Southern Company: Construction Projects Overhang Continues To Impact Valuations

Dec.17.13 | About: Southern Company (SO)

Southern Company (NYSE:SO) has underperformed the broad market and utility index YTD; the stock is down 6% as compared to the S&P and utility sector ETF (NYSEARCA:XLU), which had positive returns of 24.5% and 7.5% YTD, respectively. Also, a lower expected EPS growth rate and ongoing construction projects' risk limit upside for the stock price in future. Analysts have projected a modest next five years' growth rate of 3.8% per annum. Historically, SO has traded at 5%-10% premium valuations as compared to its industry competitors, however, I believe the stock will not regain its premium valuations until it completes its ongoing construction projects, the Kemper County project and Plant Vogtle units 3 & 4. Therefore, I believe there is limited upside stock price potential despite some positive near term stock price catalysts, including the possible approval of the Georgia Power rate case and potential loan guarantees from the Department of Energy.

Rate Case
A positive upcoming stock price catalyst is the Georgia Power rate case settlement. The company has requested a rate increase of $482 million or 6.1%, along with a requested ROE of 11.5% and capital structure (common equity/total capitalization) of 50.6%. Approval of the rate case is expected on December 17, next week. The company has a healthy relationship with the authorities and a strong rate case history, which is why I believe the company will earn a constructive outcome on the pending rate case, which will somewhat remove the prevalent uncertainty.

Ongoing Projects and Financing
Uncertainty regarding the construction of two large generation projects, the Kemper County and the Vogtle nuclear Plant, is likely to prevail in the medium term due to delays and cost overruns. The ongoing construction of the two projects will remain an overhang on the stock price until completion, and will limit any stock price upside. The company's Kemper County project, with a generational capacity of 596MW, is already approximately $1.15 billion above the original estimated cost of $2.88 billion. The Kemper project is expected to be completed by 4Q2014. Another ongoing project, the Vogtle nuclear plant, with a generational capacity of 2200MW, has experienced a cost increase of $750 million above the original estimates. The Vogtle unit 3 is expected to be completed by 4Q2017 and unit 4 is scheduled to be operational by 4Q2018.

The following table shows the rising cost estimates for the Kemper County project and also highlights the attached risk of increasing cost estimates.
Click to enlarge
Source: Quarterly Reports

The company is awaiting a loan guarantee of $3.5 billion from the Department of Energy for the financing of its ongoing projects, which will reduce its debt issuance needs. If the company gets the desired financing from the department, it will strengthen its credit outlook. It is highly probable that the company gets the loan guarantee soon, as recently on December 12, the Department of Energy finalized plans for $8 billion in loan guarantees for advanced fossil energy projects. The department has yet to determine the allocation of the guarantees among the companies.

Equity Issuance
To maintain its targeted equity ratio of 44% in the current tough business conditions, the company has estimated equity issuance of approximately $1.3 billion in total for 2013 and 2014. I believe, during the 4Q2013 earnings call early next year, the company might provide equity issuance guidance for 2015 and the years beyond. The company's equity issuance will result in earnings dilution and will further slowdown the EPS growth rate for future years.

Valuations and Conclusion
The stock has underperformed the broad market and its competitors in recent times due to construction projects' cost overruns; however, I don't believe the stock has bottomed out or is at a point where it will begin to experience stock price appreciation. Currently, the stock is trading at lower valuations as compared to its competitors' average valuations, whereas historically the stock has traded at 5%-10% premium valuations to its competitors. SO's modest future growth outlook (analysts are anticipating a growth rate of 3.8% per annum for the next five years) and the overhang of ongoing construction projects is likely to limit stock price appreciation in the future. Also, I believe the stock will trade at a discount in comparison to its historical premium valuations in the medium term, until the completion of the construction projects. The following table shows P/S and P/BV multiples contraction for SO in the recent past due to the ongoing issues.

2011

2012

2013*

P/S

2.2x

2x

1.9

P/BV

2.3x

2.3x

2.1x

Click to enlarge

Source: Morningstar.com

Due to the abovementioned ongoing problems, the stock is currently trading at a lower forward P/E of 14.4x, in comparison to its industry average of 14.9x, as shown below.

SO

Duke Energy (NYSE:DUK)

Consolidated Edison Inc. (NYSE:ED)

Utility Sector Forward P/E

Average

Forward P/E

14.4x

14.9x

14.4x

15.7x

14.9x

Click to enlarge

Source: Yahoo Finance

I believe investors should remain cautious and keep an eye on the projects' construction costs. The company might experience cost increases and delays for the projects, given the recent trend of cost increases and complexities of the projects, which will adversely impact the stock price.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.