- Just because utilities are supposed to be safe income vehicles doesn't mean they should be excluded from extensive and objective financial analysis. Right?
- Exelon and First Energy are two examples of how risky utilities' dividends can be -- and shareholders suffered as a result.
- Let's take a look at Dominion Resources' dividend strength.
This may come as a surprise, but a lot of steady-eddy utility firms receive a "Very Poor" dividend safety rating at Valuentum. We admit this seems counter-intuitive, but just because utilities are supposed to be safe income vehicles doesn't mean they shouldn't be subjected to extensive and objective financial analysis.
Hope we caught your attention.
That said, most utilities should still be viewed as generally stable entities on the basis of the stability of their business models (and sometimes fixed rate of returns). However, a utility's "Very Poor" safety rating at Valuentum reveals that, in the event of an exogenous event, the board hasn't left much in terms of excess cash-flow capacity to absorb the impact. Most utilities simply have massive net debt loads, and any threat to their credit rating means shareholder dividends are at risk.
This should be an accepted fact of their business models, a fact unfortunately that many shareholders do not accept. Exelon (NYSE:EXC) and First Energy (NYSE:FE), however, are two such examples of how risky utilities' dividends can be -- and shareholders suffered as a result. In this article, as the title suggests, let's take a look at Dominion Resources (NYSE:D) to see if it may turn into the next Exelon or First Energy.
But before we go too far, let's first start by framing the analysis for readers. Most dividend assessments tend to be backward-looking--meaning the evaluation rests more on what the company has done in the past: how long it has raised its dividend, for example. Please don't misunderstand. We think analyzing historical trends is important, but investors should understand that for a cash-rich, growing company to raise its dividend by a reasonable amount in each of the past 20, 30 or more years isn't much to write home about.
Imagine, for example, giving your grandson $1 for his age on each consecutive birthday. Though you'll effectively be raising his "dividend" each year, the payout isn't necessarily tied to your income stream, nor is it very taxing on your lifestyle (even if he lives to 100 years or older). In a similar manner, a dividend payment is not explicitly tied to a firm's earnings stream nor is it very taxing on a firm to raise its dividend each year. For one, firms with substantial earnings don't have to pay a dividend, and companies can report declining earnings and still raise their dividend in the same earnings release.
Over the long haul, earnings growth will have to support dividend growth, but in instances where the payout ratio is low, earnings don't necessarily have to expand for the company to raise its dividend for years and years. A company can double its payout ratio by raising its dividend for 50 consecutive years, for example, but the payout ratio at the end of the period could still only be 50% of earnings at the beginning of the 50-year period. Fascinating, no?
With all of this said, it becomes obvious that assessing the future capacity of growth of the dividend is really what matters most for dividend growth investors. After all, dividend growth investors are investing for the next 5, 10, 20 years, not the past 5, 10, 20. And they want their dividends to increase by a material amount. This forward-looking perspective that assesses the potential magnitude of future dividend growth is all the difference in the world. That is why we created a forward-looking assessment of dividend growth through the innovative Valuentum Dividend Cushion methodology.
For those that may not be familiar with our boutique research firm, we generate a discounted cash-flow analysis for all firms in our coverage. We use these future forecasts of free cash flow (cash flow from operations less capital expenditures) and expected cash dividend payments and consider the company's net cash position to evaluate just how much capacity a firm has to keep raising its dividends long into the future. The bells should be ringing right now. A firm's balance sheet is a key source of dividend strength, and most utilities are burdened with massive net debt positions.
The Dividend Cushion is a forward-looking ratio (with a numerator and a denominator). It tells investors how many times future free cash flow (cash from operations less capital spending) will cover future dividend payments after considering the net cash on the balance sheet. It is purely fundamentally-based and driven from items taken directly off the financial statements. Let's take a look at Dominion Resources' investment highlights and then its dividend report to see how all of the analysis comes together.
Dominion's Investment Highlights
• Dominion found its calling in the electric utility business in 1909. A merger with Consolidated Natural Gas in 2000 brought to Dominion a century of valuable experience in the gas-production and gas-transportation areas of the Appalachian Basin.
• The firm is one of the US' largest producers and transporters of energy, with a portfolio of approximately 23,000+ megawatts of electric generation, ~11,000 miles of natural gas transmission, gathering and storage pipeline and 63,000+ miles of electric transmission and distribution lines.
• Dominion continues to transition its business model, with expectations for regulated earnings to reach as much as 80%-90% of operating earnings (was about 40% in 2006). It anticipates significant growth in regulated electric/gas growth in coming years, as it sells merchant assets.
• The utility plans to invest nearly $14 billion between 2014 and 2018 in energy infrastructure projects that make up its portfolio of diverse and growing business lines. Dominion has a mountain of debt obligations (~$19.3 billion in long-term debt alone), but the company's credit ratings are investment grade across the board.
Dominion's Dividend Report
Dominion's dividend yield is nice, offering a ~3.4% annual payout at current price levels. By nice, we mean that its yield is more than the average payout of an average S&P 500 company.
