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This is the second in a series of three articles looking at undervalued utilities that pay high dividends.

I hold full positions in each of these utilities as part of my portfolio core of 22 stocks. The goals of my portfolio are preservation of capital, high current income and dividend growth, which will offset inflation. These utilities make an important contribution toward my current income. Satellite holdings in REITs, MLPs and BDCs augment the core of the portfolio.

I have recently added to my positions in each due to their favorable valuation. You too might want to consider one, two or all three of these undervalued stocks. The purpose of this series of articles is to give you an overview of each of them to enable you to decide if you wish to further evaluate them as additions to your portfolio.

Part I is about National Grid (NYSE:NGG), Part II, about Southern Company (NYSE:SO) and Part III about PPL, Corporation (NYSE:PPL).

A Comment on the Current Market and Undervalued Stocks

The US stock market stands near its all-time highs. At the close on Friday October 11, 2013, the Dow-Jones Industrial Average was at 15,237 and the S&P 500 index at 1,703. More telling is of the height of the market is its price earnings ratio (P/E) compared to historic norms. The long-term mean P/E is 15.50 and the median is 14.51. We often say, for convenience sake, that the long-term average P/E of the market is 15. While some data services to report "forward" or forecast P/Es, the historic and traditional measure is stated in terms of ttm earnings and current price.

Today the market P/E is 19.42. This indicates a higher than average valuation, which in general indicates optimism. One could also state that on historic terms, the market is overvalued, and that is a true statement. While we can look at any stock and compare its P/E to the average of 15, some stocks typically command a premium price, and others seem to be in a perpetual state of undervaluation. Therefore, when we come to the valuation of stocks, we look at its current P/E compared to its historic P/E as one measure of valuation. F.A.S.T Graphs is a software tool that facilitates this and provides a visual indication of valuation, in a flexible manner. This flexibility makes it "a tool to think with" rather than simply a source of data.

The question behind valuation should always be, why is the stock undervalued or overvalued? In general, when a stock is undervalued compared to its historic valuation it is because of market pessimism. We reject the notion that the market is a mechanism that always sets the correct price. The whole premise of value investing is that the market is not rational, and undervaluation indicates opportunity. The real value of a stock can better be discerned by its fundamentals and key among them is the generation of earnings, the basis of value. We have learned that market bubbles are caused by "irrational exuberance" and that steep declines are often caused by overreaction to bad news and fear about the future.

The old dictum "buy when the blood is in the streets" is a simple statement of market overreaction to bad news, which might indicate a buying opportunity. Bad news today is not always as dramatic as it was when the English public thought Napoleon had won the Battle of Waterloo. The Rothschild family knew better and exploited that market's error. Today investors are in angst when analysts' estimates are missed by 2 cents, as they were at the end of Q2 concerning Southern Company. The business news has a heyday reporting such things, and in the case of Southern Company bold headlines followed because a construction project is not on time and it is over budget. Who ever heard of such a thing? And, yet another dirty secret is out… it burns coal.

The individual investor is always in charge of their own destiny and is free to reject the market's consensus and find opportunity in buying sound companies that are out of favor. I believe that in the cases of the three utilities in this series the market has mispriced these stocks, to one degree or another, providing a safe opportunity for one to take positions that provide a yield not available elsewhere; not in the bond market, and not from other companies of this caliber.

The Southern Company

The Southern Company cultivates good relationships with its 4,300,000 customers, its 500,000 shareholders, its 26,440 employees and the regulatory authorities of the four states where it operates. These are Alabama, Georgia, Florida and Mississippi. These relationships, its reliable service, fair prices and superior management assure its continued success. Morningstar states in an analyst report dated October 1, 2013,

"Southern's total return proposition remains appealing for patient investors in a world of few decent income alternatives. This giant utility of the Southeast enjoys some of the best regulation in the United States and strong, consistent regulatory relationships in its key service territories of Alabama and Georgia. The company is in the middle of a huge investment program aimed at phasing out or retrofitting its massive coal fleet, building a low-carbon coal unit in Mississippi, and constructing the first new nuclear plant in the U.S. (in Georgia) after a more than 30-year freeze."

