Southern Company (SO) is one of the largest investor-owned utilities in the U.S. with 43 GW of power capacity. It is one of the best-run utilities in terms of efficiency, operational parameters and costs. The company operates mainly in the Southeastern U.S. The company gives a nice dividend yield of 4.2% and has low volatility, which you would expect from a utility stock. The company, unlike other utilities, is also involved in clean coal R&D and has a partnership with KBR to develop a coal gasification technology. SO plans to invest around $14 billion in the next couple of years for maintenance and expansion.
Southern Company has a long history of stable and growing dividends, which has made it a favorite for yield-hungry investors. While the company has excellent operations, we think that the stock has priced in most of the upside. This is mainly due to the fact that there is a dearth of low-risk, safe financial products giving a decent yield. This has led to a crowding in the utility investment space. Southern Company depends almost exclusively on coal, nuclear and natural gas for generating power. Its dependence on coal has reduced but it still depends on coal for generating more than 50% of its total power.
Why we like Southern Company
- TRIG Coal Gasification Technology - Southern Company is taking the lead in clean coal technology by promoting the TRIG technology. This is a coal gasification technology that claims to be cleaner than burning raw coal for generating electricity. The company is building an IGCC plant as a technology demonstrator and wants to market this technology all over the world. Clean coal technologies have not really caught on despite the hype to date. The company is also building one of the largest biomass plants in the Southeast U.S. - the 100-megawatt Nacogdoches Generating Facility to serve the city of Austin, for 20 years.
- Margins - SO has managed to consistently maintain a high gross and operating margins level in the past. The company had a GM of 61% and an Operating Margin of 24% in 2011. It has also got an impressive Net Margin of ~13%, which is quite good for a regulated utility.
- Growing Dividends - SO has consistently raised dividends in the last 11 years with a five-year dividend growth rate of 3.74%. The company's dividends have grown from $1.36 in 2002 to $1.87 in 2011.The payout ratio has also grown from 69% to 76% during the same period. With large stable cash flows, the company has managed to maintain a high payout ratio The company's ROA, ROE and ROIC ratios are among the best in the utility industry.
- Scale and Size - SO is one of the largest utilities in the world and the 4th-largest in the U.S. The company has got a good mix of regulated and unregulated power capacity with almost ~85% of its power under regulation. What is impressive is that SO has not used acquisitions to add weight unlike some of its main competitors lie Exelon Energy (EXC) and Duke Energy (DUK). While M&A can bring in merger synergies, they also can be potentially mismanaged, which leads to more costs than gains.
- Vogtle Risks - Southern Company is doubling the capacity of its nuclear power plant in Vogtle in Georgia, using an $8 billion guaranteed loan from DOE. These will be the first nuclear reactors to be built in the U.S. after a long time. The reactors are being sources from Toshiba Westinghouse and the plant is expected to be completed by 2017. The company generates almost 23% of its power from nuclear reactors and this plant should increase its dependence on nuclear energy. We don't think this is a good move because new nuclear plants suffer from massive time and cost delays.
- Growing Threat to Georgia Power from Solar Startup - Utilities around the world are not adapting fast enough to the growing threat from distributed solar energy. Already solar prices have become competitive with fossil fuel in many parts of the world even without subsidies. Georgia Power was forced into building 200 MW solar power capacity after a start-up threatened its monopoly position in Georgia. Utility investors have not realized the massive threat from falling solar energy prices. We see little evidence that analysts and investors have understood the threat from the drastically falling solar energy prices.
- Slowing U.S. Electricity Growth - U.S. Electricity Demand has started to slow down as the general economy slows down. Retails sales of electricity fell by 4% in Q312 compared with a year ago for SO. Residential sales fell by 8.3% due to a combination of energy efficiency and slower growth. If the U.S. economy slows down, then SO will be badly affected as all of its assets are concentrated in the U.S.
SO stock has traded in a range of $27 to $48 in the last five years hitting a low of $27 during the market crash in March 2009. The company hit a high of $48 in the first half of this year before pulling back to the $44 level currently. The stock has outperformed the S&P 500 by ~10 in the last five years; however it has underperformed by ~15% during the last year.
Southern company trades at a relatively expensive valuation with a P/B of 2x, which is 50% more expensive than the industry average while the P/S of 2.3x is also higher by the same amount. The P/E ratio at 17.2 is almost ~15% more expensive than the S&P 500. The higher valuation is due to the company's better operating metrics compared with other companies in the sector. Different industry sectors are measured by different financial ratios, for eg. financial stocks are frequently compared using the Net Interest Margin (NIM). Utility stocks are compared using their dividend yields as a yardstick. SO gives a 4.4% yield, which is in line with the industry average of 4.2%
Southern Company looks a very safe, good dividend-yielding stock; however the company like Duke Energy faces risks from the growth of distributed solar energy. There is also the risk from time and cost delays related to the construction on the new nuclear reactors in Georgia. The company faces declining U.S. electricity demand as the economy slows down and customers start to become more energy efficient. The stock currently trades near the top of its past five-year trading range as income-inclined investors crowd into U.S. utilities. Southern Company stock already prices in its better-than-industry operating metrics. We don't think that Southern Company should be bought at these levels. I would much rather buy Microsoft (MSFT) or a Dell (DELL) for dividend yield than Southern Company.