. The dividend, meanwhile, should expand at a roughly similar clip -- also a generous growth rate compared to those of peers. The payout ratio, meanwhile, is expected to drop from over 80% (at the high end of the sector) to a more reasonable 65%. In other words, Dominion is resetting and positioning itself for stronger long-term performance.
Don't bail so fast
No income investor likes to see a dividend get cut. However, it pays to think about why a dividend is being reduced before simply dumping a stock on such news. In the case of Dominion, this dividend cut is likely going to make it an even more attractive dividend stock in the long term. Yes, losing that extra income might hurt, but it looks like that near-term pain may be worth it for the long-term gain.
