For the past few years, Dominion Resources Inc (NYSE: D) has enjoyed a substantially higher valuation than other utilities thanks to its exposure to the US shale boom. The company’s operations in this area consist of midstream assets, including natural gas storage and transportation, as well as a proposed liquefied natural gas (LNG) export facility.

Last September, Dominion announced its intent to unlock additional value for shareholders by spinning off these assets as a separately traded master limited partnership (MLP). Since then, income investors have been anxiously awaiting further details of this offering.

In late March, Dominion finally appeased some of our curiosity by filing its Form S-1 with the Securities and Exchange Commission (SEC). The new entity, known as Dominion Midstream Partners LP, will trade on the New York Stock Exchange (NYSE) under the ticker symbol DM, and the proposed maximum size of the offering is $400 million, including over-allotments.

Although the filing was quite comprehensive with regard to the business opportunity, some of the more important details are still not known because the firm is in the process of ascertaining investor interest via road shows, according to the Dominion investor relations (IR) representative with whom we spoke.

That’s why the number of common units to be sold and the price range at which they’ll first be offered have not yet been determined (the relevant fields were left blank in the S-1). And the firm’s IR rep said the offering won’t move forward until the LNG export facility to be built in Lusby, Md., receives its remaining regulatory approvals.

Furthermore, Dominion’s IR rep couldn’t say the exact breakdown of earnings to be enjoyed by the utility versus the MLP. Nevertheless, the firm’s CEO did state earlier this year that the new structure would generate up to $1 billion annually in EBITDA (earnings before interest, taxation, depreciation and amortization), with the potential for another $1 billion in annual EBITDA from additional midstream assets eligible for eventual dropdown. Those figures have been reiterated in subsequent company presentations.

And we also know that Dominion will receive a portion of the cash flows, or operating surplus, generated by the MLP through its ownership of the general partner (GP), which has sole responsibility for managing DM’s operations. In fact, this is the primary way in which Dominion’s existing shareholders will have exposure to the new entity. The company’s IR rep said that the firm will not otherwise be offering current shareholders either a special dividend or a specific ratio of shares in the new entity in conjunction with the IPO.

The GP currently holds the incentive distribution rights (IDR), which entitle it to an increasing percentage of the MLP’s distribution as certain targets are met. Although the precise targets have not yet been specified, the percentages have three tiers, with the GP’s share of the total distribution starting at 0 percent, then rising to 15 percent, 25 percent, and finally 50 percent, the latter of which is known as the high splits. IDRs incentivize the GP and its owner to drop down assets or pursue acquisitions that are accretive to cash flows and, therefore, boost the distribution over time.

According to its registration, initially the MLP’s assets will include all the outstanding preferred equity interests in the Cove Point LNG import and regasification plant on Maryland’s Chesapeake Bay coast and a 136-mile pipeline that connects the Cove Point plant to onshore interstate pipelines. But the value proposition is the company’s initiative to build a natural gas liquefaction plant at Cove Point with the purpose of exporting LNG.

The proposed $3.8 billion project received conditional approval from the US Department of Energy last September to export 770 million cubic feet of liquefied natural gas per day. Other reviews and permits still need to be completed, as noted previously.

According to the filing, the liquefaction plant’s available capacity is already fully contracted under 20-year agreements with two entities: a joint venture between the Japanese firms Sumitomo Corp and Tokyo Gas Co, and a subsidiary of India’s GAIL Ltd.

The only natural gas liquefaction plant approved thus far in the US is Cheniere Energy Partners LP’s (NYSE: CQP) Sabine Pass terminal, which is expected to be in operation by the end of 2015.

In addition to Cove Point, Dominion has granted its MLP a right of first offer with respect to any future sale of its indirect ownership interest in Blue Racer Midstream LLC, which is a growing midstream company focused on the Utica Shale formation, and a possible source of exceptional growth.

Beyond dropdowns, DM will also pursue third-party acquisitions or organic growth opportunities that provide long-term, stable cash flows.

The Valuation Challenge

As it stands, using a standard enterprise value to EBITDA (EV/EBITDA) valuation multiple, we find that Dominion, a utility that derives more than 80 percent of its revenues from its regulated activities, has a significantly higher multiple than peers such as NextEra Energy Inc (NYSE: NEE), which has the largest US renewable fleet and which many believe is an industry leader. Even Duke Energy Corp (NYSE: DUK), which is the largest US utility by market capitalization, has a much lower multiple.

In fact, after plugging in various utilities of different sizes–an admittedly unorthodox approach, as this comparison is typically done between utilities of the same size–we found most utilities’ valuation multiples coalesced within a very tight band, far below Dominion’s multiple.

The only company that comes close to Dominion is NRG Energy Inc (NYSE: NRG), a firm that presumably would have a higher multiple as it is one of the largest US independent power producers, has substantial unregulated revenue, and is on the cutting edge of implementing new renewable technologies.

Chart A: Will Dominion Still Dominate the Utilities Space After the MLP?

Created with YCharts

Dominion’s relatively high EV/EBITDA valuation multiple could mean the firm is overvalued. But when compared to existing MLPs, including the two Best Buy recommendations in our sister publication MLP Profits, Dominion is actually undervalued according to this metric.

Chart B: Will Dominion’s MLP Be Able to Compete Against the Big Boys?

 Created with YCharts 

Naturally, the real question isn’t whether investors perceive Dominion as a stealth MLP, which could explain the firm’s premium valuation, but rather what might happen when the utility’s exposure to these growing assets changes following the spinoff.

