Southern Company (SO) has enjoyed an impressive rally since it bottomed, in Christmas. The stock has rallied 19% in less than three months and is now trading just 7% off its all-time high. As the recent steep move is very unusual for this slow-moving stock, the big question is whether investors should take their profits and remain on the sidelines for a correction.
Southern has exhibited daunting business performance in recent years. The company has repeatedly raised its estimated cost for its Vogtle nuclear units. In fact, it has incurred so many cost overruns that the current estimated cost, which exceeds $27 B, is more than twice as much as the initial estimate. In addition, the start-up date of the first reactor is now expected to materialize about 5 years later than the initially scheduled start-up. The latest negative development of this drama took place last summer, when Southern raised its cost estimate for the project by another $1.0 B.
However, investors should note that the worst is behind for Southern in the execution of this project. There have been no setbacks since last summer and thus the project is now 74% complete. Moreover, management recently stated that the start-up dates of the two reactors may come a few months earlier than the previous estimates. It is thus evident that management is doing its best to prevent any setbacks in this project, as management has received strong criticism for its poor execution. Overall, the worst seems to be behind the company in this project. This is a major reason behind the recent rally of the stock.
Due to the above-mentioned cost overruns and the acquisition of AGL Resources for $12 B in 2016, Southern has remarkably stretched its balance sheet in recent years. To be sure, its net debt (as per Buffett, net debt = total liabilities – cash – receivables) has more than doubled in the last 5 years, from $42.3 B in 2013 to $86.6 B now. This amount of debt is approximately 28 times the annual earnings of the company while interest expense currently consumes 45% of the operating income. Therefore, this debt load is certainly excessive.
The debt load would be worse if the company did not issue new shares on a regular basis. Southern has diluted its shareholders at a 3% average annual rate in the last 5 years. While this degree of dilution may seem benign on the surface, it is actually a burden to the shareholders and the company. First of all, it has reduced the earnings per share growth to 2.6% per year in the last 5 years. This is lower than management’s targeted 4%-6% annual growth rate. In addition, the greater share count increases the financial burden of the dividend. While the dividend per share has increased only 18% in the last 5 years, the annual dividend paid by the company has jumped 33%.
It is worth noting that Southern has $10.2 B of debt maturities until the end of 2021. As it has been posting negative free cash flows for 5 consecutive years, it will not be able to pay off its debt and hence it will have to refinance most of its debt. Even worse, this will have to occur amid rising interest rates. However, thanks to a series of non-core asset sales, the company expects to dilute its shareholders by only 5%-6% over the next 5 years or 1% per year. This is a great improvement. Nevertheless, as management has repeatedly proved optimistic in its guidance, I expect at least 2% dilution per year.
Just like most utilities, Southern enjoys a strong competitive advantage thanks to the nature of its business. As its business requires excessive capital expenses for infrastructure, it is essentially impossible for competitors to enter the market. Moreover, Southern enjoys reliable rate hikes year after year, as regulatory authorities want to encourage the company to continue investing in infrastructure.
Southern expects to grow its earnings per share at a 4%-6% average annual rate in the upcoming years. While the company has disappointed with its 2.6% annual growth of its earnings per share in the last 5 years, it will almost certainly grow its bottom line at least at the recent pace in the years ahead, particularly given that the execution risk at the Vogtle plant has decreased.
Southern has a strong dividend growth record. It has raised its dividend for 17 consecutive years and has not cut its dividend for 71 consecutive years. Its current payout ratio of 79% is certainly high so the company is likely to continue raising its dividend by 3% per year for the foreseeable future, just like it has done in the last 5 years. In fact, management recently confirmed its intention to keep raising the dividend by $0.08 per year or about 3% per year.
On the other hand, while the above payout ratio is excessive for most stocks, it is reasonable for a utility stock, as this sector is characterized by reliable future cash flows. Moreover, Southern will raise its quarterly dividend next month, most likely from $0.60 to $0.62. As a result, the stock will be offering a 4.9% dividend yield, which will be an almost 8-year high dividend yield.
Therefore, the shareholders of Southern currently enjoy an almost 8-year high dividend yield, which is much higher than the yield of most utilities. In addition, given the commitment of the company to never cut the dividend and the reliable rate hikes it enjoys, investors can rest assured that the dividend will remain in an uptrend for the foreseeable future.
Resilience to recessions
Southern has dramatically underperformed the market in the last 5 years. The stock has gained 17% whereas the S&P has rallied 49%. While a significant part of this underperformance has resulted from the poor business execution of Southern, the remaining part of the underperformance has resulted from the fact that the S&P has enjoyed a 10-year bull market, the longest in history. During bull markets, utilities tend to underperform the broad market.
In the event of a recession, Southern will outperform the market by a wide margin. In the Great Recession, when most companies saw their earnings collapse, the earnings per share of Southern fell only 1%, as its business is almost completely protected from economic downturns. As a recession has not shown up for a whole decade, the resilience of Southern is paramount, even though it is essentially impossible to predict when the next recession will show up.
Southern has enjoyed an unusually steep rally in the last 2 and a half months and is thus now trading just 7% off its all-time high. As this is a slow-moving stock, it is only natural that many shareholders wonder whether they should sell their shares and wait for a better entry point. However, the rally of the stock essentially signals that the worst is behind the company and the execution risk has greatly decreased. As a result, income-oriented investors should maintain their shares, enjoy the 4.9% yield from next month and rest assured that the dividend will keep rising slowly in the upcoming years.
The stock also offers great protection in the event of a recession while the expected return of the S&P from its current almost all-time high level seems limited. Overall, I advise the shareholders of Southern to maintain their shares. If they sell their shares and wait for a correction, they will forgo the quarterly dividends and hence such a market-timing strategy will be risky.
Disclosure: I/we 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.