Recommendation No. 2: Dominion Resources (NYSE: D)

“Sell to Open” Dominion Resources October $55 Call

Option Symbol: D121020C55

Limit Order Price: $0.80 or more

Directional View for Underlying Stock: Neutral

Personal Finance Portfolio: Income

• Income generated: $80 per options contract (representing 100 shares of stock)
• 92-day rate of return at current stock price of $54.37: 1.5 percent (5.8 percent annualized)
• Tell your broker:

“I want to sell a covered call against 100 shares of my Dominion Resources (D) stock. Specifically, I want to ‘sell to open’ one October $55 call for a credit of $0.80 per share or more.”

• Remember: You should only sell one call option per 100 shares of stock purchased. The trade can only be done in 100-share increments (100, 200, 300, 400, 500, etc.).

Alternative Trade for Those Who Don’t Already Own Dominion Resources:

Buy/Write on Dominion Resources (NYSE: D): Buy the Stock and Simultaneously “Sell to Open” the October $55 Call

Option Symbol: D121020C55

Limit Order Price: $53.57 or less (stock is at $54.37 and October $55 call is at $0.80)

Directional View for Underlying Stock: Neutral

Personal Finance Portfolio: Income

• Net cost of buy/write: $5,357 per 100 shares
• 92-day return if stock does not move: 1.5 percent (5.8 percent annualized)
• Brokers vary as to whether they call this trade a “buy/write” or a “covered stock” trade.
• Do the trade simultaneously at a single limit price, if possible. For example, if you want to buy 100 shares of stock, tell your broker:

“I want to do a buy/write trade. Specifically, I want to buy 100 shares of Dominion Resources (D) and ‘sell to open’ one October $55 call for a net debit of $53.57 per share or less.”

• Some brokers require that you buy the stock and sell the call in separate trades. If your broker is one of these, always buy the stock first and sell the call against it second:

Trade No. 1:

“I want to buy 100 shares of Dominion Resources (D) for $54.37 per share or less.”

Trade No. 2:

“I want to sell a covered call against 100 shares of my Dominion Resources (D) stock. Specifically, I want to ‘sell to open’ one October $55 call for a credit of $0.80 per share or more.”

Please note: When doing a buy/write trade in two steps rather than in one simultaneous trade, the important thing is limiting the net cost of the buy/write to $53.57 per share. The specific limit prices of the individual “buy stock” and “sell covered call” trades are just starting points and should be adjusted as needed, keeping the net cost of the overall buy/write in mind.

• Ex-Dividend Date: The stock’s next quarterly ex-dividend date is August 29th. Since this ex-dividend date is six weeks prior to October options expiration, the time value associated with the October $55 call–especially if the $55 call remains out of the money–is likely to be larger than the $0.5275 quarterly dividend, so there is little chance the call owner will exercise early to capture the dividend.
• Why the October $55 Strike?: Personal Finance associate editor Roger Conrad has set a “buy below” target of $52 on the stock. With the stock currently trading 4.6 percent above this target at $54.37, it is prudent to sell a covered call at the $55 strike. Dominion is performing well, but low natural gas prices continue to crimp profits for the company’s wholesale power generation unit in New England. In the short term, this could hinder further price appreciation for the stock. Longer term, Dominion is primed to win big from Marcellus Shale transportation fees and LNG exports.

Price Adjustments Regarding This Trade

Stock prices are currently fluctuating and option prices fluctuate with them. Consequently, the limit prices recommended in this trade alert may no longer be immediately fillable by the time the alert has been released. The alerts are valid for seven days, so be patient and place your limit orders as “good-‘til-canceled” (GTC) for seven days.

Investment Rationale for Underlying Stock:

Integrated energy company Dominion Resources (NYSE: D) has been a big winner since it was first added to the Personal Finance Income Portfolio back in 1987. And the best is yet to come due to its unique position in North America’s shale gas bonanza.

Dominion’s 7,800-mile gas pipeline and storage network connects six states in the heart of the Marcellus and Utica Shale formations, now home to the continent’s cheapest gas.

It also owns 5,400 miles of gathering pipeline, the largest natural gas liquids extraction-fractionation operation in the Eastern US, and Dominion Cove Point LNG, which is close to making good on its export potential.

Profits from this growing group of assets are assured by long-term contracts that don’t depend on gas and oil prices.

Meanwhile, Dominion is adding gas-fired power plants to its Virginia electric utility rate base, including a 1,300-megawatt combined-cycle facility announced in late February.

The plant will help Dominion meet robust local demand growth. It also reduces potential environmental liabilities, as cleaner gas will replace coal as feedstock.

And thanks to proximity to Marcellus and ownership of gas infrastructure, Dominion should be able to control its future fuel costs, even when gas prices inevitably recover.

Dominion’s five-year annualized dividend growth rate is a robust 7.6 percent. Meeting management’s 5 percent to 6 percent growth target over the next five years looks assured thanks to numerous opportunities to invest and strong regulatory support.

Dividend growth of 5 percent to 6 percent plus a 4 percent to 4.5 percent yield add up to 10 percent annual returns in this high-percentage business.

Dominion posted first-quarter results that, as expected, were on the low-end of its initial guidance. Management, however, affirmed the full-year operating profit target of $3.10 to $3.35 per share, and profit of 86 cents per share still managed to beat last year’s 82 cents.

The key negative factors during the quarter were the exceptionally mild winter’s depressing impact on sales and weak wholesale power prices in New England, where the company has substantial generation assets. The major positives were Dominion’s continued successful investments in its regulated Virginia Power electric utility and energy midstream infrastructure, particularly in the Marcellus and Utica shale regions.

The company has now reached binding contracts to sell liquefied natural gas (LNG) from its Cove Point, Maryland, facility. This deal had been opposed by the Sierra Club as part of its push against natural gas development with hydraulic fracturing. But in light of the US Dept of Energy’s approval of other facilities, it looks nearly certain to come on stream by mid-decade.

Dominion also continues to pursue plans to build a new nuclear power plant in Virginia, a potentially major addition to its rate base, which should flow through to its earnings by the end of the decade.

The New England wholesale power operations remain a concern. But the company continues to aggressively hedge future sales to limit exposure to price decreases. All output for 2012 is now locked in at favorable prices, as is 80 percent of 2013 production. That’s made the company’s future profits much more transparent, which in turn strengthens the balance sheet and ensures future dividend increases.

Virginia regulators remain among the most supportive in the country, and the state’s economy is reliably growing at a pace well above the rest of the US. The PJM (Pennsylvania/Jersey/Maryland) regional power authority anticipates 1.9 percent annualized growth in demand over the next decade. That means an additional 4,000 megawatts needed in the company’s operating territory. The company also reported a sharp increase in new connections, as growth in its Northern Virginia service territory has resumed.

Relative to other utilities, Dominion’s performance during the recent aftermath of the Great Derecho, which caused mass power outages across 10 states, was exemplary. Immediately following the storm, nearly a million of the company’s 2.4 million customers had lost power in an area stretching from North Carolina to Northern Virginia and from Tidewater Virginia to Appalachia.

No doubt there will be some who find fault with their response. But it’s hard to imagine any punitive measures will be taken against the company by Virginia regulators, given the fact that management set clear performance targets and executed on them under very difficult conditions.

Utilities always suffer some loss of sales from such outages. But system damage expenses are covered by insurance or storm reserves as a normal cost of doing business. As a result, the vast majority of storms cause no lasting impact on utility company earnings.

Dominion Resources is currently rated as a buy up to 52 in the Personal Finance Income Portfolio.