Southern Company: Dividend Comfort

Apr. 12, 2021 8:23 AM ETThe Southern Company (SO)144 Comments

Summary

SO has had some issues with large projects.
Earnings, revenue, and dividends have increased anyway.
Priced under $66, SO looks like a good value.
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My 4 Keys For Selecting Investment Partners

I have four key metrics that I look to in determining if a company is a good investment partner. They are increasing revenue or market share, increasing profits or cash generation, handling debt well, and increasing a well-supported dividend. I list the keys in this order because each key builds off of the prior one. For instance, with increasing revenue or market share, it becomes easier to grow the cash the company generates. And all 3 prior keys are what enables a company to increase the dividend while keeping it well supported.

So, how has Southern Company (NYSE:SO) done based on my 4 keys? Let's take a look.

The plot above shows values for my first two keys, changes in revenues and earnings. So while it isn't the steady upward march I prefer, both revenue and earnings are up. Revenue is up almost 17% since 2016 and earnings are up almost 16%. Again, not spectacular, but reasonable. Particularly considering that 2020 was the year of COVID.

Source: Q4 2020 Earnings Presentation

Here we see the earnings number the Southern likes to use. This number excludes a couple of items, the biggest in 2020 being the write-off for projects that are or were under construction. The numbers in the table above are losses from both the Vogtle nuclear plant project and the Kemper coal gasification project.

Some may remember from a few years ago when Southern was developing a coal gasification plant at Kemper. The idea was to use cheap lignite coal to produce natural gas to run a power plant. It proved to be significantly harder to turn lignite coal into clean natural gas than originally thought and the technology never ran for long periods of time without costly shutdowns to effect repairs. Natural gas prices also dropped dramatically making the whole project even less viable. The write-offs for the mine and gasification lines were still producing charges in 2019.

The Vogtle project is yet another big project that has run into delays and cost overruns. Southern plans to add 2 new reactions to a facility that already has 2 reactors. It has run into numerous delays that have pushed the costs up. The latest delays are due to COVID, which added $0.23 a share in costs in 2020. The good news is that Reactor 3 is scheduled to go online (and thus stop burning cash and instead producing it) in November of this year. Reactor 4 is currently scheduled to go online in November of 2022.

In the table above we can see that the EPS figure with items excluded is $3.25 for 2020. For 2016 that figure was $2.89. Since 2016 that means EPS has increased at a CAGR of 2.98%. This is not huge or spectacular but is reasonable especially considering how hard a year 2020 was.

My third key, managing debt effectively, can be illustrated with 2 slides from the latest earnings presentation.

Source: Q4 2020 Earnings Presentation

First, we can see that over the next 3 years, Southern will need to refinance about $8.5 billion in debt.

Source: Q4 2020 Earnings Presentation

Over the next 3 years, Southern Company plans to borrow some $13.7 billion, which exceeds the amount of old debt coming due by more than $5 billion. Each subsidiary also has plans to raise more new debt than it has old debt expiring with the exception of Southern Power. But its shortfall can easily be made up by the new money that the parent company will get. Coupled with a capital investment plan that targets state-regulated utilities (with their guaranteed return) I see this borrowing plan as a sign that Southern Company management is using debt very well.

Further evidence of good debt management beyond lining up financing to pay for growth and older debt maturing is when the company taking actions to reduce the cost it pays for the debt it has.

Source: Q4 2020 Earnings Presentation

This slide, from the latest earnings presentation, shows financing activity during 2020. Not only was management about to lower the long-term average debt cost, but it was able to extend the terms of the debt while doing so. As I expect longer-term rates to begin creeping up this year, locking in lower rates for longer means more certainty in the costs of debt, and more cash left to pay shareholders.

Finally, we see how the dividend has increased over the last 5 years. It has the ideal upward stair-step pattern that I like. Nice regular predictable yearly increases.

The Elephant in the Room

Big technologically complex projects have been a problem for Southern Company for years. At times the market discounted the price more than was justified by those problems. But this is still an issue that needs to be carefully examined.

One such big project, the Kemper coal gasification project, is now firmly in the past. 2019 looks to be the last year where Southern Company had charges related to that failed project.

The other big project, the two new nuclear plants at Vogtle, continues. And continues to incur cost overruns. The latest delays were caused by COVID. But we can see the light at the end of the tunnel. Reactor #3 is supposed to begin operations this coming November.

Currently, the project is running behind on starting a test that is called HFT, or Hot functional testing. Hot functional tests on a new reactor help simulate thermal working conditions of the power plant before nuclear fuel is loaded. Late in March, Southern released that it had to do some remediation work before such tests could be conducted and this would delay testing until April. While the company said the project was still on schedule, given past issues, this likely means Reactor #3 will be a month or more later coming online.

