Dominion Resources, Inc.

Transcription

1 UNIVERSITY OF OREGON INVESTMENT GROUP June 2, 2010 IME Dominion Resources, Inc. Stock Data Price (52 weeks) Symbol/Exchange D/NYSE Beta.58 Shares Outstanding 586 Million Average daily volume 3,369,180 (3 month average) Current market cap $ Billion Current Price Dividend Dividend Yield % SELL Valuation (per share) DCF Analysis $43.84 (50%) Comparables Analysis Current Price (as of 05/28/2010) Target Price $34.53 (50%) $38.96 $39.19 Summary Financials (In millions) (2009A) Revenue $15,131 Net Income $1,287 Operating Cash Flow $2,843 Company Logo/Graphic Business Overview Incorporated in 1983, Dominion Resources is located in Richmond Virginia and is one of the nation s largest producers and transporters of energy. Currently, Dominion and its subsidiaries operate in 14 states. They distribute electricity to 2.4 million customers in the North Carolina and Virginia area, and distribute gas to 1.9 million customers in Ohio, Pennsylvania and West Virginia. Dominion focuses on driving their revenue mainly from the Midwest and Eastern part of the United States where 40% of the nation s energy is consumed. They are able to operate in many locations because of their extensive energy asset portfolio. This portfolio includes 27,500 MW in generation capacity, Covering Analyst: Ryan Bennett rbennett@uoregon.edu The University of Oregon Investment Group (UOIG) is a student run organization whose purpose is strictly educational. Member students are not certified or licensed to give investment advice or analyze securities, nor do they purport to be. Members of UOIG may have clerked, interned or held various employment positions with firms held in UOIG s portfolio. In addition, members of UOIG may attempt to obtain employment positions with firms held in UOIG s portfolio.

2 56,000 miles of electric distribution lines, 21,700 miles of gas distribution pipeline, and the nation s largest natural gas storage system equal to 942 bcf (billion cubic feet). Dominion generates revenue from four segments: Dominion Virginia Power (DVP), Dominion Generation, Dominion Energy, and Corporate and Other. Dominion Virginia Power (DVP): This branch consists of Dominion s largest subsidiary Virginia Power. The segment generates revenue through electric transmission and distribution along with its retail services. DVP serves residential, commercial, industrial, and governmental customers in Virginia and North Carolina. Revenue from this segment is dependent on rates set by federal and state authorities. Weather, economic shifts, customer growth, and energy conservation are factors that can drastically affect the revenue growth. DVP is a member of PJM, which is a regional transmission organization that coordinates the movement of wholesale electricity. Therefore, DVP has no competition to their transmission services. DVP also has no competition in their electric distribution within the states of Virginia and North Carolina. Dominion Generation: This segment of Dominion is where the electric power is generated for DVP and Dominions merchant fleet. Dominion s merchant fleet operates in energy marketing and price risk management activities. Generation facilities are located all across the Midwest and Eastern part of the United States including states like Indiana, Massachusetts, Rhode Island, Virginia and others. The mix of fuels to generate power is about 30% coal, 25% gas, 20 % nuclear, 10% oil, and 15% is water, biomass, wind, or other renewable sources. Dominion Generation is dependent to the fluctuating prices in commodities and the demand for electricity which is primarily based on weather. To reduce the risk of fluctuating commodity prices, Dominion hedges a large Non-Regulated Gas Sales 14.93% Regulated Gas Sales 5.48% 2009 Revenue Breakdown Gas Transportation and Storage 8.78% Non-Regulated Electric Sales 25.13% Regulated Electric Sales 42.81% portion of its near term needs. In January 2003 retail choice was made available to customers on Dominion Generation but no competition developed. In 2007 retail choice was ended by the Virginia General Assembly, and therefore Dominion has no competition in this area. Competition is also scarce in Dominion Generation s merchant fleet because they are also part of a regional transmission organization. Dominion Energy: This segment includes regulated natural gas distribution companies, regulated gas transmission pipeline and storage, and regulated liquefied natural gas (LNG) operations. Recently, Dominion sold the last of its Appalachian exploration and production business to Consol Energy for $3.5 billion. Revenue from gas transportation, storage, and LNG storage are based on fee based contractual arrangements. Rates set by state authorities determine the revenue from gas distribution. Dominion s competition in the transmission industry is from other domestic and Canadian pipeline companies. Dominion s competition for gas distribution comes from other gas distribution companies in the states that they operate. In both cases Dominion does a good job to achieve a competitive advantage by marketing its array of services and keeping competitive prices. Other 2.88% 2

