Dominion Energy/SCANA: A Better Deal for Dominion Than the Market Has Discerned, But Unlikely to Close Because Ratepayers Can Get So Much More
Eric Selmon Hugh Wynne
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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
January 4, 2018
A Better Deal for Dominion Than the Market Has Discerned,
But Unlikely to Close Because Ratepayers Can Get So Much More
Dominion’s (NYSE:D) offer for SCANA (NYSE:SCG), were it to close on the terms proposed, would be materially accretive to Dominion’s earnings. From the standpoint of SCANA’s ratepayers, however, it would be a far less attractive option than the securitization of SCANA’s unrecovered investment in V.C. Summer Units 2 & 3. A securitization, moreover, could be used to ensure recovery by both SCANA and its partner in the project, Santee Cooper, allowing the restoration of their balance sheets and equitable treatment of the ratepayers of the two companies, rather than favoring those of SCANA alone. We believe it improbable, therefore that South Carolina regulators accept Dominion’s offer. The state’s regulator and politicians may in any case be motivated not to ensure recovery of the capital invested in the failed nuclear power plant, but to penalize SCANA and Santee Cooper for their failure by disallowing recovery.
The Key Elements of Dominion’s Offer
- The key elements of Dominion Energy’s (NYSE:D) offer for SCANA (NYSE:SCG) are:
- An exchange of shares at a ratio of 0.669 Dominion shares for each outstanding share of SCANA. At Dominion’s closing price on Wednesday of $77.19, the offer values SCANA at $51.54 per share or $7.4 billion, 33% above Tuesday’s close.
- A cash payment to SCANA’s electric customers of $1.3 billion to be paid within 90 days of closing, or the equivalent of ~$1,000 for the average residential customer.
- An additional 5% reduction in electricity rates from current levels, resulting from the return to ratepayers of the tax benefits of the write-off of the investment in V.C. Summer, a $575 million refund by SCANA of amounts previously collected from customers and the pass-through to customers of the lower corporate tax rate under the recently enacted federal tax reform.
- The write-off for regulatory purposes of $1.7 billion of existing V.C. Summer capital and regulatory assets, reducing SCANA’s recoverable investment in the plant to ~$3.5 billion.
- The recovery of this remaining amount in rate base over 20 years, rather than the 50 to 60 year recovery period proposed by SCANA when it announced the cancellation of the project.
- As previously announced, SCANA would purchase a 540 MW natural-gas fired peaker (the Columbia Energy Center) for $180 million, with no recovery of this investment from ratepayers.
- Left unsaid, but critical to the evaluation of the acquisition is the following:
- The tax benefit to SCANA from last year’s write-off, for tax purposes, of its $5.2 billion investment in the V.C. Summer Units 2 and 3 (New Nuclear Development or NND) is ~$2.0 billion. Under Dominion’s offer, these tax savings will be passed through to customers via the $1.3 billion cash payment and as part of the 5% reduction in rates.
- We note, however, that South Carolina regulators would in any case have required that customers receive the tax benefit from SCANA’s write-down last year of the $3.5 billion of NND capex already recognized in SCANA’s rate base. The value of the corresponding tax deduction, or $1.3 billion in tax savings, would have given rise to an equivalent deferred tax liability on SCANA’s books. This deferred tax liability would have been offset by regulators against the $3.5 billion of NND PP&E on the asset side of SCANA’s balance sheet, reducing SCANA’s net rate base in the Summer project to $2.2 billion. This $1.3 billion decrease in SCANA’s net NND rate base would have commensurately reduced its revenue and thus its future collections from its ratepayers.
- Dominion is in essence offering to make the $1.3 billion in tax savings available to SCANA’s customers immediately, through its upfront cash payment, but at a cost: regulatory recognition of the full $3.5 billion in SCANA’s NND rate base. To quote Dominion’s CFO, Mark McGettrick, during yesterday’s investor conference call, “In terms of [NND] rate base, … the number is about $3.5 billion, [that] is what you should model going forward in terms of what’s in the nuclear rate base. Now again, that [is net of] what we would write off that’s CWIP.” The implication of this proposal is that SCANA will be allowed to recover from ratepayers an additional $1.3 billion of rate base over time, plus its allowed return on rate base at an estimated weighted average pre-tax cost of capital of ~9.7%. The $1.3 billion cash payment offered by Dominion is thus, in effect, a loan to ratepayers to be recovered over 20 years in higher electricity rates and carrying an effective interest rate of 9.7%.
- A second key fact is that the savings to SCANA’s electric ratepayers from passing through the benefit of the new, lower corporate tax rate (estimated by Dominion during yesterday’s conference call at ~1.5% of SCANA’s current electricity revenues) are also consistent with restoring SCANA’s electric revenues to the level necessary for it to earn its allowed ROE on electric rate base.