Southern Company generates up to 45,740 megawatts of power at 33 hydroelectric generating stations, 32 fossil fuel generating stations, 3 nuclear generating stations, 13 combined cycle/cogeneration stations, 4 solar facilities, 1 landfill gas facility, and 1 biomass facility. The breakdown of energy generation by source is, 45% oil and gas, 36% coal, 17% nuclear, 2% hydro. Southern Company has responsibility for more than 27,000 miles of transmission lines, 3,700 substations, and 300,000 acres of right of way.

Performance

The yield, as reported on Friday, is 4.87%. Southern has increased its dividend for each of the past 13 years, and the 5-year DGR is 4%. It has been in business over 100 years and has paid dividends for the past 65 years. The future looks good for the region and the company. There is increasing demand for power in the growing Southeastern US and Southern Company has plans and capital to meet that demand. While speaking of capital expenditures, Morningstar predicts that,

"…earnings and cash flow growth will swell as expenditures close to rates, driving 4.5% growth in earnings and dividends through 2017 as well as 4% growth in operating cash flows."

The below chart is from the 2012 Annual Report.

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The chart shows the power of Southern Company's dividend and growth in value relative to the 20 utilities in the Philadelphia Electric Utility Index (UTY).

Over the last 20 years, a $1,000 investment in SO grew to $10,010, a $9,010 increase. The price was up $2,652 and dividends, with reinvestment, accounted for $6,358, or about 70 percent, of the gain in value. The UTY companies, which include SO, made only $3,393 on a $1,000 investment.

Southern Company's $9,010 increase is about 2.7 times more than the average increase generated by the UTY index. The graph assumes that $1,000 was invested on Dec. 31, 1992, in Southern Company's common stock and the UTY index and that all dividends were reinvested.

A question one might ask is, did these exceptional returns involve undue risk? The answer to that is they absolutely did not. By measurements of financial soundness, by the virtue of its regulated franchise, by demographic indicators, it certainly did not. One popular measure of risk involves the volatility of the stock. Currently Southern Company has the second lowest beta in the S&P 500 at 0.12. It has been one of the ten least volatile stocks by that measure for each of the past ten years.

Operating Revenue

We are trained to look at the top line of the income statement over a number of years for an indication of corporate health and growth. In the case of this electric utility further scrutiny is required. Indeed, what is portrayed as bad news may not be bad at all.

The goals of Southern Company include reducing the inefficient use of electricity. States and regulatory agencies support these endeavors and often provide tax incentives to accomplish just that. Since the year 2000, the company has performed over 128,000 energy audits. Demand has been reduced, especially peak demand. Reduction of peak demand defines the amount of generating capacity required. Southern Company is an industry leading company in reducing demand.

On the supply side, energy production is becoming more efficient and cleaner. It should be noted that in the important measurement of EPS, the company is creating more profit and has each year since the start of the economic recovery in 2009.

Through partnership with the Electric Power Research Institute and with the US DOE, many initiatives are underway in the areas of electric transportation, residential efficiencies and commercial industrial applications. The results are tabulated in a two page report available here.

Return on equity is a very important measure of a utility's management efficiency. Southern Company has a current ttm ROE of 9.6, which compares very favorably with the industry average of 5.9. In addition, dividends continue to grow, putting cash in the investor's pocket.

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Valuation

Southern Company closed Friday at $41.69. That is priced below its fair value of $45 as determined by Morningstar using its proprietary, modified discounted cash flow model. It also awards it 4 Stars, which is another indication of undervaluation. In addition, it is priced below its fair value as illustrated by the F.A.S.T. Graphs I present below.

F.A.S.T Graphs is a dynamic tool and allows the user to modify both the length of the historical perspective and the rate of growth of future earnings. I have chosen to use a 12-year historical perspective to establish the average P/E ratio. I believe that this period most closely reflects the polices that are in effect today in their full historical perspective. This was shortly after a divestiture. In addition, the company established its policy of regular annual dividend increases at that time.

