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Southern Company – Rising Infrastructure Assets But Look Out For Some Challenging Quarters

Summary Southern Company is one of the largest utilities in America. Will grow to #2 spot by customer count after the AGL Resources purchase. Southern announced its plan to acquire AGL Resources for $8B cash – fueled by debt and equity issuance. The company is a dividend contender having raised dividends for 15 consecutive years; 5-yr dividend CAGR is 3.7% and Chowder Rule is 8.56. The Southern Company (NYSE: SO ) is one of the largest utilities company in America. The company serves more than 4.4 million customers and has approximately 46,000 megawatts of generating capacity serving the Southeast through its subsidiaries. Subsidiaries include electric utilities in four states – Alabama Power, Georgia Power, Gulf Power, and Mississippi Power; a growing, competitive generation company – Southern Power; a licensed operator of three nuclear generating plants – Southern Nuclear; and fiber optics and wireless communications – Southern Telecom and SouthernLINC Wireless, respectively. (Source: September 2015 Southern Company Overview Presentation ) In August 2015, Southern Company announced that it will be acquiring AGL Resources Inc. (NYSE: GAS ) in an $8B cash deal. This combined company will shift Southern from being an electric-only utility company to an electric-and-gas utility company. The customer base is expected to double with this move and pushes Southern to become the second largest utility company in America (by customer count), if the deal is approved. Corporate Profile (from Yahoo Finance) The Southern Company, together with its subsidiaries, operates as a public electric utility company. It is involved in the generation, transmission, and distribution of electricity through coal, nuclear, oil and gas, and hydro resources in the states of Alabama, Georgia, Florida, and Mississippi. The company also constructs, acquires, owns, and manages generation assets, including renewable energy projects. As of December 31, 2014, it operated 33 hydroelectric generating stations, 33 fossil fuel generating stations, 3 nuclear generating stations, 13 combined cycle/cogeneration stations, 9 solar facilities, 1 biomass facility, and 1 landfill gas facility. The company also provides digital wireless communications services with various communication options, including push to talk, cellular service, text messaging, wireless Internet access, and wireless data; and wholesale fiber optic solutions to telecommunication providers in the Southeast. The Southern Company was founded in 1945 and is headquartered in Atlanta, Georgia. A Closer Look The Southern Company has remained focused as an electric utility company through the years. The company has remained a heavy user of dirty fuels such as coal (accounts up to 42%) for its power generation over the years, but has started transitioning to cleaner resources including natural gas, solar and wind. This move will also be welcomed as the company aligns itself with the US government mandate targeting power plants to cut carbon emissions by 32% (by 2030) on the 2005 levels. (click to enlarge) (Source: September 2015 Southern Company Overview Presentation) Acquisition of AGL Resources Inc. In August 2015, Southern Company announced a plan to acquire AGL Resources Inc. for about $8B in cash, fortifying SO’s assets with the natural gas infrastructure. AGL Resources distributes gas in Georgia, Illinois, Virginia, New Jersey, Florida, Tennessee and Maryland. Southern Co. owns utilities in Georgia, Alabama, Florida and Mississippi. (click to enlarge) (Source: September 2015 Southern Company Overview Presentation) This move lowers SO’s dependence on power generation and pushes SO to the #2 spot in the utility sector by customer count after Exelon Corp. (NYSE: EXC ). The combined company will operate 200,000 miles of electric lines and 80,000 miles of gas pipelines. The deal is expected to close in the second half of 2016. Southern Company will be issuing $3B in new stock and also tapping into the debt markets to finance the merger. (click to enlarge) (Source: September 2015 Southern Company Overview Presentation) The deal is expected to raise the long-term EPS growth rates by 4-5%. In addition, the dividend growth is expected to rise faster than current rates. Dividend Stock Analysis Financials Expected: A growing revenue, earnings per share and free cash flow year over year looking at a 10-year trend. A manageable amount of debt that can be serviced without affecting future operations. (click to enlarge) (Source: Created by author. Data from Morningstar) (click to enlarge) (Source: Created by author. Data from Morningstar) Actual: The utility industry is resilient and has seen a slow and steady rise over the years. Revenues and earnings are fairly constant with