- Per SCANA’s November 6th investor presentation at the Edison Electric Institute Conference, South Carolina Electric & Gas (SCE&G) under-earned its allowed ROE of 10.25% over the 12 months ending September 30th, 2017, delivering only an 8.97% return on its non-NND rate base of some $5.3 billion. Fortunately for SCANA, at the new, lower 21% tax rate, SCE&G could earn its 10.25% allowed ROE on non-NND rate base even with a decrease in its revenue requirement of ~$20 million. More importantly, the revenue required to allow SCE&G to earn its full allowed ROE of 10.5% on its NND rate base of $3.5 billion would be ~$51 million lower at the new tax rate of 21% than it would be under the old tax rate of 35%, on which SCANA’s rates are currently calculated. (See Exhibit 1.) Thus, the total change in SCANA’s electric revenue requirement consistent with (i) delivering to customers the benefit of the new lower tax rate, and (ii) achieving its allowed ROE on electric rate base is an annual reduction of some $52 million, or the equivalent of 2.0% of SCANA’s annual regulated electricity revenues. Even after this rate reduction, the earnings gain to SCANA, due to the benefit of sharply lower taxes, is ~$33 million annually.
- Furthermore, Dominion’s offer of a 1.5% reduction in SCANA’s electricity revenues, and attributed by it to the impact of lower corporate taxes, is equivalent to only $40 million per year, materially lower than the revenue reduction of ~$70 million calculated above. We believe that Dominion’s proposal, rather than pass through these additional savings, is retaining them in the revenue requirement for the NND rate base in order to allow for the recovery of that investment in 20 years.
Exhibit 1: How the 21% New Tax Rate Will Lower Rates and Lift Earnings at SCE&G
Source: Company reports, SSR analysis and estimates
- What costs, then, are SCANA and Dominion incurring as a result of the proposed acquisition that would result in incremental benefits to SCANA ratepayers that they would not have enjoyed otherwise?
- It can be argued that Dominion’s proposal to write-down, for regulatory purposes, the $1.7 billion of capital and regulatory assets at V.C. Summer Units 2 & 3 that have not yet been recognized in NND rate base represents such a concession. Our own view, however, is that the recovery of these costs has become highly uncertain, given the evidence that SCANA may have incurred these costs imprudently, having continued construction despite the knowledge that the project could not be completed at the budgeted cost, and that SCANA may have misled it regulators by withholding this information. The proposal to accept the write-down of these costs may be a case of bowing to the inevitable.
- Another concession is the proposed 5% reduction in SCANA’s electricity revenues. Of this amount, 1.5% reflects the pass-through to ratepayers of lower corporate tax rates, which, as we have discussed above, will also result in SCANA earning its full allowed ROE on electric rate base. A second component of the 5% revenue reduction is explained by Dominion as a $575 million “refund of amounts previously collected from customers.” Returned over 20 years at $28.5 million annually, this concession reduces the revenue requirement associated with SCANA’s $3.5 billion of NND rate base from the current ~$430 million to ~$400 million. We note, however, that $400 million is the annual revenue required to recover the $3.5 billion in NND rate base using a mortgage-style amortization at SCANA’s allowed return on rate base. It could be argued, therefore, that there is no concession; had Dominion not offered a $575 million “refund” in rates, SCANA would over-earn by a similar amount, and would have been required to return the $575 million to ratepayers in any case.
- In summary, of the proposed 5% rate reduction, equivalent to ~$130 million annually, 1.5% or ~$40 million annually corresponds to the pass-through of lower corporate tax rates and a further $30 million to what Dominion calls “the refund of amounts previously collected from customers.” The remaining $60 million potentially represents a real savings to customers that they otherwise would not have enjoyed. If guaranteed for 10 years, it would be worth $600 million to customers and would cost SCANA $470 million after taxes.
- We note, however, that from a cash flow perspective, Dominion will be able to fund this final concession from SCANA’s tax savings, arising from the write-off of $1.7 billion in CWIP and regulatory assets not included in NND rate base. These tax savings, equivalent to $650 million, would have otherwise gone to SCANA’s shareholders. More importantly, the consideration offered SCANA shareholders through the exchange of shares takes into account the surrender of these tax savings to ratepayers.
The Impact on Dominion’s Earnings per Share and Rate Base
- That Dominion can offer significant benefits to SCANA’s ratepayers at very little cost to itself is what renders this deal, in our view, so attractive to Dominion shareholders.
- Should the transaction close on the terms proposed, Dominion will have acquired a utility with an estimated $10.6 billion of regulated rate base, $5.5 billion of regulatory equity and a blended allowed ROE of 10.25% (see below).
Exhibit 2: SCANA Electric and Gas Rate Base, Allowed ROEs and Equity Ratios
Source: Company reports and SSR analysis
- Given that Dominion is in a position to restore SCE&G’s earned ROEs to allowed levels, while simultaneously reducing the utility’s revenue requirement, we find it plausible that SCE&G could in the long run realize its full allowed ROE.
- If so, SCANA’s annual contribution to Dominion’s after-tax earnings can be estimated at some $510 annually, even after rate concessions, well in excess of the consensus estimate for SCANA’s 2019 net income of $408 million. This is consistent with the repeated assertion by Mark McGettrick during yesterday’s investor conference call that Street estimates for SCANA’s 2019 earnings are too low. In his words, “Our view, after very significant due diligence on this company, is that  net income for SCANA will be significantly higher than what the Street estimate is.”
