Dominion Resources Inc. will need to sustain its recent strong performance for “at least a few quarters” before investors become comfortable with the inherent risks in its new system, which includes plans to build up its exploration and production (E&P) business, Merrill Lynch analysts said in a report last week.

Dominion held its annual analyst meeting last Tuesday, showcasing its E&P business, and it also provided an update on the first few months of operation under Virginia’s new frozen rates and fuel factor legislation.

“Management did a good job highlighting the E&P business as a self-funding growth unit within the overall integrated business model,” said analysts Steven J. Fleishman and Jonathan P. Arnold. “The business is more earnings-focused than the typical stand alone E&P company, however, and uses hedging to provide more stable results and consistent positive free cash.”

Other key takeaways, said the analysts, were strong operating comparisons versus “dedicated players” and a “heavy bias toward lower-risk onshore reserves and capital spending.” The deepwater projects, including Devil’s Tower and Frontrunner in the Gulf of Mexico “have been the focus of much recent investor attention, but exploration now represents only 10% of the typical $1 billion annual capital expenditure budget” for the E&P unit.

The company also updated operations under a new frozen fuel clause in Virginia, which has been in place since May. The net expected results this year will be $2 million more than was projected a year ago, which Dominion said resulted from the net of weather and sales, higher fuel expenses and higher E&P margins.

“The key message is that Dominion’s integrated model has been working — with the impact of higher fuel costs offset by benefits in terms of E&P margins,” said analysts.

One of the company’s “main earnings’ risks” was the open 2006 coal position, but analysts said that coal hedging has “substantially” increased with 2005 now 100% covered, 2006 at 60% and 2007 at 70%. The company did not elaborate on pricing, but indicated that the new hedges were supportive of earnings guidance, and it was able to secure favorable pricing for multi-year deals.

“The correlation between natural gas and coal prices is a key factor behind Dominion’s approach to its integrated business model,” said the analysts. And they noted that “management presented strong evidence of this correlation — at least for the past few months — with prices for natural gas (which Dominion is long) increasing at a faster rate than those for central Appalachian coal (which Dominion is short).”

Dominion reiterated its earnings guidance this year at $4.75-4.90 and 2005 at $5.10-5.30, with 5-7% growth thereafter. However, the Merrill analysts said that “overall, we believe our estimates — at the low end of guidance for both years — may prove somewhat conservative.” Following the meeting, Merrill reiterated its buy and $70 price objective. “The stock is also one of the few names that can be purchased at a discount to peers where there is a meaningful prospect of upside earnings surprises over the next couple of years.”

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