Dominion's Dividend Continues to Look Safe, but Dividend Growth Prospects May Weaken Further as Debt Markets are Under Stress

Shares of Dominion and other utilities have been dragged down with the broader market over the past month, a surprise to many since utility stocks are normally seen as safe havens during a downturn.

In fact, Dominion's dividend yield spiked to 6.3% on Monday (its highest level in over a decade) and now sits at 5.6%, causing some investors to wonder whether such a high yield might indicate trouble for Dominion's dividend.

As a public utility, Dominion enjoys much greater assurance of profit than most companies. Approximately 70% of the firm's earnings are generated by state-regulated utility operations, with another 25% from gas transmission and storage services backed by long-term contracts and regulated tariff rates.

Dominion's earnings are still sensitive to demand, though. And with much of the country shutting down to slow the spread of the coronavirus, energy demand is undoubtedly on the decline.

Last week, the Wall Street Journal reported that in northern Italy, electricity demand was down 18% since a regional quarantine went into effect in late February.

For context, demand for electricity in the U.S. was down at most 5% from its peak during the last recession.

Needless to say, Dominion's results may take a hit in the next quarter or more, depending on how long the shutdown lasts and how quickly economic activity ramps back up.

However, a couple bad quarters shouldn't pose a threat to Dominion's dividend.

While Dominion's payout ratio (85%) is the highest amongst peers, the firm's strong balance sheet and BBB+ investment grade credit rating give management flexibility to issue debt to cover short-term gaps in financing.

Furthermore, Dominion had access to $5 billion under its credit revolver at the end of 2019, providing substantial liquidity when needed. (Dominion's dividend costs $3 billion annually, for context.)

What investors are more likely reacting to is Dominion's high dependence on debt markets, which are currently facing their greatest test since the 2007-09 financial crisis, and the implications on Dominion's growth potential as a result.

Utility companies like Dominion spend huge amounts to maintain and grow their infrastructure. Since earnings are typically stable and investments are guaranteed a minimum return by regulators, utilities can generally afford to pay out most of their cash flow in dividends and instead raise debt to fund capital spending.

For example, Dominion's budget for capital spending in 2020 is $8 billion, which management was planning to fund in part by issuing between $5.3 and $6.3 billion in new debt.

Now, however, debt markets may be freezing up just as they did during the financial crisis, a time when nobody wanted to loan money.

As illustrated by the chart below from Morningstar, the premium debt investors are currently seeking over risk-free treasuries to finance new corporate bonds is roughly 4%, the highest "credit spread" seen since the financial crisis.

At one point in 2008 when credit spreads were near their peak, Dominion was forced to issue long-term debt at a nearly 9% interest rate. It's hard to grow earnings when your cost of capital is that high.

Issuing equity (i.e. new stock) to finance projects isn't a much better deal right now, as Dominion's share price sits near a five-year low. (Dominion already wasn't planning to raise equity outside of its dividend reinvestment program.)

Regardless, it is more expensive in this environment for Dominion to raise capital. And since Dominion doesn't retain much cash flow after paying dividends, the firm (like most utilities) is almost entirely reliant on outside money to fund capital spending.

In other words, Dominion's ability to meaningfully grow earnings (and thus the dividend) is now more in question.

Whether this environment persists is anyone's guess. Debt investors are clearly spooked about the ripple effects of a nationwide (and global) shutdown on the ability of individuals and businesses to meet their debt obligations.

The Federal Reserve has stepped in quickly to bolster debt markets, and Congress is on the verge of passing a $2 trillion stimulus bill to provide relief to workers and businesses, which may calm the nerves of debt investors.

But the current economic shock is unprecedented in its swiftness and magnitude, and nobody is certain what the economy will look like a few months or even a few years from now.

Combined with some fear in the stock market about long-term damage to the economy from the coronavirus pandemic, it's not hard to see why Dominion's dividend yield is at its highest level in a decade.

That said, unless the situation got substantially worse or no economic rebound was in sight, it's hard to imagine Dominion reducing the dividend. Credit markets were worse in 2008, and Dominion was still able to raise capital then, albeit at high prices.

However, Dominion's payout ratio was much lower in 2008 (50%), and the company enjoyed a higher credit rating (A-) then.

While it's too soon to say how severe and prolonged the challenges facing Dominion will be, investors should be prepared for little dividend growth as the firm grapples with high financing costs and a decline in short-term earnings.

In fact, eager to bring the firm's payout ratio down to 65-75% (closer to that of peers), management had already stated well before the crisis began that their intention was to slow dividend growth to around 2% annually.

All said, Dominion's dividend continues to look safe, but the company's dividend growth prospects may be weakening further.

We will continue to monitor developments and provide an update if Dominion's dividend safety profile experiences a material change.