year-over-year growth ranging between -0.3% to +0.15%. The debt load is also stable and SO enjoys a ‘A-‘ credit rating from S&P. SO has a debt/equity of 1.36 and a current ratio of 0.80. Those numbers can be expected to change significantly over the course of next year or two as the AGL purchase moves closer to closing. Dividends and Payout Ratios Expected: A growing dividend outpacing inflation rates, with a dividend rate not too high (which might signal an upcoming cut). Low/Manageable payout ratio to indicate that the dividends can be raised comfortably in the future. (click to enlarge) (Source: Created by author. Data from Morningstar) Actual: Utility companies are slow and steady growers and are perfectly suited for long-term dividend investors. Southern Company is a Dividend Contender having raised dividends consecutively for 15 years. The 1-, 3-, 5-, and 10-year dividend CAGRs are 3.5%, 3.6%, 3.7%, and 39% respectively. Coupled with a current dividend yield of 4.86%, SO has a Chowder Rule number of 8.56. The current payout ratio is 89%. Outstanding Shares Expected: Either constant or decreasing number of outstanding shares. An increase in share count might signal that the company is diluting its ownership and running into financial trouble. (click to enlarge) (Source: Created by author. Data from Morningstar) Actual: The number of shares have risen steadily over the years and are expected to rise more as the company intends to issue $3B of new equity to finance the AGL deal – approx 66M new shares based on current price, an increase in the number of outstanding shares by ~7%. Book Value and Book Value Growth Expected: Growing book value per share. (click to enlarge) (Source: Created by author. Data from Morningstar) Actual: The book value is a bright spot in the company’s financials. The book value has steadily increased over the years maintaining a nice upward trajectory, although we can expect this to stumble when more debt and shares are issued in the coming years. Valuation To determine the valuation, I use the Graham Number, average price-to-earnings, average yield, average price-to-sales, and discounted cash flow. For details on the methodology, click here . The Graham Number for SO with a book value per share of $22.22 and TTM EPS of $2.35 is $34.28. Based on the last closing price, the stock is currently 30% overvalued. SO’s 5-year average P/E is 18.92, and the 10-year average P/E is 17.80. Based on the analyst earnings estimate of $2.94, we get a fair value of $55.62 (based on the 5-year average) and $52.33 (based on the 10-year average). SO’s average yield over the past five years was 4.60% and over the past 10 years was 4.61%. Based on the current annual payout of $2.17, that gives us a fair value of $47.17 and $47.07 over the 5- and 10-year periods, respectively. The average 5-year P/S is 2.16 and average 10-year P/S is 2.0. Revenue estimates for next year stand at $21.18 per share, giving a fair value of $45.74 and $42.35 based on 5- and 10-year averages, respectively. The consensus from analysts is that earnings will rise at 3.58% per year over the next five years. If we take a more conservative number at 3%, running the three-stage DCF analysis with an 8% discount rate (expected rate of return), we get a fair price of $36.73. The following charts from F.A.S.T. Graphs provide a perspective on the valuation of SO. (click to enlarge) (Source: F.A.S.T. Graphs ) The chart above shows that SO is slightly undervalued. The Estimates section of F.A.S.T. Graphs predicts that at a P/E valuation of 15, the 1-year return would be 2.75%. (click to enlarge) (Source: F.A.S.T. Graphs ) Conclusion Electric utilities in general have seen slower sales industry-wide amid a combination of energy conservation, energy efficiency and shift towards independent power generation/natural gas usage. Coupled with the new regulations from the US government to reduce carbon emissions, electric utilities have started focusing a shift away from dirty fuels such as coal. Southern Company still relies heavily on coal, but has started focusing on cleaner energy alternatives to meet the target. In a move to diversify and fortify its assets, the company is moving to acquire AGL Resources Inc. in a deal financed by new share and debt issuance. While this is good for the overall company’s business, in the short term (over the course of next few quarters/years) some balance sheet damage can be expected as the company takes on more debt and investors see share dilution. An added risk for investors is the potential rise of interest rates by the US Fed. Bond substitutes such as utility stocks suffer the most in rising rate environments. Based on the metrics discussed above, if we give equal weight to all metrics, we get a fair value of $45.31. Full Disclosure: None. My full list of holdings is available here .

Does East Going West Make Sense For Southern Co.?

