This Mega Merger Is A Huge Win For Dividend Lovers

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Regulated utilities are often a cornerstone of low-risk, high-yield portfolios because of their wide moats, and highly stable, recession resistant cash flows. However, the downside is that these government sanctioned monopolies are usually very slow growing. Dominion Energy (D) is a rare exception, and thus one of my favorite regulated utilities. In fact, I own it in my high-yield, retirement portfolio.

Dominion just announced that it was purchasing SCANA Corp. (SCG) in a $14.6 billion all-stock deal. After carefully analyzing what this means for investors in both companies, I’m happy to give my blessing to this corporate union. This is because not only is this deal great for SCANA’s customers (and thus likely to receive regulatory approval) and investors, but most importantly, it makes Dominion Energy an even more powerful dividend growth machine.

Best of all? The news of the deal has caused Dominion’s share price to drop to a level that makes now the perfect time to add it to your low-risk, high-yield dividend portfolio.

Merger Is A Big Win For Troubled SCANA

On January 3rd, Dominion announced it was buying SCANA in a $14.6 billion, all stock deal. This valued the South Carolina based utility at a 38% premium to its previous closing price. The merger is expected to close in Q3 2018, and SCANA shareholders will receive 0.669 Dominion Energy shares for each share of SCANA they own.

The reason this merger is such a great deal is because all parties involved, Dominion investors, SCANA shareholders, and SCANA customers, will benefit.

Source: Dominion/SCANA merger presentation

For example, SCANA has recently been caught in a huge scandal involving the utter failure and abandonment of its VC Summer nuclear project. The $12.8 billion plant expansion has seen long delays that causes costs to soar to $20 billion, resulting in massive rate increases for customers over the last several years.

And with the bankruptcy of Westinghouse Electric, SCANA finally made the smart decision to fully abandon the project after having spent about $9 billion so far. The anticipated write down SCANA was facing was $2.0 billion much of which the utility wanted to make customers pay for under the 2007 South Carolina Base Load Review Act. This law allows a utility to pass on financing and capex costs to customers even for abandoned projects.

However, SCANA customers, as well as South Carolina lawmakers and regulators, are understandably up in arms over this debacle and considering a lawsuit to suspend the rate increases. In addition, SCANA’s partner on the project (45% stakeholder), Santee Cooper, has lobbied for the state to force SCANA to not abandon the two reactors but rather continue paying to maintain them for possible future completion or sale. The problem is that if SCANA did sink more money into this black hole by maintaining the reactors, it would be unable to take its write down, which cuts its ultimate loss on the project in half.

In addition, the SEC has recently launched an investigation into whether or not SCANA “failed to disclose information that should have been disclosed” pertaining to rate increases. Things got so bad that Jay Lucas, speaker of the South Carolina House of Representatives, called for Kevin Marsh, SCANA’s CEO, to resign saying, “Neither South Carolina ratepayers nor the South Carolina House of Representatives can have faith in Scana under Marsh’s leadership.” On October 31st, Marsh did in fact announce an unexpected early retirement, with COO Jimmy Addison replacing him on January 1st, 2018.

The bottom line is that SCANA’s nuclear disaster was a huge albatross around the neck of both its customers and its shareholders. Now, however, Dominion is swooping in to save the day and giving everyone an easy out. SCANA customers will get an average rebate of $1,000, 5% lower electric rates, and Dominion will take a $1.7 billion write down on the VC Summer plant project.

So it’s clear that SCANA and its customers are big winners. But why exactly is Dominion being so generous, both in terms of paying a 38% premium and bailing out this terribly mismanaged utility? Because despite the high premium, Dominion is actually getting a great deal.

Deal Is Even Better For Dominion

Morningstar utilities analyst Travis Miller estimates that based on its fundamentals, SCANA shareholders should have gotten an exchange rate of 0.69 shares of Dominion Energy. This means that it’s possible that Dominion actually underpaid by about 3%.

Source: Dominion/SCANA merger presentation

The reason is that the SCANA acquisition greatly expands Dominion’s regulated gas and electric business. In fact, with a total of 6.5 million gas & electric customers, Dominion will now be a dominant utility in five states, three of which benefit from fast growing economies and populations.

