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As usual within the utilities sector, Southern Company (SO) offers an attractive dividend yield of 4.8%, which may represent a good opportunity for income investors. Southern Company is one of the largest electric power companies in the U.S., and its main competitors are other large electric power companies, such as Duke Energy (DUK), Exelon Corporation (EXC), or American Electric Power (AEP). It has a market capitalization of $36 billion and is listed on the New York Stock Exchange.

Company Background

Southern Company has operations and business activities in several southern states, through its subsidiary units. Its regulated operations serve a 120,000 square-mile territory in Alabama, Florida, Georgia, and Mississippi. Its competitive generation business extends to markets in six southern states. The company has about 4.4 million customers and nearly 46,000 megawatts [MW] of generating capacity. The company has also intra-group fiber optics and wireless communications businesses. Furthermore, Southern Company operates three nuclear power plants, and it is building the first new nuclear unit over the past decades in the United Sates. The company was founded in 1945, and at the end of 2012 it had more than 26,000 employees.

Electric utility companies are under increasing legislative pressure to adopt cleaner electricity generation methods while maintaining competitive prices. This requires cleaner fuel sources, such as nuclear or wind power, instead of coal. On this point, Southern Company as a long way to go, given that its sources of generation are 36% coal, 45% oil and gas, 17% nuclear, and only 2% hydro. Therefore, the company is much more susceptible to 'green legislation' than some of its peers, like Exelon or Duke Energy. However, the proportion of natural gas and nuclear generation to the total fuel mix is likely to increase in the future, decreasing coal's weight in the fuel mix.

In 2012, Southern Company's revenues decreased by 6.3% to $16.5 billion, affected by lower wholesale revenues. Revenues decreased due to a reduction in the average price of energy and lower consumer demand. Its operating income amounted to $4.4 billion, an increase of 5.5% from the previous year. This increase in income is justified by lower fuel costs, leading operating expenses to decline by more than $1 billion during the year. Its operating margin improved from 24% in 2011, to 27% during the past year. Southern Company's net income was above $2.3 billion or $2.70 earnings per share, compared to $2.57 in 2011.

Regarding its most recent results, the company increased its revenues by 4.6% during the first six months of 2013 to $8.14 billion. For the first six months of 2013, earnings were $378 million, compared to $991 million in the first six months of 2012. This fall in earnings is justified by Southern Company's second quarter 2013 earnings at only $297 million, a deep decline from the $623 million achieved during the same quarter of 2012. This decrease in earnings is mainly due to after-tax charges of almost $1 billion related to increased cost estimates for the construction of Mississippi Power's Kenter County project. Excluding these extraordinary costs, earnings would have been relatively stable compared to 2012.

Going forward, the company should be able to achieve good earnings growth, given its investment program of $14 billion over the next three years for the construction of two new reactors at the company's existing nuclear site in Georgia. Moreover, about 90% of Southern Company's earnings come from regulated businesses, proving a stable base of operation which should lead to a reliable earnings stream for the foreseeable future.

Dividends

Southern Company's dividend history is quite impressive, given that it has paid quarterly dividends consecutively since 1948. The company recently increased its annual dividend to $2.03 per share, which marks the 12th straight year that Southern Company has raised its annual dividend. Its dividend was increased by $0.07 per share, or 3.6% higher than its previous annual dividend. The quarterly dividend was raised by 1.75 cents, increasing the quarter distribution to $0.5075 per share. At current Southern Company's stock price this means a dividend yield of 4.84%.

The company's dividend payout ratio was about 75% in the past year, which is acceptable given its relatively stable and heavily regulated business. Going forward, Southern Company targets a dividend payout ratio of approximately 70% to 75% of net income, which is in-line with its peers. Due to increased costs with ongoing projects the dividend payout ratio should increase over the coming quarters, but without these extraordinary effects and over the long-term it should remain within the company's target.

In 2012, Southern Company's cash flow from operating activities amounted to $4.9 billion, which was enough to finance its capital expenditures. The company's capex was about $4.8 billion during the past year, an increase of 6.3% from 2011. For the next couple of years Southern Company expects capex to be above $6 billion, and to decline to $5.2 in 2015. However, the company's cash flow from operations should not be enough to finance this expected investments. Therefore, it has to raise funding from capital markets which explains why the company plans to issue debt between $2.7 billion to $.34 billion per year during 2013-2015. It also expects to raise equity to maintain an acceptable gearing ratio (net debt to equity ratio). Furthermore, if the cost of new nuclear units increases further, it will certainly increase the company's leverage and deteriorate its credit profile, putting its dividend in jeopardy. At the end of 2012, its net debt to EBITDA ratio was about 3.3x, which is still below its peers average but close to the upper limit to keep its current credit rating.

Regarding dividend outflows, the company returned $1.6 billion in 2012 to shareholders. However, this was mainly financed through debt issuance, leading to a higher balance sheet leverage, and also a lower cash balance. During the year, cash decreased by almost $700 million to only $600 million at the end of the year. Given the company's high capex expected over the next few years, its dividend will be completely financed through debt issuance which is not supportive for its dividend sustainability.

Major Risks

Southern Company's operations may be adversely affected by several factors that could hurt its revenues, profitability, and cash flow generation capacity, resulting on lower financial flexibility and less capacity to distribute dividends to shareholders. Among the major risks the company faces, are the following:

  • Declines in demand for electricity as a result of economic downturns reduce overall electricity sales, or an increase in the cost of operating the facilities would have the potential to lessen Southern Company's net income and cash flows;

  • The company's businesses are subject to regulation on the federal and state level. Regulation can have a great impact in the way the company operates, and new legislation and changes to regulation cannot be anticipated or hedged. Moreover, compliance with current and future regulatory requirements may result in substantial costs for the company;

  • Operation of nuclear facilities involves inherent risks, like natural disasters seen in Japan at Fukushima. These risks could result in fines or the closure of the nuclear units owned by the company, and which may present potential exposures in excess of insurance coverage;

  • Southern Company's revenues and earnings are impacted by fluctuations in power prices and fuel costs. Exposure to these risks generates higher earnings volatility in the unregulated business, and may affect the company's cash flow. Also, the company uses financial derivative contracts to hedge some of these exposures, leading to more stable earnings.

Conclusion

Southern Company has a relatively stable business and a very good dividend history. At first glance, its dividend yield of 4.8% seems attractive and to be relatively safe. However, given its huge investment program the company's free cash flow is expected to be negative over the next few years. This implies external financing to keep paying dividends to shareholders, which will result on higher balance sheet leverage. Therefore, based on cash flows, its dividend does not seem to be completely safe, as the company is susceptible to adverse events like construction costs becoming higher than the company expects which may result in a dividend cut. Moreover, its reliance on capital markets to maintain its dividend policy is not a good proposition, making the company especially vulnerable to future financial crisis.

Source: Southern Company's 4.8% Yield May Not Be Sustainable