Southern is copying PCG strategy by combining its electric utility with a natural gas company. The deal will take Southern’s profitability over that of PCG. Its nuclear plant remains a risk. Southern Co. (NYSE: SO ) today announced its most transformative deal to date, an agreement to buy AGL Resources (NYSE: GAS ), parent of Georgia utility Atlanta Gas Light, for $68 in cash, a 38% premium over Friday’s close. Southern will also assume AGL’s debt, making the deal worth $12 billion. Does this make sense? If your interest lies in controlling customers, controlling a regional economy, and maintaining your dividend yield, it makes perfect sense. The model here is Pacific Gas & Electric (NYSE: PCG ), which controls both natural gas and electric utilities businesses in northern California. Over the last year PCG has done much better, as a stock, than Southern, and is still up 9% over the last year despite Monday’s sell-off. Southern, by contrast, has been flat for the year, and is now down. This has happened despite PCG having a much, lower-yielding dividend than Southern, 3.5% vs. 4.9%. It has happened despite PCG having much less control over its home state’s politics than Southern. PCG is in California, while Southern is in Georgia, Alabama, Mississippi and Florida. This means that when someone puts up a solar panel in northern California, PCG pretty much has to buy their excess power. It means that when someone wants to compete against PCG with their own grid, PCG’s ability to fight that is limited. It means that if PCG wants to build another coal-fired or nuclear power plant, and throw that cost on the back of ratepayers over the next 20-30 years, its regulators aren’t going to just roll over and ask to have their bellies tickled. Southern Co. has succeeded in slowing the growth of alternative energy throughout its service area. It has been successful in getting new power plants built and put into the rate base. It has used this to spin a story that it is a more stable investment than a company like PCG, which is subject to both market and regulatory discipline. The market says that argument is nonsense, so Southern is now interested in copying the PCG strategy, at least to the extent of offering heating as well as cooling. The impact of this deal will not be as great as many think, because Southern is much, much bigger than AGL. The combined company had revenue last quarter of $5.014 billion, and $685 million of net income. Compare that to the $406 million in net income on $4.217 billion achieved by PCG over the last quarter – Southern actually comes out a bit ahead with 13.6% of gross going to net against 9.6% for PCG. Then consider the “synergies,” the administrative expenses Southern can cut out, and this looks very good, indeed. Southern still has some serious problems. Southern’s latest nuclear effort has already cost it $1 billion in overruns – Southern subsidiary Georgia Power is on the hook for a little less than half that, $467 million. Can it sell that extra power for enough to justify the expense? That is becoming a real risk. Excepting that, this is a pretty good deal. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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.

Long-Term Potential Not Enough To Change Hold Rating On Southern Company, For Now

Summary Company’s strategy of making hefty growth investments in renewable energy generation projects means it is well placed in capital intensive U.S. utility industry. Analysts anticipating a healthy sales growth rate of 2.10%for SO, above the industry median. Strong growth prospects of the company will grow its cash flow base. I reiterate my hold rating on Southern Company (NYSE: SO ) due to the prevailing construction-related challenges at two important power projects of SO. As a matter of fact, the Kemper and Vogtle project delays have restricted its near-term growth potentials, but in the long run, these projects along with SO’s ongoing renewable energy generation related projects will support its top and bottom-line growths. Given the healthy long-term growth potentials of SO, I believe its cash flows will remain reasonably strong in the years ahead, which will help it improve stock price performance by making increasingly healthy dividend payments to shareholders; SO offers a dividend yield of 4.7%. Near Term Concerns But Healthy Long-Term Waits for SO Over the past few years, the U.S. utility industry has gone through a transformational phase due to aggressive spending by utility companies in several infrastructural growth related projects. I believe the industry transformation is not over yet, because companies like SO, American Electric Power (NYSE: AEP ), Exelon (NYSE: EXC ) and Dominion (NYSE: D ) are still making hefty investments to develop and enhance power generation units. The following map shows the capacity and location of new power projects planned for 2015. (click to enlarge) Source: Minnpost.com SO has also been making capital expenditures to strengthen its power generation assets. In fact, SO has made all-time high growth investments in two major energy generation projects named Kemper and Vogtle, but both projects have been facing construction delays, which have increased construction costs for the company. As far as the 582MW Kemper project is concerned, the project was started with the intent to boost the company’s future growth potentials, but the constant delays and cost overruns at the