Source: Dominion/SCANA merger presentation

And despite the scandal surrounding the VC Summer expansion, SCANA still benefits from a generally friendly regulatory environment with above average return on equity that is in line with Dominion’s own approved ROE.

Source: Dominion Energy investor presentation

Better yet? With the end of SCANA’s ill conceived nuclear project, the company is expected to double down on gas fired plants. Dominion’s large and fast growing midstream provides it with abundant access to the very low cost, and hyper prolific Marcellus and Utica shale gas formations of Pennsylvania, Ohio, and West Virginia.

In other words, by acquiring SCANA, Dominion can become an even larger, and more integrated regulated utility giant. One that also benefits from strong growth catalysts in the electrical transmission and midstream industries.

But best of all, because SCANA has fallen so hard in the past year (about 35%), the deal is immediately 11% accretive to Dominion’s EPS.

Utility Revenue Net Income Shares Outstanding TTM EPS Forward EPS Tax Cut Adjusted Forward EPS
Dominion Energy $12.462 billion $2.278 billion 632 million $3.38 $4.04 $4.74
SCANA $4.305 billion $0.45 billion 143 million $3.15 $3.06 $4.04
Dominion + SCANA $16.767 billion $2.728 billion 728 million $3.75 $4.30 $4.90

Sources: press release, Morningstar

And with the added benefits of the recently passed tax cuts, Dominion’s earnings are likely to soar in the coming years. That’s because Dominion’s effective tax rate over the past year is just 25.4%, compared to SCANA’s 31.0%. This means that SCANA will benefit from the tax cut almost twice as much, with a permanent one-time EPS boost of 32.3% in 2018 compared to Dominion’s 17.3%. All of which means that if the deal closes as planned, then factoring in the new 21% corporate tax rate, Dominion’s EPS is potentially set to expand 45% to $4.90 for 2018.

However, the benefits of this merger extend far beyond just a one-time bump in EPS. SCANA’s plans for about $750 million a year in capex spending will also add to Dominion’s already massive growth pipeline.

Source: Dominion Energy investor presentation

In fact, with the addition of SCANA, Dominion’s growth spending will rise to about $4.25 billion through 2020, and about $4.75 billion per year over the long term. This would likely continue to make Dominion Energy one of the fastest growing utilities in the country, with 8% to 10% EPS growth in the short term supporting its planned 10% annual dividend increases through 2020.

Source: Dominion/SCANA merger presentation

Even beyond that, Dominion’s fast growing presence in midstream and electrical transmission (a key component of renewable energy expansion) should allow it to maintain one of the best long-term payout growth rates in the industry.

Dividend Lovers Win Most Of All

Utility Yield TTM EPS Payout Ratio 2018 Payout Ratio 10 Year Projected Dividend Growth 10 Year Potential Total Return
Dominion Energy 4.4% 91% 71% 6.5% to 7% 10.9% to 11.4%
SCANA 5.4% 78% 61% -2.1% 3.3%
S&P 500 1.8% 50% NA 6.1% 7.9%

Sources: Morningstar, Gurufocus, FastGraphs, CSImarketing, Multpl.com

Some SCANA shareholders may be upset that they will be replacing one of the highest-yielding utilities with shares of a utility that yields 1% less. However, keep in mind that what truly matters isn’t just yield, but the overall dividend profile. That means you need to look at three things: yield, dividend safety, and long-term growth potential.

At a 4.4% yield, Dominion is still one of the top yielding utilities (industry median yield 3.3%), and one that has a very safe dividend. This is because its forward payout ratio is expected to fall to 71% thanks to the lower corporate tax rate and several midstream projects coming online this year.

As importantly, Dominion has a very strong balance sheet, which is the other part of the dividend safety puzzle.

Utility Debt/EBITDA EBITDA/Interest Debt/Capital S&P Credit Rating Average Interest Rate
Dominion Energy 5.5 5.36 55% BBB+ 3.4%
SCANA 5.1 4.08 48% BBB 4.8%
Dominion + SCANA 5.4 5.06 54% BBB+ 3.7%
Industry Average 7.8 5.17 61% NA NA

Sources: Morningstar, FastGraphs, CSImarketing

Now it is true that Dominion’s large investments into big midstream projects and acquisitions over the years has caused its leverage ratio to rise over time. However, in the coming years, management expects cash flows generated by projects coming into service to reduce its leverage ratio.

