Infrastructure Investments Widen Dominion's Moat

Dominion's D investments in energy infrastructure projects in the Eastern United States in the next five years should result in wide-moat businesses generating about 50% of earnings by 2021, up from about 40% in 2013. The remaining earnings are primarily from narrow-moat regulated gas and electric utilities in states with long histories of constructive regulatory frameworks, industry-leading sales growth, and high-return investment opportunities.

Dominion's wide-moat businesses include natural gas transmission and storage in the Marcellus and Utica shale regions, a liquefied natural gas export facility in Maryland, and interstate electric transmission regulated by the Federal Energy Regulatory Commission. The Questar acquisition, which closed in late 2016, added a 2,700-mile pipeline network in Utah, Wyoming, and Colorado that we believe will offer wide-moat investment opportunities into the next decade.

We estimate Virginia Electric Power Company will contribute about 38% of consolidated earnings in 2021 excluding transmission. VEPCO's unique regulatory arrangement will keep retail base electric rates frozen through 2022. Typically rate freezes are terrible for regulated utilities, but VEPCO actually stands to benefit, given its attractive rate riders, strong electric demand growth outlook, and above-industry-average allowed returns. We think Virginia will continue to support a highly constructive regulatory environment to encourage investment in new service and reliability. This should allow VEPCO to earn above its cost of capital for a very long time. Dominion's gas utilities--including Questar's utilities--also enjoy topnotch regulation and attractive returns on capital.

Together, Dominion's wide-moat nonutility businesses and constructive narrow-moat regulated utilities should allow the company to earn returns above its cost of capital for many years to come.

Nonutility Businesses Dig Wide Moat
We believe a regulated utility can establish a wide economic moat if its nonutility businesses are a material portion of earnings and have a sustainable competitive advantage. In our opinion, Dominion will have met these criteria by 2021 when nonutility wide-moat businesses (including FERC-regulated transmission) constitute roughly 50% of earnings, up from about 40% in 2013.

These wide-moat businesses include natural gas transmission and storage in the Marcellus and Utica shale plays, a unique LNG export facility with sustainable competitive advantages and long-term contracts with creditworthy counterparties, and electric transmission regulated by FERC. Dominion's electric utility assets are located in an area of the country that requires high reliability for Internet traffic and defense operations. In our opinion, these factors are sustainable and should allow Dominion to earn above its cost of capital for a long period.

Natural gas transmission pipelines are arguably the best illustration of wide moats due to efficient scale. Transporting natural gas produced from the Marcellus shale gas play to utilities in Virginia and North Carolina is an excellent example of the dynamics of the efficient-scale moat source. Once a pipeline is constructed, there is little incentive for competitors to enter a market. Pipelines have the added benefit of not needing to rely on potential entrants to be rational. The pipeline industry is heavily regulated because of environmental and safety concerns and eminent domain considerations. In addition, regulators prevent new pipelines from being built unless there is a demonstrated economic need to do so. Because of the monopoly status of many interstate pipelines, FERC regulates the rates that pipelines can charge, but it generally allows companies to earn an adequate return on their capital.

The Atlantic Coast Pipeline demonstrates these competitive advantages. The ACP is a $5.0 billion-$5.5 billion natural gas transmission line that will run from West Virginia to North Carolina, passing through Virginia. Partners in the ACP are Dominion (48%), Duke Energy DUK (47%), and Southern SO (5%). Dominion will construct, operate, and manage the ACP.

The pipeline's owners and another utility have signed 20-year contracts for the pipeline capacity. Many times pipeline owners have anchor contracts with gas producers, which can come with high credit payment risk. The fact that the ACP's contracts are with more creditworthy utilities further supports its wide moat.

We also consider Dominion's Cove Point LNG facility to be a wide-moat asset. It is currently an LNG import/regasification and storage facility on the Chesapeake Bay near Lusby, Maryland. Construction began on a natural gas export/liquefaction facility on land on the existing site after receiving final FERC approval in September. U.S. exports of LNG are expected to dramatically increase over the next decade, driven by the supply of shale gas and projected growth in worldwide demand. Because of the difficulty in siting a new LNG export facility on the East Coast, we believe the primary source of Cove Point's wide moat is the intangible asset category.

