Southern Company's Premium Valuation In Danger

| About: Southern Company (SO)


Company remains a defensive utility stock.

Has the financial base to tackle cost overruns.

Future earnings remain sensitive to allowed return of equity and recovery of incurred CAPEX.

Company unlikely to trade at premium valuation due to issues related to projects under construction.

Southern Company (NYSE:SO) has remained a popular stock for dividend-hunting investors, as it offers a yield of 4.9%. The company has large exposure to both regulated and competitive markets in the U.S. and is considered a premier utility stock. However, the construction of two ongoing projects, Kemper County IGCC and Vogtle Nuclear, have inflated the company's risk profile. The ever-increasing costs and delays for Kemper IGCC have proved to be a drag on Southern's earnings, and remain a concern for investors. Also, slowing capital spending (MUTF:CAPEX) through 2016 does not augur well for the company's future earnings. The risk attached with the two projects, especially Kemper, and slowing earnings growth (mainly due to decreasing CAPEX) are likely to put pressure on the stock valuation.

The Kemper County IGCC generational project in Mississippi continues to be a pain for investors and continues to weigh on earnings because of delays and cost overruns. In 2013, Southern registered an after-tax charge of $729 million, triggered by Kemper project delays and an increase in expected costs. Moving into 2014, the problems do not seem to be fading away, as the company took another $380 million charge (after-tax charge of $235 million or $0.27 per share) in the first quarter of 2014. The recent charge relates to lower labor productivity due to adverse weather, unexpected installation inefficiencies and labor turnover. Also, the company pushed the expected in-service date for the project to May 31, 2015; the fourth quarter of 2014 was the previous expected in-service date. The extension of the in-service date for Kemper is likely to result in a loss of $120-$150 million bonus depreciation. Also, any further delays beyond the new expected in-service date will cost $25 million per month.

The recovery of Kemper project's costs, through rate base increases, remain limited to a $2.88 billion cap, whereas the recent increase in expected costs brings the total expected costs to $4.44 billion, excluding cost cap exceptions and net of federal grants.

The company's management indicated that the recent cost overrun does not necessitate additional equity needs beyond the previously announced $600 million for 2014. However, in my opinion, any further increase in costs and/or delay for the Kemper project could prompt additional equity needs, which will result in dilution and a further slowdown in EPS growth. An increase in labor costs, loss in productivity and delays in startup activities are the major risks attached to the Kemper project.

Southern is currently in discussions with Mississippi PSC to renegotiate the seven-year rate plan for the Kemper project. Despite this fact, Southern has the financial muscle to observe cost overruns and write-offs. I think that its future earnings remain sensitive to a recovery of costs through rate base increases and allowed return on equity. Therefore, the company needs to present a strong case in front of PSC for cost recovery, as only expenditures deemed prudent will be allowed to be recovered.

The Southern Vogtle nuclear project remains on schedule with the expected in-service dates for Units 3 and 4 being in Q42017 and Q42018, respectively. In my opinion, as the Vogtle nuclear project remains on schedule, it does not currently weigh on the stock price. However, changes to the completion schedule and estimated construction costs for the project could add to investor concerns and prove to be a drag to shareholder value.

Other than a risk to the construction projects, the slowing 3%-5% earnings growth for 2014-2016 remains a concern. Since 2008, the company has been regularly increasing per share dividend by $0.07 per year. With an expectation of slow earnings growth for the next couple of years, the expectation of rising treasury yields and dedication to increase the $0.07 per share dividend every year, the company might be required to increase its payout ratio, which could put stress on stock valuation.

Final Take

Southern Company remains a defensive utility stock. The company has the financial muscle to deal with cost overruns, but its future earnings remain sensitive to allowed return of equity and the recovery of incurred CAPEX. Southern has historically traded at premium valuation in contrast to its peers; however, in the present situation, with uncertainties attached to two construction projects and an earnings growth slowdown, the company is unlikely to trade at premium valuation. Currently, Southern is trading at a forward P/E of 15.3x, versus the utility sector's forward P/E of 16.6x.

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.

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