3 Corporate and Other: This segment includes operating activities that are not attributable to profit measures. This can include its corporate, service company and the net impact of certain operations disposed of or to be disposed of. Business and Growth Strategies Risk Factors: Dominion s current business strategy is to provide the best utility service to all its customers. However, with all the business risks in their operations providing the best service is easier said than done. Some of the risks Dominion faces are fluctuations in commodity prices, severe weather, and increases in energy conservation. It is hard for Dominion to take activities to limit their risk to the weather changes. In order to minimize the risk of fluctuating commodity prices, Dominion takes part in commodity price hedging. This involves the purchasing of long and short term contracts of future fossil fuel purchases and then buying the rest on the spot market. Some years Dominion receives benefits from this activity, while other years they receive a loss. Dominion would like to limit their exposure to the risk of fluctuating commodity prices going into the future. Future Growth: In the future Dominion plans to focus on revenue from regulated operations. They hope this will reduce the risk of the company, and allow for more consistent revenue streams and earnings. Over the last five years they have divested over $14 billion worth of exploration and production properties. With the finalization of the Appalachian sale Dominion no longer operates in the exploration and production industry. This sale reduces their exposure to commodities prices by 20% and should reduce capital expenditures $250 million annually in future years. Dominion is now looking into the future at how they can grow their regulated operations. In their most recent annual meeting to shareholders, Dominion listed some goals they have for the coming years. One is to maintain competitive electric rates and enhance their customer service. They also plan to meet the projected load growth of 5,600 MW they have forecasted for They would like to do this internally to reduce their reliance on outside power imports. Management projects strong future growth, compared to the industry, in their regulated electric sales because of the location of their operations. Virginia has a very strong economy that uses a large amount of power, and as the economy turns around demand for power should only increase. Another important growth opportunity is in Dominion s future gas operations. It is projected that the use of gas is going to increase as an input for electric generation. The reasons for this are that gas burns cleaner than the standard coal generation process and more power plants have the technology to use gas to generate electricity. The demand for natural gas is also expected to grow as households become more environmentally aware. This will have large growth effects on Dominions gas distribution, transmission, storage and transportation sales. Management and Employee Relations Thomas Farrell, 55, is president, CEO, and chairman of the board. He was hired by Dominion in 1995 and has held many management positions in his career at Dominion. He has held his current position as CEO and President since January 2006 and his current position as Chairman of the Board since April With the ownership of about 1.5 million shares worth close to 60 million, Farrell is very invested in the future of Dominion. At Dominion, top executives are required to own 3-8 times their salary in Dominion s stock. This is another good sign that the interests of upper management are in line with that of the shareholders. Also, in 2004, officers didn t receive an annual bonus because D didn t meet internal goals. The only worrisome facts about Dominion s upper management are the perks they receive, including company cars and the use of the company plane. 3