Half of Cove Point's capacity has been contracted with a joint venture of Sumitomo and Tokyo Gas, the largest natural gas utility in Japan. The remaining 50% is contracted with a wholly owned indirect U.S. subsidiary of GAIL, one of the largest government-linked natural gas companies in India. The 20-year agreement with each of these creditworthy counterparties begins on the in-service date and has a fixed fee that covers all operating and capital costs, including profit. Natural gas is supplied by the counterparties. Thus, Dominion takes no commodity or volume risk.

Financial details of the agreements have not been released, but given the favorable economics of sourcing natural gas in the U.S. and liquefying and transporting to Europe and Asia, we suspect the returns for Cove Point are well above Dominion's cost of capital for at least the 20 years of the two agreements.

We believe high-voltage electric transmission regulated by FERC is also a wide-moat business. We expect investments in high-voltage electric transmission to total approximately $800 million per year through 2021, resulting in average annual earnings growth of approximately 9% from this business. The investments are driven by more than 100 growth and reliability projects in Virginia. The state has the highest concentration of technology workers per capita in the nation, resulting in more than 50% of U.S. Internet traffic passing through Loudoun County on a daily basis. This has driven data center growth in VEPCO's service territory, and Dominion estimates that electric demand growth from these centers will increase 9% annually through 2020.

Because of the large number of military and government installations served by VEPCO, the security of the transmission system is of critical importance. Dominion estimates that it will spend roughly $300 million-$500 million during the next 5-10 years upgrading substation security. Thus, we believe investing in wide-moat FERC-regulated transmission could go on through the next decade, supporting Dominion's wide moat.

Regulation a Risk
Utility regulation in Virginia is the primary source of uncertainty, since Dominion has significantly reduced its commodity exposure. Utility regulation in Virginia has historically been constructive for investors. However, regulation can be political, and regulators are always under pressure to reduce utility rate increases. This could result in lower allowed returns on equity, the disapproval of growth projects, or rejection of some expenses from being passed through to customers.

Additionally, the firm is exposed to operating risks such as hurricanes, which can damage utility property, and shifts in customer energy use. Dominion's exposure to commodity prices is lower now but remains a factor for its merchant nuclear plant, particularly the spread between power prices and natural gas prices in the Northeast.

Dominion is in good financial health and has a solid capital structure. The completion of Cove Point and the ACP and the reduced volatility of its earnings allows Dominion to target a payout ratio of 70%-75%, up from its previous range of 65%-70%. As a result of operating cash flow growth, bonus depreciation, and the higher payout ratio, we expect annual dividend increases of over 8% during the next five years, in line with management's target. The board raised the dividend 7.9% in 2016 and 8.1% in 2017.

Management Is Exemplary
We assign management an Exemplary stewardship rating, owing in large part to its good record of creating long-term shareholder value. In 2010, the current management team sold the exploration and production operations, a no-moat business that didn't fit with its utility and gas transmission and distribution businesses. In addition, it sold or retired merchant power plants that were not providing acceptable returns or required significant capital expenditures for environmental compliance that would probably not achieve an acceptable return on the incremental investment.

Dominion's management team has done a good job of capital allocation, moving quickly into areas with attractive returns on investment. Virginia legislators wanted more in-state fossil and renewable power generation, passing legislation and encouraging regulators to allow rate rider mechanisms that provided incentive returns on equity for new generation projects. Dominion responded by proposing several large power plant projects and to date has achieved returns well above the industry average on these investments. We believe management deserves credit for its skillful handling of the regulatory process.

In addition, Dominion's gas transmission system is in an ideal location to provide transmission and gas gathering services for shale gas producers in the Marcellus and Utica gas plays. Although the location can mostly be attributed to good luck, management has responded by quickly allocating capital to transmission expansion and nonregulated midstream processing facilities. These projects are expected to provide returns well above Dominion's cost of capital.