A large driver was the utility's expansion into midstream infrastructure, specifically natural gas and liquified natural gas (LNG) storage, transportation, and export capacity.
Why Dominion Energy is Offering to Buy Out Dominion Midstream Partners
As a result, the MLP would benefit from rapidly growing distributable cash flow to fund its generous and fast-growing payout (20+% annual growth since its 2014), and Dominion could quickly recoup the large costs it incurred to construct these valuable, long-lived assets.
Specifically, since Dominion owns 51% of DM's limited partner units and its incentive distribution rights, about 75% of the cash flow from Dominion Midstream's long-term, fixed-fee and volume committed contracts flowed back to Dominion Energy, who serves as the MLP's sponsor. Dominion could use this cash to fund additional growth initiatives, strengthen its balance sheet, and fuel its own strong dividend growth.
Two major midstream projects that Dominion Energy has recently completed or is in the process of building are the $4 billion Cove Point LNG export terminal and the $5 billion Atlantic Coast Pipeline (ACP). Dominion Midstream Partners was expected to be an important financing vehicle to back these opportunities.
While FERC revised the policy in July to be less damaging to MLPs, the market's uncertainty over what this would mean for Dominion Midstream's cash flow still resulted in its unit price collapsing nearly 50% from its 2018 high.
As a result, the MLP could no longer affordably issue equity to buy Cove Point and other midstream assets from Dominion. As a result, Dominion Energy determined that its MLP can no longer serve its function as a funding vehicle.
Therefore, on September 19, 2018, Dominion offered to buy out the 49% of remaining DM units it doesn't already own for a fixed ratio of 0.2468 Dominion shares for each Dominion Midstream unit that investors hold.
At the time, that offer represented a price of $17.75 per unit or an 8.2% premium to the MLP's average 30-day unit price. Management expects a buyout deal to be struck by the end of the year and the acquisition to be completed in the first quarter of 2019.
"Continued weakness in MLP capital markets combined with the prolonged disruption in Dominion Energy Midstream's (DM) common unit price since the March 15 Federal Energy Regulatory Commission policy revision were key factors that led to this decision...The proposed transaction would provide a premium to recent market trading levels for DM common unitholders and also benefit Dominion Energy shareholders by removing uncertainty as to the future of DM and the potentially negative impact of changes in FERC tax policy to the future cash flows of current DM assets."
In other words, by buying out Dominion Midstream in a $1.1 billion all-stock deal, management believes it can eliminate the negative cash flow implications of the FERC rule change (since those only apply to MLPs).
In addition, by eliminating the uncertainty of how it will fund its midstream growth, the company believes Dominion's stock will lose an important overhang that has caused its share price to fall over 10% in 2018.
What the Buyout Deal Means For Dominion Midstream Investors
There are several important implications for Dominion Midstream unitholders to understand. First, you will end up with much less dividend income once the deal closes since Dominion Energy's yield is lower. Specifically, your annual dividend income will drop by about 41% once the deal closes based on each company's current payout and the share exchange ratio proposed by Dominion Energy.
The other implication has to do with taxes. MLPs are taxed very differently from corporations like Dominion Energy. And since this buyout, if it's approved (very likely), will be a corporate conversion, that means that any deferred tax liabilities Dominion Midstream investors have accrued over the years will have to be paid.
And most unfortunately of all, the buyout price, which is a fixed ratio of shares, means that anyone who bought the MLP at a high cost basis will be looking at a potentially significant (though unrealized) capital loss. Eventually shares of Dominion will hopefully recover enough to offset these losses, but only if investors don't sell their MLP units and are willing to wait a number of years.
What the Buyout Deal Means For Dominion Energy Investors
After the FERC rule change, management amended its dividend growth guidance to 10% in 2018 and 2019 and "6% to 10%" in 2020, depending on whether or not Dominion Midstream's unit price recovered sufficiently to allow it to buy Cove Point.
Following the FERC rule change, management had to adapt its long-term growth financing plans to include issuing its own loan to finance Cove Point, selling non-core assets, and issuing new Dominion shares.
In the past few months, Dominion has successfully tapped alternative financing options including:
- Raising $2 billion in equity
- Obtaining a $3 billion low interest term loan on Cove Point
- Selling three non-core three merchant generation assets for $1.3 billion
In total, Dominion thinks it now has sufficient capital to avoid further equity issuances through 2020 and complete its $11.4 billion in planned growth projects through 2020.
Most importantly, Dominion Energy expects the MLP buyout to be neutral to its earlier EPS guidance and credit rating. That's because upon acquiring Dominion Midstream, the company will retain 100% of its highly stable cash flow.
What this effectively means for Dominion Energy investors is that management is reiterating its updated EPS growth guidance of last quarter which called for at least 10% EPS growth in 2018, about 7% annual growth through 2020, and "at least 5%" growth beyond 2020.
Closing Thoughts on Dominion Energy's Planned Buyout of Dominion Midstream
The failure of Dominion Midstream to live up to its purpose as a funding vehicle for Dominion Energy is disappointing. But ultimately it shouldn't put the utility's dividend at risk and appears to have only minimally impacted Dominion's long-term earnings and payout growth prospects.
Despite this most recent midstream setback, Dominion Energy still has a solid base of predictable regulated businesses, a strong financial profile, and a number of attractive long-term growth drivers. In other words, the stock appears to remain a reasonable holding as part of a well-diversified dividend growth portfolio.
However, investors considering Dominion Energy need to be comfortable with the proposed SCANA merger, which should have a final verdict by the end of 2018. If it goes through, this deal could prove to be an excellent opportunistic acquisition by Dominion, but it also comes with its fair share of risks given the large size of the acquisition and the liabilities Dominion could inherit related to SCANA's partially-completed nuclear plant.
For now, management continues to deserve the benefit of the doubt.