4 Portfolio History The Tall Firs Portfolio purchased 404 shares of Dominion on 5/6/2002 at a cost basis of $13, or a per share price of $ As of May 28, 2010 Dominion is trading at $38.96 giving unrealized gains of 17.24%. The Svigalls Portfolio currently purchased 86 shares of Dominion on 11/29/2006 at a cost basis of $ or a per share price of As of May 28, 2010 Dominion s price was $38.96 which gives the Svigalls Portfolio unrealized losses of 3.28%. It should be noted that these figures take into consideration the 2:1 stock split on November 20, Recent News Virginia appeals court affirms power plant permit - May 25, 2010 The court ruled against an environmental group protesting Dominion s new coal fired 585 MW generation facility in Virginia. The court ruled Dominion is meeting all environmental guidelines. As environmental regulations become more severe, it is good to see Dominion meet regulations. Dominion focusing on regulated energy business - May 18, 2010 CEO Thomas Farrell laid out plans to more toward more regulated operations at the shareholders annual meeting. He also talked about plans to harvest natural gas in the Marcellus Shale located underneath Ohio, West Virginia, and Pennsylvania. This will limit Dominion s exposure to commodity prices in the future. Consol buying Dominion arm for nearly $3.5 billion - March 15, 2010 Dominion and Consol Energy came to an Plans for Appalachian Sale Proceeds agreement to sell Dominion s Appalachian Offset 2010 Equity Issuances $400 exploration and production business. After Debt Reduction $250 this acquisition Dominion will no longer Offset Virginia Power Rate Settlement $220 operate in the E&P industry. This will make Contribution to Pension Plan $250 earnings more consistent and reduce capital Offset 2011 Equity Issuances $250 expenditures $250 million annually. Dominion Repurchase Shares $910 plans to receive an estimated $2.28 billion after tax proceed from this sale. The table to the Total $2,280 right shows what they plan to do with the (Numbers in millions of us dollars) proceeds. Industry Dominion operates in many industries including power generation, natural gas distribution, gas pipeline transportation, and electric power transmission, control, and distribution. Power generation was broken up into three separate segments because each has different industry risks, competitors, and outlooks. Coal and Gas Power Generation: This industry is primarily comprised of coal, oil, and gas fired electricity production. Companies in this industry operate power plant facilities that take the aforementioned fossil fuels and burn them, making steam. This steam is then used to power turbines that generate electricity. Coal is by far the largest fossil fuel firms use to generate electricity and margins for this industry are very dependent on price fluctuations of this input. The importance of 4

5 natural gas in the industry is rising as it becomes more competitive with coal in generation efficiency and cost. It is also an environmentally cleaner choice than coal. Prices of natural gas not only affects the industries margins but also the amount of natural gas the industry uses. Oil is a much smaller contributor in total generation and therefore price changes in oil have little significance in the industry. In general, it is expected for margins to increase as fuel prices increase while retail electricity prices stay around the same levels. Revenue projections in the industry over the next five years average around 3% each year. These projections are based on a similar annual GDP growth rate. There is concern this industry about future legislation. As we, a society, become more environmentally concerned there will be more legislation reducing greenhouse gas emissions from the power plants. This past year the American Clean Energy and Security Act was passed in the House of Representatives. This act aims to cut emissions by 20% from 2005 levels by With more legislation firms will have to update their facilities to meet the new regulations. To compensate for future regulation, 63% of new power plants being constructed are gas fired, which is cleaner for the environment. Nuclear Generation: The nuclear generation process is similar to coal, gas, and oil generation, in that nuclear fuel is processed to steam which is used to power turbines that generate electricity. Five companies, including Dominion, make up 42% of the industry; while 70 others make up the other 58% of the industry. The price of uranium, which is the nuclear fuel, plays a large impact on this industry. Over the last 14 years there have been no new nuclear plants that have come online, but total nuclear power generation has grown due to increased efficiency. Revenue for the industry is supposed to increase at an average annual rate of 5.3%. A major concern in the industry is safety of nuclear power plants. However, nuclear generation is much cleaner than coal generation and emits fewer greenhouse gases. This should improve the image of the industry going into the future. Hydroelectric and Renewable Power Generation: This industry is composed of hydroelectric, wind, solar, geothermal power, and biogenic municipal waste power generation. Power generation is dominated by four government owned firms that make up 45% of the industry generation. This industry has a unique relationship with fossil fuels. Even though this industry doesn t use them for their generation, they impact the overall demand for energy. Therefore, the renewable power generation industry growth is dependent on fossil fuel prices staying at reasonable prices into the future. Projected revenue growth for the industry is an annual average of about 7% until Natural Gas Sales: The main activities in this industry are operating gas distribution systems and transmitting and distributing gas to final consumers. There are thousands of companies in the industry with the top four holding only 12% market share. Natural gas is used as the main heating source in almost half of the households in the United States. Total revenue in 2010 was 111 billion compared to 142 billion in Revenue was constant in the industry through 2008 even with relatively high prices. However, in 2009 revenue took a huge dip of 33%, even with extremely low gas prices, because of the economic downturn. The only increase in natural gas sales during 2009 was from increased demand for gas to be used to generate electric power. As the economy recovers and GDP grows the industry should experience an average growth in revenue of 7.1% over the next five years. The graph above shows prices of gas into the future until The units are in U.S dollars per thousand cubic feet of gas. P r i c e Projected Gas Prices Year 5