Source: Q4 2020 Earnings Presentation

Management estimates that each month of delay in Reactor #3 coming online will cost approximately $25 million, so I expect we will see a total of $50 million or so more of costs beyond the figures management presented in the Q4 report.

There hasn't been a new nuclear plant constructed in the US in over 3 decades. The new projects to build them were structured poorly so that there was no incentive to contain costs. And then the events in Japan caused considerable safety changes to be required. These facts doomed projects in South Carolina and Florida. The two Vogtle reactors look to have survived and are close to completion. Within a year, we should see the newest nuclear reactor enter service in the U.S.

How Safe is the Dividend?

My analysis of how safe the dividend is starts with CFFO (Cash Flow from Operations). While companies have other means of getting cash to pay the dividend, CFFO is the most repeatable and reliable source. I then look to see how bad the wheels have to come off for CFFO not to cover the dividend after 5 bad years.

For Southern Company, I start with CFFO from the latest 10-K. I will assume that the CFFO for the next 12 months will be the same as it was for 2020, or $6.696 billion. There are currently 1.056 billion shares outstanding. I will assume that to raise more cash, management will increase the share count by 1% each year. Currently, $15 million is required to cover the dividends on preferred shares, and I will assume that this increases 5% a year as management sells more to get more cash. Finally, management has a $40 billion CAPEX program in place and while they will borrow most of that money, I assume they will use about $2.5 billion of CFFO each year to help fund the program (so they will borrow approximately 75% of the money).

Source: Author's calculations and company data

I also project a 3% increase in the dividend and assume that the dividend increase this year will be 2 cents a share per quarter. Using those values, I calculate that CFFO would have to decrease an more than average of 3.5% for 5 years before the CFFO would no longer cover the dividend. That tells me that the dividend is reasonably safe.

What is a Good Price?

To figure out a good price, I do a DDM calculation using my Excel-based DDM calculator (pictured below, you can see the web-based calculator I based it on here and read a discussion on how the formulas were developed here). I also found this discussion of DDM, and note that in the article the author uses a discount rate of 5%.

Looking at the David Fish CCC List (which contains data on companies that have raised their dividend each year for 5 or more years) I see that the current dividend for SO is 64 cents a quarter. Since 2016 the raise each year has been 2 cents. To be a bit conservative I will assume a slightly lower than normal dividend bump and estimate that the dividend for the next 12 months will total $2.60. The two cents a quarter bump is roughly 3%, which is close enough to the growth in EPS to be a good value to use as well. I will use 2% as the terminal dividend growth rate because that will solve that term of the calculation to match a yield of 4.4% which is a bit lower than the current market price would produce.

Source: Author's calculations and company reported data

Using those parameters, I calculate that the NPV (Net Present Value) of the projected dividend stream is $65.40. That sets my buy under price at $66. SO closed at $62.73 this makes SO a good value at this time.

Conclusion

Southern Company has struggled with big projects. Much of that is now in the past and the remaining large project is nearing completion. But even during the worst of its struggles, the dividend for SO was increased like clockwork. Dependable dividends are what I want and SO has produced them. Looking forward, it looks to me like this earnings and dividend dependability will continue. And the current price is a good value. SO looks like a good buy under $66.

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This article was written by

PendragonY

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Beginning in October of 2018 I began working with Rida Morwa and his team at HDO. I both write articles in collaboration with the HDO team and on my own. Contributing authors, if any, will be listed after the bullet points at the start of articles.

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I have been a software engineer developing applications in various fields for over 30 years. I began investing in mutual funds for my 401(k) back in 1988.I started investing outside of my retirement account a little over 23 years ago. I used to follow a value oriented strategy, but after I saw how that worked during the financial crisis, I began to switch over to a more income based approach. I have been an income investor since around 2009 and have only written income investor focused articles for SA.

I long ago switched my portfolio to a DGI strategy but more recently focused on the more immediate income implementation of that strategy..
One of my most profitable picks turned out to be Freddie Mac, which I originally chose because I liked the dividend and because I once worked there. When it first ran into problems I increased my holdings because it still looked like a good value to me. I eventually managed to buy several thousand shares at a cost of $0.50 (I knew that was a good value) and eventually exited the stock at a price that was $5 a share above my average share cost.
My biggest miss was when I sold out my 100 shares of Apple shortly after Steve Jobs returned but before he had done much to improve the companies outlook. You can see my holdings here :

https://seekingalpha.com/instablog/5663201-pendragony/5279959-dividend-growth-portfolio-summary-page

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