Results are only a little different than when using the F.A.S.T. Graphs default of 15 years, but since I have the information I will use it. On the 5-year projection, we have no reason to believe we can better the consensus of 22 analysts, so we have left the rate of earnings growth unchanged from what was provided by F.A.S.T. Graphs.

Based on these results we can say that at a price of 45 or below, Southern Company is fairly valued or slightly undervalued. This is the first time since May of 2010 that this has occurred. In this overvalued market where high yield commands a premium, we find this is an exceptional opportunity to buy Southern Company.

I would like to draw your attention to an article published by F.A.S.T. Graphs on September 13, 2013 with the title, "Southern Company: The Wait For Fair Valuation Is Over." That article, which I highly recommend, states, "Today, Southern Company appears fairly valued in relation to both its historical earnings and relative valuation." It was selling for 40.76 at the time that article was written, and that is not far from today's price. The article suggests that investors might consider the firm's stock as a bond replacement.

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Data Bar

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Risks

No investment is without risks. It is important to understand risks to weigh their importance. A risk for any public utility, especially one that has excellent regulatory relationships, is that a change in the regulatory environment may occur. Southern has a case pending at this time, the outcome of which is uncertain. Georgia Power is requesting a rate increase of $482 million or 6.1%, accompanied by an ROE of 11.5%.

Cost overruns and delays at its Kemper project, a 21st century coal gasification plant in Mississippi, are a continuing risk to Southern Company. "It will miss a deadline, which would have given it $133 M in tax incentives," Reuters reported. "Southern Company's smallest utility unit, Mississippi Power, is building the integrated (coal) gasification combined-cycle (IGCC) plant near oil fields, meaning it can capture and inject underground the majority of carbon dioxide it emits to increase oil field production. Southern will take a $278 million charge in the second quarter as costs continue to rise. It has already taken a $333 million charge in Q1 because of cost overruns."

I believe that this innovative project will be managed to profitability and will yield long-term favorable results. The other concern is the risk of delays and cost overruns on the first new nuclear plant in the US in over 30 years, which is now under development. Concern about these issues has contributed to the easing of the price of Southern Corporation and contributed to this buying opportunity.

There are two recent articles on Seeking Alpha, which offer a different point of view on the purchase of Southern Company. An article by Equity Watch suggests "…the ongoing projects and pending rate cases provide uncertainties." Equity Watch advises investors to wait until the uncertainty is resolved before they buy Southern Company. That certainly is a defensible conservative approach. However, I expect that with resolution of the issues the price of the stock will rise.

In an article by Abba's Aces, the author states he is not excited about Southern Company. I must agree that utilities are not exciting and for that I am thankful. In the conclusion, he discusses the risk that utilities have in a rising interest rate environment. He goes on to say, "Southern Company is inexpensively valued based on future earnings but extremely expensive on future growth." If I understand that correctly, he believes the value is there from an income perspective, but he is unimpressed by the rate of earnings growth the stock offers.

I believe that is an accurate assessment of this stock that yields nearly 5%, has a DGR of 4% and EPS growth rate of 5%. Indeed, this is a bond-like equity.

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Conclusion

Thomas A. Fanning, the CEO of Southern Company, states, "I truly believe that Southern Company is the greatest electric utility in America." While one must always consider the source of glowing praise of a firm, in this case I believe he has a very defensible point of view. There might be a few folks in Virginia who would root for their home team, but all would agree that Southern is among the best.

There are differences between it and other electric utilities. Southern is involved in the process of shaping governmental policy at all levels. That is, from the local community, through all levels of the state government and at the Federal level. I will note that Thomas Fanning is also a Director of the Federal Reserve Bank of Atlanta.

Southern is building the most diversified energy portfolio in the country with a total investment of $20 billion. Yes, there are risks, seen and unseen, and many challenges will be faced. To once again quote the CEO, "We will not merely react to these challenges, we will aggressively and proactively pursue solutions that enable us to leverage the very best of our talents and capabilities."

I am a shareholder in this firm. I believe that any investor who has a goal of high income with the safety of corporate stability should consider this company.

Take care in doing your own due diligence and in discerning if this stock will further your portfolio goals. I wish you good luck.

Source: 3 High Yielding, Undervalued Utilities, Part II: Southern Company