6 Gas Pipeline Transportation: The industry primarily consists of brokering natural gas, distribution of gas to final consumer, and the transportation of natural gas. Key factors in industry growth are the demand for gas, availability of gas, and government regulations. Competition is fierce in this industry with over a thousand companies in the industry. These companies have been expanding the infrastructure over the past couple of years by constructing more underground gas transportation lines. The demand for natural gas is supposed to grow over the next five years at an average annual rate of 3.3% as demand in the industry increases. Electric Transmission, Control, and Distribution: The main operating activities in this industry are the transmission of electric power, and the distribution of electric power. The transmission system includes transmission lines that transport huge amounts of electric power from power plants to the distribution centers which then distributes it to the final consumers. This industry is very dependent on GDP growth like other energy industries. Therefore, the projections for revenue growth are in line with future projections of GDP growth. Industry Revenue is supposed to grow at an annual average rate of 2.6% over the next five years. S.W.O.T. Analysis Strengths: Balanced Generation Mix: o Dominion s generation mix consists of about 30% coal, 25% gas, 20 % nuclear, 10% oil, and 15% water, biomass, or other renewable sources. This diverse mix keeps Dominion from being too dependent on one source and lowers their risk to changing fuel costs. Dominion operates in areas with strong demand for utilities: o Virginia has one of the best economies in the United States (Forbes). There will be electric demand growth in the area they operate. Weaknesses: Dominion s operations are extremely reliant on the weather: o Natural disaster can damage operations and power plants. o Seasonal weather can affect energy usage from customers Dominion is subject to rising fuel prices: o Even though Dominion uses risk adverse processes like hedging, Dominion s margins can be severely lowered if fuel prices rise. Opportunities: Strategic refocus: o Management has decided to focus more towards regulated revenue. This will allow Dominion to have more consistent revenue streams into the future. Expansion of Cove Point LNG facility o With the future expansion of this facility Dominion will be in ready to take advantage of the more environmentally aware consumer. Dominion s share in the storage space is planned to reach 1.8 billion cubic feet. 6

7 Threats Business operations and bottom line are vulnerable to environmental regulations: o In the future, if stricter regulations are passed, Dominion s operations might need to change substantially, affecting their efficiency and profit margins. o If future emission laws were to tighten, Dominion would have to make a large investment in converting their power facilities to comply with environmental standards. Comparables Analysis Allegheny Energy (AYE) 10% Allegheny Energy, Inc. owns and operates electric generation facilities, and delivers electric services to customers in Pennsylvania, West Virginia, Maryland, and Virginia. The company owns or contractually controls coal-, gas-, and oil-fired generation facilities, as well as hydro generation facilities. It operates in two segments, The Merchant Generation and The Regulated Operations. (Yahoo! Finance) I chose Allegheny Energy as a comparable to Dominion for a couple of reasons. First they operate in a similar geographical area as Dominion, putting them at a similar risk to weather related incidents. Also I wanted a company to that heavily relied on coal because that is Dominion s largest input. AYE uses coal for 95% of their generation inputs, therefore I thought it was a good comparable for price fluctuations of coal. AYE was given a weighting of 10% because they only operate in the electric generation and distribution industry. Also, they are a much smaller company with a completely different capital structure. American Electric Power (AEP) 20% American Electric Power Company, Inc. engages in the generation, transmission, and distribution of electric power. It generates electricity using coal and lignite, natural gas, nuclear, and hydroelectric energy. The company distributes electric power at wholesale to other electric utility companies, rural electric co-operatives, municipalities, and other market participants, as well as to retail customers in its service areas. It also operates non-regulated wind farms and barging operations, as well as provides various energy-related services. (Yahoo! Finance) I chose American Electric Power because of their similar diverse generation mix to Dominion. They are also in the industry of distributing energy on the wholesale market. AEP also operates in similar states as Dominion giving them similar risks to the weather. Their Debt/Equity ratio is much different than Dominion. Also, like AYE, AEP doesn t operate in the gas industry and thus, were given a weighting of 20%. NiSource (NI) 15% NiSource Inc., an energy holding company, through its subsidiaries, provides natural gas, electricity, and other products and services. It operates in four segments: Gas Distribution Operations, Gas Transmission and Storage Operations, Electric Operations, and Other Operations. (Yahoo! Finance) 7

