The naysayers are shouting to sell utility stocks as interest rates nudge upwards. It seems many investors have heeded the call as the S&P Utility Index (NYSEARCA:XLU) collapsed by 8.8% in the month of May. However, looking at historical data, investors of Southern Company (NYSE:SO) should be using this weakness as a buying opportunity.
First, look at the historical data during the previous three turns in interest rates. Below is a quote taken from a previous SA article titled, "An Unconventional View Of Utility Stock Performance During Initial Interest Rate Hikes":
In reviewing the initial periods of interest rate environments transitioning from a medium-term dovish stance to a medium-term hawkish stance, dividend stocks and utilities have performed pretty well. Below is a table outlining three periods of initially rising rates: Jan 1994 to Feb 1995; May 1999 to May 2000; and May 2004 to June 2006. The table includes the Fed Fund rates, 10-yr Treasury yields, the total return (capital gains plus dividends) for the Dow Jones US Select Dividend Index (NYSEARCA:DVY), the total returns for the S&P 500 (NYSEARCA:SPY) and the total return for the S&P Utility Index . XLU was not introduced until 1998, and although the DJ Select Dividend Index was not available until 2003, it can be back tested to 1991.
I have included stock performance for SO during the same time period in the updated table below:
DJ US Select Dividend DVY
S&P 500 SPY
S&P Uts ETF XLU
$1.48 (5 payments)
$1.34 (4 payments)
$2.95 (8 payments
Source: economy.com, Morningstar.com, finance.yahoo.com (adjusted for 2:1 stock split in 1994)
During the 1994 to 1995 time period, there was one dividend increase; during the 1999 to 2000 time period, there was one dividend increase; and during the 2004 to 2006 time period, there were two dividend increases.
What should become clear is that during the turns in interest rates in 1994, 1999, and 2004, SO provided investors with adequate comparable total returns
To those who claim, "This time will be different," my answer is - do not bet on it.
Southern Company is the best regulated utility in the industry. By conventional evaluation and by my bit unconventional comparisons, SO is the preeminent utility holding:
- SO ranks high in customer satisfaction;
- SO is geographically far away from the disruptive aspects of wind and solar generated power;
- SO has the highest credit rating of the 56 utility-members of the Edison Electric Institute at S&P rated "A";
- SO has some of the best regulatory environments in the US;
- SO has a high trailing 12-month and 5-yr average ROIC for the sector;
- SO is in the sweet spot for utilities with a 4-4-4: 4%+ yield, 4%+ dividend growth and 4%+ earnings growth;
- SO has a S&P Equity Quality Ranking of "A-" for 10-year consistency in earnings and dividend growth.
Operationally, SO continues to outperform its peers. Three-year average revenue growth is 1.7% vs. 1.0% for its regulated peers; 3-yr average net income growth is 12.2% vs. 11.0% for its peers; operating margins for trailing 12-months is 23.9% vs. 19.5% for its peers; net margins for trailing 12-months is 12.3% vs. 8.8% for its peers.
Share prices over the past month have followed the overall utility market down and shares now trade in the $44 range. This and any further drop should be considered a gift to long-term shareholders.
The excellent relationships with regulators are not expected to sour. By maintaining electric rates below other parts of the country and by creating great customer satisfaction, regulators have granted SO some of the higher allowed ROE in the country.
High ROE in addition to a return of population growth via migration in its service area will drive earnings higher. As the housing market recoups in the North, retired individuals looking to move to the sunny South will have their opportunity once again after a 5-year hiatus. It is estimated that about 20% of homeowners are underwater currently, down from a high of over 30% in 2011. Housing prices have begun to rise in some Northern areas while they have not in many parts of the South. This is important, as a growing population is a cheap way for utilities to increase earnings through higher customer counts.
Current yield is around 4.6% and 5-yr average dividend growth has been 4.05%. 5-yr average return on invested capital (ROIC) is 6.25% and a continuation of the above average ROIC will support continued dividend growth over the next 5 years.
SO maintains an in-house engineering and design team. As the company builds additional power plants, such as its current programs with nuclear and "clean coal", this advantage translates into historically lower construction costs.
The company is also geographically far away from the power markets controlled by PJM. PJM controls both the power grid and electricity pricing via 3-yr auctions for about 60 million customers in the Northeast and Midwest. Currently, merchant power pricing is very weak in PJM territories going out to 2016/2017 auctions. SO's merchant power segment, Southern Power, utilizes long-term Power Purchase Agreements (PPA) contracts and is not nearly as affected by the negative pricing found in its northern peers. Southern Power PPAs have an average duration of 10 years remaining and is sufficiently long enough for merchant power markets to recover.
The stock has a very low beta of 0.24 and a market capitalization of $38 billion.
However, critics of SO have a right to be concerned. The clean coal and nuclear plant construction projects are both going over budget and cost overruns may not be included in future rate decisions. The Kemper clean coal facility needs to be on-line by May 2014 or SO could lose upwards of $120 million in tax credits. Expensive EPA-mandated coal-fired conversions may increase electric rates, encountering the ire of both customers and regulators.
Overall, SO should be a core holding in most all stock and income portfolios. There are even pundits that offer a potential capital gain; potential for share prices to reach $52, or about 18% above current trading levels. I plan to add more shares with any further weakness - you should too.
Author's Note: Please review important disclaimer in author's profile.