Kemper construction site are weighing on SO’s profits. The company took the additional charge of $14 million (after-tax) during 2Q’15 due to an increase in the construction cost of the Kemper gasification-combined cycle project. In its efforts to cover these cost overruns, SO had previously signed a case for an interim rate hike of 18% for Kemper’s gasification plants in the state; the rate increase request is recently approved by regulators, which will allow the company to partially offset the increase in construction cost. Although SO’s management expects Kemper to be operational in the first half of 2016, if the project continues to be affected by project delays and cost overruns, I believe the recent rate hike will fail to cover the cost overruns in the longer run, thereby disrupting the company’s profitable margins. Moreover, SO’s plan to build two Vogtle nuclear power plants in Georgia is facing similar delays. Although the management has predicted a three-year delay in the Vogtle project, as per the government’s review, the project will be delayed longer than three-years, costing the company around $8.2 billion . Although issues related to Kemper and Vogtle are both key concerns for the company’s profits, with the commencement of their operations, both projects will act as vital sources of generating strong revenues, earnings and cash flows in the years ahead. Moreover, SO is working hard to grow its renewable energy generation portfolio to hedge against fossil fuel risk and to supply low-cost power to customers. In fact, there are many ongoing and upcoming solar energy generation projects by the company, which contain a strong upside for its future earnings and cash flows. As part of its plan to establish a strong renewable energy generation asset base, SO had acquired the Blackwell Solar facility. Although the acquired facility is currently under construction phase, with the completion of construction, the acquired facility will help the company serve around 11,000 homes. In addition, SO’s plan to construct a new 46MW solar energy generation facility at Marine Corps Logistic Base-Albany has been approved by regulators, which is expected to commence operations by the end of 2016. With this approval, the company’s subsidiary Georgia Power has attained 166MW of solar generation capacity on Georgian military bases. Given the fact that all of the abovementioned power generation projects of SO will improve its production capacity and optimize its power generation portfolio, I expect to witness strong revenues, stable cash flows and healthy earnings growth in the longer run. Analysts are also expecting that SO’s earnings will grow at a decent pace in the years ahead, as shown in the chart below. (click to enlarge) Source: Nasdaq.com Furthermore, SO’s management is also working to convert existing coal-based power generation plants to gas plants. The company has announced in a press release that its 120MW Gadsden plant in Alabama will be switched from a combination of natural gas and coal to entirely natural gas. Given the fact that SO has incurred around $3 billion over the last decade to meet regulatory standards regarding limitation of carbon dioxide emission from coal base plants, I believe the conversion of Gadsden plant on natural gas is a good step by the company, as this allows it to comply with regulations and will portend well for its profit margins in the long term. Investors Remain Rewarded at SO The company has been making healthy cash returns to its shareholders through dividends. Year-to-date in 2015, SO has returned around $34 million in the form of dividends to its shareholders. These healthy dividend payments have earned it an attractive dividend yield of 4.70% . Given the strong growth potentials of the company’s growth investments, I believe SO will have strong cash flows to carry on its policy of making hefty dividend payments in the years ahead. Analysts have also projected growth in the company’s book value per share and cash flow per share, as shown in the chart below. (click to enlarge) Source: 4-traders.com Risks Continuous increases in construction costs at Kemper and Vogtle plants will remain an overhang for the company’s profits in future. In addition, any laxness exhibited by the management during the operational stage of ongoing renewable energy generation projects will result in SO’s failure to report financial numbers as per the management’s plans. Furthermore, harsh weather conditions, unforeseen negative economic changes, strict government regulations and taxes to limit carbon dioxide emissions from nuclear units are key risks that might hamper the company’s future stock price performance. Conclusion Despite the current cost overruns and project delays at SO, the company’s strategy of making hefty growth investments in renewable energy generation projects makes me believe that it is well placed in the capital intensive U.S. utility industry. Analysts also view the company’s long-term growth prospects positively, as indicated by their anticipated healthy sales growth rate of 2.10% , which is well above the industry median of 1.80%. Moreover, the strong growth prospects of the company will grow its cash flow base, meaning more upside for its future dividends. Also, analysts have projected a decent next five-years growth rate of 3.55% for SO. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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.