Image Source: Valuentum
The bottom right of the table in the image above reveals our expectations of the utility's future pace of dividend growth (~5%-8% per annum). Go ahead, take another look if you missed it. Dominion's dividend should expand roughly in-line with earnings growth, as management is targeting paying out 65%-70% of operating earnings per share each year.
You thought you were reading an article about Dominion Resources' risk of a dividend cut? Well, you are. The following is how we add analytical value to your dividend analysis across all sectors and companies -- please do keep reading. Remember -- the Dividend Cushion ratio informs not only our opinion of the safety of the dividend but also its capacity for future growth. It is a comprehensive ratio that considers the health of a firm's balance sheet as well -- the ratio is the only one of its kind.
Dominion's Dividend Safety/Cushion -- VERY POOR/0.5
Finally, you've reached the juicy part. We assess the safety of a firm's dividend by adding the company's balance sheet net cash (total cash less total debt) to our forecast of its free cash flows (cash flow from operations less capital expenditures) over the next five years. We then divide that sum by the total expected cash dividends over the next five years. This process results in our Dividend Cushion™ ratio. A Dividend Cushion above 1 indicates a firm can cover its future dividends with net cash on hand and future free cash flow, while a score below 1 signals trouble may be on the horizon. And by extension, the greater the score, the safer the dividend, as excess cash can be used to offset any unexpected earnings shortfall.
Dominion Resources scores a 0.5 on our Dividend Cushion™, which is VERY POOR. Why? Because the utility has more than $20 billion (yes, billion) in long-term debt (and an addition ~$4 billion in short-term debt) and only ~$400 million (that's million, not billion) in cash. The firm is leveraged to the hilt as it relates to net debt, and while its credit rating considers a variety of other factors, the capacity to keep paying a dividend (as it relates to the balance sheet) emanates from cash (net cash, to be more specific).
Dominion's Dividend Growth Potential -- VERY POOR
This section is where we lose some readers. How can we be factoring in dividend growth, but yet we say that Dominion's dividend growth is Very Poor? Are we off our rockers? Or just trying to be confusing?
Well, for starters, we don't want our readers to think that Dominion Resources' dividend is ultra-safe, nor do we think it is safe at all in the context of a massive debt load that could compromise payments to shareholders in the event that its credit rating is challenged. All else equal, we prefer high-yielding, cash-flow rich firms, with balance sheets overflowing with net cash -- and ones that are underpriced at that.
For Dominion, we state in very simple terms that its Dividend Growth potential is VERY POOR, matching the utility's Dividend Safety assessment. In the same breath, however, we also think the firm's annual dividend will be $2.22 per share within the next several years (by the end of fiscal 2018).
Inconsistent? Well, not really. Confusing? Maybe. Informative? We sure hope so.
For interested readers, we generally assign the quantitative dividend growth rates to firms on the basis of their qualitative Dividend Growth rating. The scale we use as guidance to assign future dividend growth rates is shown below. This, of course, doesn't apply to the utilities in our coverage.
Dividend Growth Potential Scale
Excellent: 8% or higher
Very Poor: 0%-2%
In addition to assessing the Dividend Cushion ratio and the firm's track record, we also evaluate recent growth rates in the dividend and/or the dividend payout ratio to fine-tune the trajectory of the future dividend forecasts. For those interested in dividend growth forecasts for other companies, we have dividend growth forecasts for every company in our 1,000+ firm coverage universe that pays a meaningful dividend.
Dominion's Risk of Capital Loss -- MEDIUM
Though the dividend certainly can impact a company's share price, we assess the risk of capital loss within the valuation context. If the stock is undervalued (based on our DCF process), we think the risk of failing to recoup one's original capital investment (ex dividends) is relatively LOW. If the stock is fairly valued (it falls within our fair value estimate range), we think the likelihood of losing capital (ex dividends) is MEDIUM. If the stock is trading above our estimate of its intrinsic value, we think the likelihood of losing at least a portion of one's original investment (ex dividends) is HIGH. Dominion Resources registers a score of MEDIUM on our scale. Though we generally prefer firms that are underpriced, or have a LOW risk of capital loss, in this market environment, very few dividend growth firms are in this situation. You'll have to visit our website to see its 16-page valuation report.
Wrapping It Up
Clearly, this article is going to be confusing for some readers -- utilities, for one, don't fit all that well into the Dividend Cushion, but extensive and objective financial analysis is supremely important to the investment-decision making process. And just because a business model is run differently (think the regulated returns of utilities), it doesn't mean that cash is not king when it comes to valuation analysis and the payment of dividends.
We hope this article helps clarify how investment analysis sometimes isn't as straightforward as just looking at the size of the dividend yield -- and why jumping to conclusions about qualitative remarks may be painful in the long run -- especially in the context of an overconfidence bias. Exelon and First Energy shareholders may have been overconfident of the safety of their firms' dividend payouts, too.
Perhaps needless to say, Dominion Resources' dividend doesn't make the cut for inclusion into the Dividend Growth portfolio. We just can't get comfortable with the utility's massive net debt position. Any exogenous shock could cause the firm to cut its dividend, as we've seen before in the utility space.
The following provides the definitions of the terms you may have read in the dividend report (image) above. Thank you for reading!
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.