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Summary

  • Company faces risks of an increase in treasury yields and rotation out of defensive sectors.
  • SO offers a high dividend yield of 4.70% backed by solid cash flows.
  • Investors should keep a check on estimated costs and timeline of two power projects.

In a low interest rate environment, utility stocks remain an attractive investment option for dividend-seeking investors, as utility stocks offer high dividend yields. In H1 2014, the utility sector has outperformed the broader market. In the first half of 2014, the Utilities Select Sector SPDR ETF (NYSEARCA:XLU) is up 12.30%, whereas the S&P 500 is up 7%. The utility sector's outperformance in H1 2014 can be attributed to an improving sales trend, an improvement in merchant power markets and a drop in treasury yields. As utilities are dividend paying stocks, their price performance is sensitive to treasury yields. Treasury yields are expected to move higher in H2 2014 and thereafter, due to a systematic end to the Fed bond purchases, which I believe will adversely affect the stock prices of utilities. Also, rotation out of defensive sectors is another risk being faced by the utility sector. Due to the risks of an increase in treasury yields and an increase in investor risk-taking ability, I believe the utility sector will underperform the broader market in H2 2014. As the utility sector faces a couple of risks, there is one company, Southern Company (NYSE:SO), which I believe remains a good long term investment option for dividend investors. The following graph shows the drop in the 10-year treasury yield year-to-date.

Source: Yahoo Finance

SO is among the leading utility companies in the U.S. and offers a high dividend of 4.70%. The company has been consistently paying dividends since 1972. Dividends offered by the company are safe and sustainable as they are backed by its healthy cash flows, evident by the strong dividend coverage ratio (dividend coverage= operating cash flows/dividends), as shown below. Also, the company has managed to keep its dividend coverage within a decent range of 72%-76% in the last four years. The following table shows dividend per share, payout ratio and dividend coverage for the company for the last four years.

Annual Dividend per share

Payout Ratio

Dividend Coverage

2010

$1.80

76%

2.65x

2011

$1.87

73%

3.70x

2012

$1.94

72%

2.70x

2013

$2.02

74%

2.95x

Source: Company Reports and Calculations

The company is expected to continue to grow its dividends in line with its earnings in the future. SO is likely to benefit from the capital expenditure it has been undertaking, which will add to rate base. SO is projected to spend $17 billion on capital expenditure and is expected to experience an EPS growth rate of 4%-to-6% from 2014 to 2016. The following chart shows the capital expenditures projected by the company.

Source: Investors Presentation

The following table shows EPS, dividends and payout ratio guidance provided by the company for the next three years.

Source: Investors Presentation

SO has been building two power projects, Kemper County and Vogtle 3 and 4, with electricity generation capacities of 582MW and 2,200MW, respectively. SO, in recent quarters, has announced an increase in estimated costs and delays for the construction projects. Currently, the Georgia Public Service Commission is reviewing and evaluating the ninth/tenth VCM report. If the commission approves the report, 46% of the Vogtle project will be approved and verified by regulators.

However, an increase in estimated costs and delays has increased the risk profile of the company, which could remain an overhang on the stock price in the short term. In the long term, once the projects will be completed, it will strengthen SO's electricity production assets and portend well for the company's performance. The company will provide an update on the two ongoing projects and on future capital expenditure during the earnings release later this month, which will provide investors with clarity and confidence. I recommend investors keep track of the construction of the two projects, as further cost increases and delays might pressurize the stock price in the short term, which I believe will present a good entry point for long term dividend-seeking investors.

Conclusion

Despite the risk of an increase in treasury yields and rotation out of defensive sectors, I believe SO remains a good investment option for long term dividend investors. The company offers a high dividend yield of 4.70%, backed by its solid cash flows. Also, the company's capital expenditures will fuel EPS growth in the future. Moreover, I recommend investors keep a check on the estimated costs and timeline of the two projects. The company is likely to provide an update on the two projects and capital expenditures during the second quarter's earnings release later this month.

Source: Southern Company: A Good Option For Long Term Dividend Investors