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Southern Company (SO) is an electric utility company with operations in the Southeast United States. It serves 4.4 million customers with a majority of its 43,500 megawatts of capacity coming from coal-fired plants.

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Southern currently trades at $45.94 per share. A quarterly dividend increase was recently announced, putting the current yield at 4.23%. Yield is only one component of a dividend stock; the other is dividend growth. Here's a ten-year dividend history for Southern:

YearDividendGrowth
2002$1.35512.1%
2003$1.3852.21%
2004$1.4152.17%
2005$1.4754.24%
2006$1.5354.07%
2007$1.5953.91%
2008$1.66254.23%
2009$1.73254.21%
2010$1.80254.04%
2011$1.87253.88%
2012$1.9425*3.74%

*Quarterly dividend increase already announced

Since 2005 the dividend has consistently increased at about 4% per year. I'll calculate payout ratio as a fraction of free cash flow. The result is shown below.

YearFree Cash Flow (Mil $)Float (Mil Shares)Payout Ratio
2002$114714848%
2003$1,06473295%
2004$582743180%
2005$160749690%
2006$-264748N/A
2007$-150761N/A
2008$-563775N/A
2009$-1,407796N/A
2010$-95837N/A
2011$1,378864117%

Southern Company, like many utility companies, doesn't generate enough cash flow to support capital expenditure and dividends. Net debt as well as the float has increased over time to support the spending, and a plan for the first new nuclear power plants in decades has recently been approved, coming with a price tag of $14 billion. 2011 was the first year since 2005 that the company has had a positive free cash flow, and with large capital expenditures in the near future dividend growth may become threatened.

Valuation

I will use the Dividend Discount model to put an estimated value on the company. This model assumes that the value of a company is purely the sum of all future dividends discounted back today. This is a reasonable valuation method if you are a dividend investor. The discount rate should be your required rate of return, and I will use a discount rate of 8%, which is roughly the long-term growth rate of the market as a whole. I will assume that the dividend will grow by 4% for the next 10 years and 3% after that in perpetuity. Using these parameters I arrive at a fair value of $42.60 per share. The result is shown in the Dividend Value Plot below.

A company with a yield and dividend growth rate that fall on the Fair Value Line in the plot above is fairly valued, a company that falls underneath this line is overvalued, and a company that falls above this line is undervalued. Southern Company falls just under this line, close enough to call the stock fairly valued at current prices.

Conclusion

Southern Company offers a high yield for a fair price, but the dividend is supported by increasing debt and issuing new shares, and this brings into question its sustainability. Clearly Southern is a reasonable investment only for the dividend, and if you believe that the dividend is safe in the long term, then Southern is a fairly valued, high-yield stock that may be worth your consideration.

Source: Southern Company: High Yield, Fair Price, And Questionable Sustainability