The Southern Company: What To Expect Next?
Summary
- My last articles performed analyses focusing on the specifics and ROCE of the Southern Company.
- This article reviews the return drivers in the past decade, and then provides an outlook for the next one.
- The results unfortunately suggest that it is unlikely that the past decade's performance can be repeated for the next one.
Thesis and recap
My last articles performed analyses focusing on the specifics and ROCE of the Southern Company (NYSE:SO). This article reviews the return drivers in the past decade, and then provides an outlook for the next one. The results unfortunately suggest that it is unlikely that the past decade performance can be repeated for the next one.
Much of the details of the company and its operations has been covered in my earlier articles. Here we will just briefly recap the most relevant information to facilitate the new in-depth discussions. SO has been a very stable and reliable utility stock. It is on its way of becoming a dividend aristocrat – it has been steadily increasing its dividend for an impressive 21 years consecutively so far. As seen in the chart below, its dividend yield has been bounded and stable between about 4% to 5% almost all the time. And currently, the yield is toward the lower end, suggesting overvaluation, but not out of the ordinary range.
Source: author based on Seeking Alpha data.
The following table shows a valuation of SO primarily based on its yield. At its current price levels, it is slightly overvalued in terms of dividend yield (by ~3%). By its historical PE multiple, it is about 10% overvalued. Based on its historical valuation record, a total return around 6~7% annually is expected in the next a few years as detailed in my early articles.
Source: author based on Seeking Alpha data.
Return drivers in the past decade
Building on the earlier works, this article reviews the return drivers in the past decade, and then provides an outlook for the next one.
As seen from the next three charts, SO investors have been decently rewarded in the past decade through a combination of earning growth, dividend, and valuation expansion. The stock delivered 154% of total return over the past decade, translated into an almost double digit CAGR of 9.8%.
The above return was driven by three factors as illustrated in the next two chart. EPS growth is the first driver as seen from the second chart. Over the past decade, SO was able to grow the EPS at 3.1% CAGR. Second, thanks to a long bull market, PE expansion is the second driver as seen in the second chart, contributing 2.13% CAGR into the total return. Lastly, dividend reinvestment contributed the remaining 4.54%, making it the largest contributor. This chart really highlights the power of dividend reinvesting for a dividend growth stock.
Now looking forward, the natural questions are: can these same return drivers be repeated? And if not, what will the return drivers look like in the next decade?
And we will examine these questions immediately below.
Source: Seeking Alpha
Source: Author based on Seeking Alpha data
Source: Author based on Seeking Alpha data
Will the PE expansion continue?
Unfortunately, my view is no. I do not expect the PE expansion experienced in the past decade to continue for the next decade. The following chart shows the annual average PE of the stock in the past decade. As seen, the average is 16.7x and the standard deviation is ~1.8. The current PE is about 2 times deviation away from the mean, a two-sigma event. Obviously, there is no reason why the PE has to return to the mean or why it cannot further expand into a 3-sigma event. But for a stable and well-established stock like SO, there is no reason to expect a sudden quantum leap in its valuation either. And a large part of being a conservative investor means to be aware of the rule of reverse selectivity – I am more inclined to expect something old to repeat itself again than to expect something completely new to show up.
Source: Author based on Seeking Alpha data
Will the EPS growth continue?
My take on this question is yes. In the long term (like 10 years or more), the growth rate is “simply”:
Longer Term Growth Rate = ROCE * Reinvestment Rate
ROCE stands for the return on capital employed. Note that ROCE is different from the return on equity (and more fundamental and important in my view). ROCE considers the return of capital ACTUALLY employed, and therefore provides insight into how much additional capital a business needs to invest in order to earn a given extra amount of income – a key to estimate the PGR. The reinvestment rate is the portion of income the business plows back to fuel further growth.
So to estimate the long term growth rate, we need to estimate two things: ROCE and reinvestment rate.
To estimate the ROCE of businesses like SO, I consider the following items capital actually employed:
1. Working capital, including payables, receivables, inventory. These are the capitals required for the daily operation of their businesses.
2. Gross Property, Plant, and Equipment. These are the capitals required to actually conduct business and manufacture their products.
Based on the above considerations, the ROCE of SO over the past decade are shown below. As seen, SO was able to maintain a relatively stable ROCE over the past decade with an average of 9%, a respectable level of profitability in the utility sector.