Among Wall Street analysts, sentiment is tilted toward neutral, with 10 “buys,” 12 “holds,” and two “sells.” So the Street is nearly evenly divided about Dominion’s near- to medium-term growth prospects.

On the one hand, there are those analysts that have put Dominion on “hold” and don’t want to risk a possible correction, stating the company is fairly valued when considering the MLP spinoff. On the other hand, there are analysts that don’t feel there is enough material information to warrant a ratings change, and also base their view on the firm’s track record of success in creating shareholder value.

Your correspondent sides with the latter group, as there is a significant amount of time for investors to evaluate Dominion against its MLP offering. The LNG export facility isn’t expected to be operational until 2017, and there really isn’t any material information at present that necessitates action. That being said, investors should monitor developments at Dominion closely over the next few months.

Avoiding the Low-Growth Trap

There is reason to believe that Dominion’s management wouldn’t place all the high-growth midstream and LNG assets in its MLP at the expense of the utility’s total growth profile. Those long familiar with Dominion would observe that the firm is once again at a crossroads of sorts at defining the business for investors.

Seven years ago, Dominion underwent a massive restructuring, selling strategic parts of its energy exploration and production (E&P) business that would have bolstered the firm’s growth profile even today. Some of the company’s longtimers felt the firm had cut too deeply, sacrificing future growth to appease the near-term demands of income and growth investors alike.

In 2006, Dominion’s operations were a mix between a utility and an E&P company. As one veteran portfolio manager I knew observed at the time, those investors who viewed the firm as a utility wanted Dominion to maximize cash flow, while those who owned it for its oil- and gas- production assets wanted the firm to increase investment to realize the value of its energy reserves.

This “schizophrenia” in the investor base, as some referred to the problem, caused the firm to be undervalued against both E&P and utility peers. From the standpoint of energy investors, the firm was viewed as not being a big enough risk taker, while utility investors understandably preferred a sleepy, regulated utility. As such, many investors believed this problem could be resolved with some kind of restructuring.

And so, the then newly minted CEO, Thomas Farrell II, heeded investor feedback and sold off billions of dollars worth of onshore and offshore E&P oil and gas assets within a year or so of his appointment, an incredible feat in itself. Mr. Farrell’s vision for the company at the time was to create a business that would derive the majority of its earnings from regulated businesses. However, the firm did retain some of the assets from its E&P segment, which are now the focus of the MLP.

Years later, many Dominion veterans find it ironic that it’s the midstream assets and LNG that have been the major growth driver of the company’s valuation and the catalyst for a potentially higher multiple as part of an MLP.

Some may attribute these views to sour grapes, common in restructurings. And there is certainly something to be said of the increased earnings on billions in regulated infrastructure projects the firm is developing under the utility. But there is no debate that the hiving off of the E&P business did undercut the firm’s growth in the ensuing years, and could do so again, as many argue.

Following the firm’s sale of its oil and gas E&P portfolio, Dominion’s EV/EBITDA valuation multiple dropped precipitously in the summer of 2008, from a high of 21.8 to 13 by the end of the summer, just before the Global Financial Crisis.

In later years, Dominion trailed the valuations of peers such as Duke and NextEra at various times, though the differences in multiples were sometimes negligible. Of course, the decline of all three firms during this period could also be attributed to the lingering effects of the downturn and the resulting decline in economic activity and power demand.

Chart C: Dominion Ultimately Trailed Its Peers After Its E&P Divestiture 

Created with YCharts 

Whether Dominion’s investors choose to stay with the parent or flee to the MLP will largely depend on how management communicates the new value proposition and how the asset mix will change over time. And there is really no way to predict the result.

For example, NRG Energy recently created a yield company spinoff, known as NRG Yield Inc (NYSE: NYLD). NRG Yield holds the parent company’s contracted assets and trades at a much higher multiple than NRG Energy.

Some might find this situation to be counterintuitive because typically the large independent power producers offer higher growth exposure to competitive markets, and thus enjoy higher earnings multiples. But investors’ voracious appetite for yield, amid historically low interest rates, is undoubtedly causing NRG’s subsidiary to enjoy the spotlight and outperform its parent.

Conversely, Kinder Morgan Energy Partners LP (NYSE: KMP), actually trades at a discount to the owner of its general partner, Kinder Morgan Inc (NYSE: KMI). Some attribute the reason to a recent public debate over whether the MLP’s distributable cash flow is overstated because its maintenance capital is understated. 

Chart D: There Is No Guarantee the MLP or Spinoff Will Command a Premium

 Created with YCharts

But the point is that there are no guarantees as to whether YieldCos or MLPs will trade as intended, even as the segregation of assets should better align investor risk preferences and, therefore, garner higher valuations.

Still, it’s worth noting that Dominion’s spinoff will be significantly smaller than many of its more established MLP peers. And while Dominion will likely drop down some attractive midstream assets to its MLP over time, investors should wait until the new entity has established a track record of success, particularly when its first major asset won’t even be operational until 2017, at the earliest.

As we noted last year when covering NRG Energy’s YieldCo spinoff, financial innovations, if implemented properly and with the right safeguards, can be a source of greater shareholder value, as we’ve seen in the traditional MLP space.

But given low power-demand growth fundamentals, technological disruption from renewables, and changing market fundamentals, power utilities might be better served by keeping their most stable, income-producing assets in house.

We recommend holding off on investing in electric utility industry YieldCos or MLPs until their management teams build a longer-term track record, at which time these investments can be properly evaluated.

As a note, in the interest of transparency, your correspondent was a former employee of Dominion seven years ago, as an adviser on power plant and renewable energy projects.