8 I chose NiSource as a comparable for two main reasons. One, they operate in the gas distribution agency, and supplied 3.3 million customers last year in similar areas as Dominion, like Pennsylvania and Ohio. Second, they have a large underground natural gas storage system that is similar to Dominion s. NiSource has a small operating segment that delivers electricity which is different from Dominion. Also they are a much smaller company with a different capital structure. I gave NiSource a weighting of 15% because I think they are a good comparable of the gas industry, which is an industry Dominion will focus on in the future years. Duke Energy (DUK) 30% Kentucky. (Yahoo! Finance) Duke Energy Corporation operates as an energy company in the Americas. It operates through three segments: U.S. Franchised Electric and Gas, Commercial Power, and International Energy. The company s U.S. Franchised Electric and Gas segment generates, transmits, distributes, and sells electricity in central and western North Carolina, western South Carolina, southwestern Ohio, Indiana, and northern Kentucky; and transports and sells natural gas in southwestern Ohio and northern I chose Duke Energy as a comparable for a couple of reasons. They operate in similar areas as Dominion by selling electricity in North Carolina and gas in Pennsylvania. This means Duke and Dominion share similar weather risks. They are also of similar size as Dominion. Duke is a little higher leveraged than Dominion but they still have comparable capital structures. The limitation of Duke is that they a business segment in fiber optics communications. In this segment they serve wireless, local, and long distance communications companies. They were given a weighting of 30% Southern Company (SO) 25% Southern Company, through its subsidiaries, operates as a utility company that provides electric service in the southeastern United States. The company generates, transmits, and distributes electricity through coal, nuclear, oil and gas, and hydro resources. (Yahoo! Finance) I chose Southern Company as a comparable because of the similar power generation mix and capacity. They use coal, oil, gas, nuclear, and other renewable energy sources for their generation facilities, which give them similar risks to Dominion with price fluctuations in fuel inputs. They also have a similar Debt/Equity ratio and similar size as dominion. The limitations of SO are they don t operate in the gas industry and they also operate in different locations than Dominion. They were given a weighting of 25%. Metrics Used: I used the three metrics of EV/Revenue, EV/EBITDA, and EV/OCF in my comparables analysis. I weighted all metrics equally at 33.33%. From my comparables analysis I derived an implied price of $34.64 which is an overvaluation of 11.08%. 8

9 Discounted Cash Flow Analysis Beta: I derived a beta of.58 from running a hamada. When I calculated a 5 year monthly regression against the S&P 500 total returns index, I also derived a beta of.58. I am confident in a beta of.58 and think it characterizes the risk of Dominion well. Revenue: My revenue model is based off of future growth estimates from IBIS World and from Dominion s management team. Electric Sales: First, Dominion operates in one of the best business and economic environments in the United States. Virginia has a low unemployment rate compared to other states where Dominion s competitors operate. Virginia is also is home to many internet data centers that use the energy equivalent to thousands of households. All these factors make management believe regulated electric sales are going to grow in the upcoming years by 5-6%. As noted earlier in the report Dominion is trying to increase its regulated operations while decreasing their dependence on non-regulated operations. Therefore I have non-regulated electric sales grow at a small rate going forward. Gas Sales: Management believes the gas market still has potential to grow quite a bit in the future. For regulated sales I grew revenue a large amount in 2011 because demand should be back to normalized levels at that point. Gas prices are also projected to be around a similar level as 2007 and therefore the sales projection is in line with that year. Nonregulated gas prices were projected similarly to non-regulated electric sales, with growth rates being small into the future. Gas Transportation and Storage: I forecasted revenue from this segment based primarily on the expansion of Cove Point LNG facility. This is the one of the nation s largest LNG import facilities. Dominion is in the process of expanding their capacity to handle large cargo ships. This operating segment will see good growth in the future years as demand for natural gas increases. Other: Since this operating segment is a small part of revenues and there was little guidance about future growth, I decided to grow it annually at 1%. Expenses: Electric Fuel and other energy related purchases: I forecasted this expense as a percent of revenue. This category is dependent on gas and coal prices as these are the main commodities used in Dominion s generation. The prices for gas and coal are supposed to increase into the future. Therefore I gradually increased electric fuel expense as a percent of revenue until After 2015 I kept it constant going to the terminal year. Purchased Electric Capacity: A large portion of this expense comes from long term contracts. I kept this at a constant percent of revenues because I don t foresee a large increase or decrease of this expense in the future. 9

