Southern Company: Solid Dividends, Undervalued Stock

 |  About: Southern Company (SO)
by: Bennington Investment Ideas

The Southern Company (NYSE:SO) is a collection of utilities serving approximately 4.4 million retail customers. Its customers are located across Georgia, Alabama, Florida, and Mississippi, and are serviced through four regulated utilities: Alabama Power, Gulf Power, Georgia Power, and Mississippi Power. SO has approximately 42 Gigawatts of generating capacity and over 25,000 miles of transmission lines. SO constructs generating assets to sell power into the wholesale markets through its merchant division Southern Power. SO also has various interests in nuclear and telecommunications services.

SO had about $17.5 billion in revenue with $14.8 billion in retail revenue from its regulated subsidiaries in 2010. SO has a market capitalization of $34.3 billion and an enterprise value of $55.7 billion, suggesting significant leverage. SO has a strong track record of paying dividends. Its estimated forward dividend yield is 4.8% based upon a closing price of $39.97 and the author's projected annual dividend of $1.928. SO has had a recent track record of 4% annual dividend growth. The following graph shows the historical yield and spread to the 10-year Treasury bond.

Created from data from Yahoo Finance.

One can see that the dividend yield has consistently been between 4% and 6% over the past seven years. Note that the graphed dividend yield is based on the trailing twelve months dividend and a lower yield than the forward dividend yield. The next graph shows the normalized performance of the stock price, the dividend, and the trailing dividend yield.

Created from data from Yahoo Finance.

This shows that the stock price except for the dip in 2009, allowing the yield to spike, has largely kept pace with the dividend increases. This suggests that the growth prospects from five years ago are the same today. The southeastern U.S. has grown considerably, with Atlanta, Georgia leading the way. Applying the dividend discount model to SO shows a potential undervaluation.

The first step to using the dividend discount model is to calculate an equity hurdle rate with the Capital Asset Pricing Model. SO has a beta of 0.31 and with the risk free rate at a very low 2.1% this gives the discount rate to be a 3.9%, which is lower than the recent dividend growth rate. One can look at the valuation using some sensitivities around growth rates and discount rates. The following table shows these figures:

SO DDM Sensitivities
Implied Price Hurdle Rate
Growth Rate 3.9% 4.9% 5.9% 6.9%
1.0% 65.80 49.06 39.11 32.51
2.0% 99.90 65.80 49.06 39.11
3.0% 207.31 99.90 65.80 49.06
4.0% NA 207.31 99.90 65.80
Click to enlarge

Source: Author calculations

The above table shows that SO is potentially undervalued; however, it also highlights a key issue of the dividend discount model which is that as R-G, where R is the equity hurdle rate and G is the growth rate, approaches 0, the implied price approaches infinite. Looking at a slightly higher discount rate, even modest growth suggests that SO is undervalued.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.