Meanwhile, because SCANA’s debt levels are slightly below that of Dominion, the $6.7 billion in debt it is assuming to buy SCANA isn’t likely to put it at risk of a credit downgrade. In fact, Dominion’s balance sheet will get slightly stronger as a result, though its overall interest rate will rise slightly due to higher-yielding SCANA bonds.

However, the bottom line is that by buying SCANA under these terms, Dominion is becoming an even better dividend growth stock, and one that will raise its payout much faster than SCANA ever could. This means that Dominion is likely to not just outperform most other utilities but also the S&P 500 over the coming decade.

That’s especially true given that the recent decline in Dominion’s share price means that its valuation is looking particularly attractive right now.

Valuation: Dominion Is A Great Buy Right Now

Chart
D Total Return Price data by YCharts

SCANA’s nuclear nightmare has made for a terrible year, which is why Dominion is buying them now at a great price. However, the combination of general utility weakness (over concerns of rising interest rates), and the news of the merger, has meant that Dominion has itself vastly underperformed the S&P 500 in the past year. But while some see that as a bad thing, I think of it as a great buying opportunity.

Utility Forward PE Historical PE Yield Historical Yield Percentage Of Time In Last 22 Years Yield Has Been Higher
Dominion Energy 19.0 22.0 4.4% 3.7% 34.9%
Industry Median 17.1 NA 3.3% NA NA

Sources: Gurufocus, YieldCharts

This is because Dominion’s forward PE is currently far below its historical average. And when you factor in both the SCANA merger and the profit boosting effects of a 21% corporate tax rate, Dominion’s forward PE falls to just 15.7.

Source: Ycharts

More importantly, the current yield is much greater than the stock’s historical norm. In fact, in the past 22 years, Dominion has only offered a higher yield about 35% of the time. This means that today is the best time to buy Dominion in seven years.

Then again, backwards looking valuation metrics are not the be all and end all when it comes to a decision about whether or not to buy a stock. After all, profits and dividends come from the future, not the past. This is why I like to use a long-term forward looking valuation model to make sure that a stock is trading at a fair price or better.

Forward Dividend 10 Year Dividend Growth Rate Terminal Dividend Growth Rate Fair Value Estimate Growth Baked Into Current Share Price Discount To Fair Value
$3.34 5.5% (worst case scenario) 3% $83.42 2.8% 8%
6.0% (conservative case) 3% $86.06 11%
6.5% (likely case) 4% $97.7 21%
7.0% (bullish case) 4% $100.98 24%

Sources: management guidance, Gurufocus, FastGraphs

Specifically, I use a discounted dividend model, which uses a 9.1% discount rate. The reason for this is that a S&P 500 ETF has historically (since 1871) generated a 9.1% total return, net of expense ratio. Since a low cost index ETF is the best default investment option, I consider 9.1% to be the opportunity cost of money.

Now understand that any long-term growth model is far from perfect, and should never be used as the sole reason for buying any stock. This is because such models require assumed, smoothed out growth rates which can be hard to predict.

This is why I use several growth scenarios to estimate the net present value of Dominions future dividend payments and help generate a fair value estimate for the stock. Under all realistic scenarios, it appears that the market is vastly underestimating Dominion’s true worth. That’s because the price is baking in a pessimistic 2.8% dividend growth rate.

Maybe you don’t believe that Dominion will be able to maintain its double-digit dividend growth beyond 2020. That’s a smart and conservative approach to take. But right now Dominion is priced as if its dividend growth rate beyond 2020 will be just 1.1%, which is absurd given its industry leading long-term growth project pipeline.

The bottom line is that thanks to this merger, corporate tax cuts, and one of the best long-term growth runways in the utility industry, Dominion Energy is a strong buy right now.

Risks To Consider

While I’m very happy with the terms of this deal, there are nonetheless several risks to keep in mind.

First, Dominion investors need to expect a small decline in overall profitability. This is because SCANA is a less profitable and well run utility.