- If SCANA could add $510 million to Dominion’s 2019 consensus earnings of $2,787 million, and if Dominion’s share count at that time, adjusting for the exchange of shares, were 746 million, then Dominion’s post-deal earnings would rise to $4.42 per share, some 4% above the current 2019 consensus EPS estimate of $4.26.
- Finally, we note that the potential exists for Dominion to realize material cost savings as a result of the merger by eliminating redundant personnel in senior management, finance, and human resources, and realizing efficiencies in the areas of information technology and the procurement of fuel, equipment and services. If these cost savings were just 10% of SCANA’s trailing 12-month operation and maintenance expense ($740 million), on an after-tax basis they would allow a $58 million reduction in SCANA’s revenue requirement, thereby creating headroom in rates for $450 million of incremental rate base, equivalent to over 4% of estimated SCANA’s electric and gas rate base in 2019.
How South Carolina Can Do Better for the Ratepayers of SCANA and Santee Cooper
- We believe that South Carolina regulators and legislators can achieve greater savings for ratepayers by accelerating the recovery of SCANA’s investment in V.C. Summer Units 2 & 3 through a low-cost securitization of customer receivables. More specifically, by pledging a portion of SCANA’s electricity revenues as a collateral for 20-year bond to be placed in the capital markets, the funds could be raised to allow immediate recovery of SCANA’s NND rate base.
- Critically, Dominion’s proposal to acquire SCANA is contingent upon the recovery of SCANA’s $3.5 billion in NND rate base over 20 years, at an estimated weighted average cost of capital of 9.7%. As explained above, we believe Dominion may be contemplating a mortgage-style amortization of this rate base over 20 years, which would require ~$400 million of annual revenues. A more traditional calculation of SCANA’s annual revenue requirement, based on straight-line depreciation of SCANA’s NND rate base, would require $500 million in revenue in the first year, gradually declining thereafter as depreciation expense reduces the net PP&E of the plant.
- By contrast, to recover $3.5 billion for cost of V.C. Summer Units 2 & 3 via securitization, assuming an interest rate of 3.5%, would require the allocation of only $245 million of customer revenues annually. As illustrated in Exhibit 3, a securitization would cost ratepayers less in each year of the 20-year recovery period.
- Securitization would reduce rates by 7.5%, once the $40 million rate reduction from tax savings is added, compared to a 5% rate reduction in Dominion’s proposal.
- A $3.5 billion securitization, moreover, would allow for an immediate $1.3 billion payment to ratepayers, similar to that proposed by Dominion, because SCANA is already receiving a $1.3 billion tax benefit from the tax write-off of the $3.5 billion. As a result, $1.3 billion from the securitization can be refunded to ratepayers upon issuance of the debt and, as SCANA would recover a like amount through tax savings, its recovery of the full $3.5 billion in NND rate base would still be assured. This would be the equivalent of loaning ratepayers $1.3 billion for 20 years at 3.5%, much more attractive than the 9.7% implied in Dominion’s proposal.
- If legislators and regulators prefer, they could reduce rates further by securitizing only $2.2 billion and not giving ratepayers any immediate refund. This would reduce rates by a further $90 million per year, or an additional 3.5%.
- Securitization would also address concerns about SCANA’s balance sheet, as SCANA could use the net bond proceeds and tax savings to reduce debt and buy back shares. The downside from a shareholder’s standpoint, of course, is a reduction in SCANA’s earnings power compared to Dominion’s proposal.
Exhibit 3: Comparison of the Annual Revenue Required to Recover $3.5 Billion of Nuclear Rate Base Over 20 Years in SCANA’s Rate Base vs. Through the Securitization of Customer Revenues in the Capital Market ($ Millions per Year)
Source: SSR analysis and estimates
- Unlike Dominion’s offer to purchase SCANA, moreover, a securitization of the unrecovered costs at V.C. Summer Units 2 & 3 could reduce the cost of recovery not only to SCANA’s ratepayers but to those of Santee Cooper as well.
- The disparity in the treatment of SCANA’s and Santee Cooper’s ratepayers remains a key concern of South Carolina Governor McMaster. Asked by the South Carolina publication The State for his reaction to Dominion’s proposal, Governor McMaster pointed out that, “Over seven hundred thousand electric cooperative customers face the prospect of having their power bills sky rocket for decades to pay off Santee Cooper’s $4 billion in debt” from V.C. Summer Units 2 & 3. Dominion’s proposal to provide rate relief to SCANA’s customers, contingent as it is on the return to ratepayers of the value of tax deductions and the pass-through of lower corporate tax rates, cannot be easily replicated for state-owned Santee Cooper.
©2018, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein. The views and other information provided are subject to change without notice. This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.
- This sum comprises $1.2 billion of construction work in progress, $0.2 billion of capital expenditures recently added to rate base and $0.3 billion of regulatory assets, representing in part the cost of interest swaps to lock in the yield of future bond issues to fund the construction of the V.C. Summer plant. With the cancellation of the project, these bonds will not be issued and the associated swaps will be broken, requiring SCANA to settle them at their market value. ↑