Source: Author based on Seeking Alpha data
Now let’s see the reinvestment part. The following chart shows how SO has been allocating its income in the past decade. As can be seen, dividend and maintenance CAPEX have been the major items, costing on average 83% of operation cash (“OPC”). Neither cost is optional. For a dividend stock like SO, the dividend is not really optional – it probably will be the last cost that management is willing to cut. Maintenance CAPEX is simply what it takes to keep the business running.
For the remaining 17%, the company does have a choice. It can use it for a variety of things: reinvest to fuel further growth, pay an extra special dividend, pay down debt, buyback shares, et al. And the next chart shows what kind of growth rate the business would be able to achieve if different portions of this dispensable income is reinvested in the business.
Source: Author based on Seeking Alpha data
This following table shows the long-term growth rate at different combinations of ROCE and reinvestment rate. The color in the background shows the possibility of each combination. The darker the background color, the more probable the scenario is expected to materialize. And the numbers highlighted in red are the most likely scenario given the average ROCE in the past decade and the reinvestment rate that makes sense to me for a business at SO’s scale. Note that in this table, I also added 2.5% of inflation to the growth rate. So as a result, even when the reinvest rate is 0%, it would still have a growth rate of 2.5% because of inflation. I think this is justified as utilities has demonstrated in the past it has the pricing power to pass on inflation cost to customers. As seen, I do not expect the SO would be able to low back all 17% of its dispensable income into grow for various reasons. One thing is to manage debt. The past decade has seen a steadily decline of debt cost, and this trend obviously could not continue indefinitely.
Putting all the above considerations together, as shown from this analysis, a growth rate in the 3~4% range is expected for the next decade.
Source: Author
Putting it all together
Now we can put all the pieces together and make some observations for the outlook in the next decade.
What I always like to do is a reality check as shown in the chart below. It is essentially a back of envelop calculation to estimate what is the growth rate and valuation required to deliver a target ROI in the next 10 years. And see if such growth rate and valuation can pass a common sense test. To make it really simple, let’s assume dividend and earning grow at the same rate, and dividend are not reinvested.
As an example, if we require a 10% annual ROI, represented by the black line (10% annual return translates to 160% total return in 10 years because 1.1^10=260%), the growth rate will have to be about 7% if the PE ratio does not change from its current level. And if the PE contracts to 16.7x (the historical average) as shown by the green line, the growth rate would have to be about 8% to deliver the required 10% ROI.
With the above background, the purple box symbolizes what I think would be the expected region for the next 10 years. Based on the discussions we had in the earlier sections, the reasons are:
1. For the valuation - I do not expect the PE to further expand from here. I would consider it a lucky case the PE stayed at the current level.
2. For the growth rate – as aforementioned, I consider somewhere between 3% to 4% the most likely scenario given the average ROCE in the past decade and the reinvestment rate that makes sense to me for a business at SO’s scale.
Under the above arguments, the expected return would be 5% to about 8% in the next decade as highlighted by the purple box. And to achieve the high end of the return, we’d need to have some luck on our side. Valuation has to remain at the current record level.
Lastly also note that the result is consistent with my past analysis, which was obtained from a completely independent approach (valuation of SO as a bond).
Source: author
Conclusion and final thoughts
This article reviews the return drivers of SO in the past decade, based on which an outlook for the future is then provided. The past 10 years represented an extra-ordinary period for SO investors, with a near double digit return for a stable utility business. Such return was aided by a long bull market in the background, steadily declining borrowing cost, and valuation expansion. Looking forward, I expect many of these factors to either discontinue, stabilize, or even reverse, and as a result leading to lower expected total return in the mid- to upper single digit (say 5% ~ 8%).
Nonetheless, 5~8% total return in the long run, when adjusted for risks involved in SO, is still a respectable investment opportunity. For investors interested in a utility stock, SO is overall a solid candidate considering its current valuation, profitability, and safety.
Thx for reading! See you next time and let me know your comments and thoughts!
This article was written by
Envision Research, aka Lucas Ma, has over 15+ years of investment experience and holds a Masters with in Quantitative Investment and a PhD in Mechanical Engineering with a focus on renewable energy, both from Stanford University. He also has 30+ years of hands-on experience in high-tech R&D and consulting, housing sector, credit sector, and actual portfolio management.
He leads the investing group Learn more.Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
Recommended For You
Comments (18)
