Article Thesis

On the weekend, Berkshire Hathaway (BRK.A) (BRK.B) announced that they would acquire several natural gas assets from Dominion Energy (D) in a deal valued at $10 billion. Looking at the price of the deal and the assets Berkshire will get, it looks like Buffett's Berkshire is the winner in this deal, being able to acquire assets at a quite low valuation. Dominion Energy, on the other hand, does not seem to be much of a winner in this deal.

The deal also has implications for other natural gas assets and their owners, as they now got the "stamp of approval" from Buffett himself.

Source: Imgflip.com

The Deal For Dominion's Assets

The deal was first announced on Sunday and values the assets at $9.7 billion. About $4 billion of that will be paid in cash, while Berkshire Hathaway will also assume $5.7 billion in associated debt. Net proceeds for Dominion Energy will be lower than $4 billion, however, as the company will have to pay taxes on the amount it receives, which is why net proceeds for Dominion are seen at just around $3 billion. Dominion Energy still gets rid of close to $6 billion in debt on top of the cash proceeds it will receive, which will help clean up its balance sheet to some degree.

The assets that Berkshire Hathaway will acquire consist of close to 8,000 miles of natural gas transmission pipelines, and 900 billion cubic feet of natural gas storage capacity. Dominion Energy will sell most of its natural gas-related assets in this deal. Both companies expect that the deal will close during the fourth quarter of 2020.

Why Berkshire Is Buying Natural Gas Assets Now

Buffett himself has oftentimes stated that buying when valuations are low is a key factor for outperformance, highly publicized quotes such as "Buy when there is blood in the streets" underline this belief. Berkshire Hathaway thus oftentimes does not buy what is in favor and expensive, but rather the stocks or assets that are currently unloved and available at low valuations.

This certainly is true for natural gas-related assets and stocks right here:

Data by YCharts

Shares of natural gas midstream players like Energy Transfer (ET), Williams Companies (WMB), and Kinder Morgan (KMI) are down 30% to 50% from their respective 52-week highs, whereas the S&P 500 index is trading just marginally below all-time highs. The goal of buying what is unloved and trading at an undeservedly low valuation thus is accomplished in this deal -- natural gas and everything that is related clearly is not in favor right now. This means that players with a very long-term focus that do not worry about the near-term sentiment -- such as Berkshire Hathaway -- can make inexpensive buys right here.

Berkshire Hathaway clearly sees value in the midstream industry, and they already own a meaningful natural gas asset base. Following the close of this acquisition, Berkshire Hathaway will own 18% of all interstate natural gas pipelines in the US. Berkshire clearly sees value in natural gas assets, or, more precisely, in natural gas midstream assets. Why is that? There is a range of reasons why these assets could be quite valuable in the long term, including the following:

• Natural gas is much cleaner than both oil and coal, thus switching towards natural gas use for electricity generation will be a win for the environment. Demand for natural gas should thus remain high for a long period of time, as it will have to replace coal-powered plants that will be phased out in the future.
• Natural gas is a commodity that is not cyclical. Demand is mostly used for heating and for cooking, on top of electricity generation. During recessions people don't stop cooking or heating their homes, so unlike industrial metals, kerosene, for example, natural gas use is relatively consistent, no matter the strength of the economy. Buffett choosing to go for the stable, non-cyclical commodity makes sense as he wants to be conservative in this environment, showcased by past comments during the current crisis.
• It becomes increasingly hard to build large infrastructure in the US (and many other countries), due to increasing regulation and bigger hurdles by authorities, environment watchdogs, etc. This means that existing assets will likely become more valuable, as they will become even harder to replace. The already strong moats around these midstream businesses will likely grow further, which will not only increase the value of these assets but which could also result in an attractive future negotiating position with customers.

There is thus, overall, a range of reasons why natural gas midstream assets could be strong investments in the long run, and at the same time, they currently are unloved and inexpensive. We don't know yet what the EBITDA, cash flow, or net profit contribution from these assets will be for Berkshire Hathaway, but we can make some educated guesses based on the price natural gas midstream companies are trading at:

Data by YCharts

Kinder Morgan, Williams, and Energy Transfer all are trading at less than 10 times EV to EBITDA, with Energy Transfer being valued at even less than 8 times its EBITDA. This results in 10%-12%+ EBITDA yields when one invests in these companies. Buffett chose to invest in Dominion Energy's assets instead of buying shares of these companies, so he may have gotten an even better deal. Even if not, terms must have been attractive for him to invest close to $10 billion, so EBITDA returns will likely be at least 10%.

Based on Dominion Energy's new guidance -- they reduced their EPS estimate for 2020 by more than 20% -- the accretion of the assets that Berkshire Hathaway will buy could have been quite large. The planned asset sale is not the only reason for the guidance downward revision, though, so it is not possible to calculate the exact impact on a net earnings basis.

Last but not least, it should be noted that Berkshire Hathaway held a cash position of close to $140 billion at the end of Q1, so they don't have to increase their debt or anything like that in order to finance the acquisition. Quite the contrary, cash was sitting around not generating any meaningful returns anyway (with 10-year treasury yields well below the rate of inflation). Buffett found a way to employ parts of this cash in an accretive way, buying quality assets with a strong moat, that are inflation-hedged. The deal also takes place at a time when the segment as a whole is unloved, which results in below-average valuations.

To us, it thus clearly looks like Buffett's Berkshire Hathaway is the winner in this deal.

What It Means For Dominion Energy And Natural Gas Names

Dominion Energy has announced a new guidance range for this year's EPS, which are now seen at ~$3.50, roughly 20% below the previous guidance midpoint. On top of that, the company also announced that it would reduce its dividend to about $2.50 per year, which equates to a dividend reduction of roughly one-third versus the previous payout of $3.76 per share.

Management indicated that the future dividend growth rate would be faster to make up for that, but it is not clear whether this will really be beneficial for shareholders. Based on current prices, the dividend has been changed from a 4.5% yield with 2.5% annual growth to a 3% yield, with 6% annual growth. Assuming the dividend growth rate remains constant, it would take 7 years of 6% annual growth for the dividend to get back to the previous level. When we include the fact that the dividend would have continued to grow in the "old" scenario, and that dividend reinvestment would have been much more impactful due to the larger yield, the change does look even less beneficial. Overall, Dominion Energy and its owners do not look like they are the winners in this deal at all, and Dominion Energy may very well be a worse investment now than it was before this deal was announced.

The deal between Berkshire Hathaway and Dominion Energy also has some implications for third parties, mainly natural gas infrastructure plays. They got the "stamp of approval" from Buffett, as he clearly sees these assets as viable long-term investments. This could result in a positive change in sentiment for the stock prices of midstream players such as Williams or Kinder Morgan. On top of that, it may also be a positive message for compressor players such as Archrock (AROC) -- Buffett buying natural gas assets is a pretty strong indicator that the US natural gas industry likely is not doomed at all.

Takeaway

The fact that Berkshire Hathaway had not been buying big during the March crash was quite confusing to many investors, but it looks like Buffett still is able to find attractive deals. It looks like Berkshire Hathaway is able to expand its natural gas pipeline footprint substantially, while sentiment is weak and valuations are low. These assets could be strong long-term investments, as natural gas will likely be important for decades, and as the value of these pipes could go up a lot. Overall, Berkshire looks like the winning party in this deal, while other natural gas infrastructure players got a bit of an endorsement from Buffett, which could improve sentiment (and share prices).