10 Purchased Gas: I decided grow this expense as a percentage of revenues going into the future because the price of gas is supposed to increase. The low expense in 2009 is an anomaly because of the extremely low prices during that year. Other Operations and Maintenance: This expense consists of maintenance, SG&A, and random other expenses. Management projected lower levels in this expense over the next four years. More specifically, they gave predicted levels of around $3.09 billion in The cuts to this expense can only be maintained on a short term basis and afterwards they will have to increase as operations expand. After 2013 I grew it as percent of revenues. Depreciation: A large amount of capital expenditures over the next three to four years are going to be spent growing their electric infrastructure. Therefore, I grew depreciation expense as a percent of revenues going to the terminal year. Other Taxes: This expense is primarily made up of property taxes and payroll taxes. I kept this expense constant going into the future because past historic levels have indicated this trend. Tax Rate: Dominion expects the average tax rate to stay at 37% into the future. In 2010 they have a first quarter tax rate of 47%. This was due to items Dominion had deferred paying taxes in years past coming due this quarter. Therefore I kept a tax rate of 40% for 2010 estimated year. However, I did not think 40% was an appropriate level going into the future because Dominion has the ability to decrease their tax rate with adjustments. Some years they will have a tax rate lower than 37% and some years they will have a tax rate higher than 37% but it should average out going forward. Net Working Capital: To project net working capital I had to transform current assets and liabilities from previous years. I took out assets held for sale from current assets since Dominion no longer has this or plans to have this in their current assets. I also eliminated securities due within a year from liabilities. After doing this I found that current assets held a fairly constant level as a percent of revenue. I then grew current assets as a percent of revenue going to the terminal year. With current liabilities management said they would like to keep it around 2009 levels. Therefore, I trended it down until After 2015 I grew it as a percent of revenues because Dominion will need current liabilities to grow as they continue to grow. Capital Expenditures: Capital expenditures were projected by management until Management also projected an annual decrease of $250 million after the sale of the Appalachian E&P business. I decreased capital expenditures close to this amount until 2016 and then I forecasted it as a percent of revenues. After 2016 I decreased it as a percent of revenues because their new regulated business structure will not require as much capital expenditures. Cost of Debt: Dominion issued long term debt three times in Two of issuances were senior notes. One issuance was for 500 million and the other was for 350 million, with rates of 5.20% and 5.00% respectively. I decided to do a weighted 10

11 average and received a cost of debt of 5.11%. This gives Dominion a WACC of 5.7%. I am confident in this WACC and it is also in line with management estimates for this year. Recommendation Dominion is a company that is changing their business operations. They are going to rely on more consistent revenue sources as they move forward. They are moving towards smaller growth opportunities than they have had in the past, but at the same time they are going to limit capital expenditures and reduce their risk in commodity pricing. Dominion also has a great opportunity as the economy turns around and people s demand for energy rises. However, the company is maturing and with the sale of their Appalachian E&P business they will be limited to the growth they can get from their regulated industries. While they do operate in some of the best economies for utilities, the industry is mature and heavily concentrated. My DCF analysis gave me an implied price of $43.84 or an undervaluation of 12.53%. My comparables analysis gave me an implied price of $34.53 or an overvaluation of 11.38%. I weighed both analyses at 50% for a target price of $39.19 or an undervaluation of.59%. I am recommending a sell for both the Svigalls and the Tall Firs Portfolio. 11

12 APPENDIX 1 COMPARABLES ANALYSIS 12

13 APPENDIX 2 DISCOUNTED CASH FLOWS ANALYSIS 13

14 APPENDIX 3 DISCOUNTED CASH FLOW ASSUMPTIONS APPENDIX 4 HAMADA AND BETA SENSITIVITY ANALYSIS 14

15 APPENDIX 5 REVENUE PROJECTIONS APPENDIX 6 SOURCES Dominion 10-k and 10-q Yahoo! Finance IBIS World Morningstar Factset Dominion Investor Relations Datamonitor Global Markets Direct Energy Information Agency 15