Utility Operating Margin Net Margin Return On Assets Return On Equity Return On Invested Capital
Dominion Energy 31.7% 17.2% 3.0% 13.7% 5.6%
SCANA 21.8% 10.5% 2.3% 7.9% 5.0%

Sources: Gurufocus, Morningstar

However, keep in mind three things. The overall decline in margins and returns on capital are likely to be small since this Dominion’s highly lucrative businesses will still remain the vast majority of revenue and earnings.

Second, a big reason for SCANA’s low profitability is the massive bungling of the VC Summer nuclear plant. On the other hand, Dominion Energy’s management team has shown excellent capital allocation skills in recent years when it decided to sell off its volatile and non-core oil & gas production, and merchant power units.

Chart
D Operating Margin (TTM) data by YCharts

Since that time, Dominion’s smart focus on expanding into midstream gas and power transmission has led to substantial growth in its profitability. Hopefully, Dominion’s far superior management can avoid the kind of disastrous decisions SCANA has made, and thus boost the returns on capital of its new assets.

Finally, remember that dividends aren’t paid with margins but earnings and cash flow. So even if Dominion’s new assets end up being permanently less profitable than its existing ones, the accretive nature of this deal still helps support faster dividend growth in the future.

Of course, all of this assumes that the merger is approved by numerous regulators in three states, which isn’t guaranteed.

Source: Dominion Energy/SCANA Merger Presentation

The good news is that Dominion has experience with South Carolina regulators, having bought part of SCANA’s gas business in 2014. Analysts anticipate governor Henry McMaster’s support and an overall highly favorable regulatory view of the deal meaning a 75% chance the merger closes.

But even if the deal is consummated as expected, there is always the risk that the SCANA’s nuclear debacle might end up hurting its long-term relationship with regulators. That in turn might mean that future ROE might not be as great as the relatively generous (compared to other states) 10.25%.

Or to put another way, SCANA is a bride that has a lot of baggage, and Dominion shareholders are now going to be responsible for cleaning up SCANA’s mess. While I am confident that Dominion’s top shelf team can clear the wreckage eventually, it might take longer, and potentially cost more than expected.

Finally, we can’t forget about the risk of rising interest rates. The Federal Reserve has indicated that it plans to raise rates three times in 2018, but some analysts think the accelerating economy means we might get four.

Now it’s important to note that the Fed fund rate doesn’t directly affect long-term rates at which Dominion borrows. Those are set by credit markets, which are usually benchmarked off long-term US Treasury rates. However, over the long term, rising short-term rates generally do coincide with rising long-term rates which can raise borrowing costs for capital intensive industries like this.

That being said, Dominion has successfully grown for decades, including times when long-term rates were much higher than we’re likely to ever see again.

Chart
10 Year Treasury Rate data by YCharts

In other words, Dominion’s overall growth, and its dividend aren’t likely to be at much risk from rising rates. However, the share price might take a short to medium-term hit should rates spike higher. That’s because utilities have become bond alternatives in recent years, and so should long-term US Treasury yields rise high enough, demand for all high-yield stocks might fall.

While that would be a potentially great thing for new investors who could lock in higher yields on Dominion shares, it would also hurt price sensitive investors such as retirees living off the 4% rule. This means that if your portfolio isn’t large enough to fully live off dividends, you need to potentially prepare for a short-term decline.

One approach is to sell stocks now in order to maintain a one- to two-year cash reserve to minimize the risk of having to sell your holdings during a market or high-yield stock downturn.

Bottom Line: One Of America’s Best Utilities Just Keeps Getting Better And Is A Strong Buy Right Now

Large scale M&A is like a marriage, fraught with both great risk and opportunity. Undoubtedly, there will be some bumps in the road for both Dominion and SCANA.

However, given Dominion’s excellent capital allocation track record in the last few years, and the highly favorable and immediately accretive nature of this deal, I think investors on both sides of this corporate marriage have reason to cheer and be optimistic about the future.

Most importantly of all, the new bigger and better Dominion Energy will be an even better high-yield dividend growth stock. And with its shares now very attractively priced, I consider today to be an excellent time to add this Grade A utility to any diversified dividend portfolio.

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Studies show that most investors have underperformed the stock market by about 80% over the past 20 years due to a large number of mistakes including: market timing, improper portfolio structure, and poor stock selection.

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Disclosure: I am/we are long D.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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