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Southern Company: Invest While The Yield Is Still High

Summary Blue-chip utility Southern Company yields over 4.5%. Southern Company has healthy relations with regulators. The southeast region is one of the fastest-growing regions in the U.S. Bonus: Live fully functioning earnings and price-correlated graph on Southern Company. Introduction In consideration of today’s low interest rate environment, fixed income securities offer little in the way of return. Moreover, the safety characteristics normally associated with fixed income are also potentially upside down. Since early 1982, the interest rates available with fixed income have been in a continuous freefall. This has presented both good and bad news for the conservative investor desirous of a high and safe income stream on their portfolios. The good news is that bond prices move inversely with interest rates. Therefore, when interest rates drop, as they have done since 1982, the prices of previously issued bonds will rise. Therefore, fixed income investments, primarily bonds, have provided the opportunity for high yield and either capital appreciation or at least stable prices. This falling interest rate trend has gone on for more than three decades, and as a result, fixed income returns have been abnormally strong and even high. However, the first part of the bad news is that fixed income investors need to understand that previously issued bonds will move to a premium valuation as rates are dropping, but will eventually move back to par when they mature. Consequently, the only way to lock in capital appreciation in addition to your interest income would be to sell your bonds before they mature. Otherwise, temporary capital gains created by falling rates will inevitably dissipate to breakeven levels. As a result, investors that hold bonds to maturity will in effect suffer losses of purchasing power due to inflationary forces. On the other hand, the additional bad news is that falling interest rates result in the inability to reinvest in newly-issued fixed income instruments at rates that are attractive. But the worst bad news is that those investors purchasing fixed income at today’s extremely low rates are exposing their capital investments to potential losses in a rising interest rate environment. Investors need to understand that bond prices fluctuate just as stock prices fluctuate. If future interest rates move higher, and if that were to happen quickly, originally issued bond prices could drop just as much as stock prices did during the Great Recession. Bonds are considered safe because they mature at par; however, bonds are also liquid. Therefore, bond prices can, and do, fluctuate between their issue date and maturity. Fairly Valued Utility Stocks for Income and Safety Consequently, and as the result of the fixed income dynamic discussed above, I have been, temporarily at least, eschewing fixed income. In other words, I have been recently looking for viable alternative income-producing opportunities. Importantly, I am just not focused on finding higher income streams; I’m also concerned about finding income-producing alternatives with reasonable safety characteristics. I believe that carefully selected utility stocks can fit the bill, as long as they are purchased at sound or attractive valuations. Stocks and bonds are different investment types and therefore possess different investment merits and characteristics. In other words, I believe it would be a stretch to state that utility stocks are perfect fixed income alternatives. On the other hand, utility stocks, when purchased at sound valuation, do possess and/or share characteristics with bonds that are similar enough to consider them a reasonable alternative. When interest rates are at normal levels, bonds pay higher interest income than most blue-chip dividend paying stocks provide in dividend yield. Furthermore, since bonds provide an implicit guarantee of returning principle at maturity, they also provide a level of safety not normally associated with stocks. However, it is also true that all dividend paying common stocks are not the same. Utility stocks are generally regulated monopolies, and as such, have a history of producing reliable and consistent earnings growth and above-average levels of dividend income. Nevertheless, even though the earnings growth on utility stocks is generally consistent and reliable, earnings and dividends generally do not grow very fast. Regulation provides consistency and a level of reliability, but at the expense of higher or above-average growth potential. Southern Company High-Yield Sound Valuation Southern Company (NYSE: SO ) is a blue-chip utility stock that is considered one of the strongest among its peers. The two primary reasons supporting this view are the relatively friendly regulatory environment they operate in, and the better-than-average economic fundamentals associated with its region. Headquartered in Atlanta, Southern Company dominates the power business serving both regulated and competitive markets across the southeastern region. For example, Zacks considers Southern Company one of the largest and best managed electric utility holding companies in the United States. Operating in one of the fastest-growing and strongest regions of the country, Southern Company is a holding company for four regulated Southern electric utilities that serve about 4.4 million customers. Those utilities are Georgia Power, Alabama power, Gulf Power, and Mississippi power. Additionally, Zacks estimates that Southern Company’s impending acquisition of AGL Resources (NYSE: GAS ) could double its customer base and generate more revenues. However, this additional growth potential is slightly mitigated by what many consider the high valuation (approximately $28 billion) they paid for AGL. The following earnings and price correlated graph on AGL illustrates the premium valuation that Southern Company is paying. (click to enlarge) On the other hand, when looked at from the perspective of the 3- to 5-year trendline growth estimates for AGL Resources, the valuation that Southern Company might be paying appears more reasonable. These long-term growth estimates may in fact be reasonable, and more importantly, could provide a meaningful benefit to Southern Company. Considering that Southern Company currently generates approximately 40% of its power from coal-fired plants, the AGL acquisition could provide a breath of fresh air (pun intended). According to MorningStar: “If the AGL deal closes, Southern will operate 7 gas LDCs, including a core Georgia business and a large LDC in Illinois, while gaining stakes in two midstream gas projects with upside to more.” MorningStar also believes that: “Southern Company operates in the business friendly Southeast, where its relatively low power prices and sterling reputation help to foster a constructive and stable regulatory atmosphere.” The following Short business description courtesy of S&P Capital IQ provides further insight into Southern Company and its businesses: “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.” The biggest negative I see with Southern Company relates to issues within their nuclear power businesses. Cost overruns on their Georgia Power nuclear projects, principally Vogtle, do raise some concerns. However, I think those concerns are exaggerated given the diversity of Southern Company’s diverse electric generating businesses. Investing In Utility Stocks at Sound Valuation Is Critical When investing in low-growth companies like utility stocks, getting valuation right is even more critical. Just as it is with all companies, utility stocks can become overvalued from time to time. However, since utility stocks do not grow very fast, overpaying for future earnings can dramatically destroy the dividend income advantage that utility stocks typically offer. Paying too much for a low growth enterprise can easily result in long-term capital losses and future earnings will generally not be large enough to bail you out. You can test this statement by utilizing the following live earnings and price correlated Southern Company graph. Bonus: Live Fully-Functioning Historical F.A.S.T. Graphs on Southern Company In order to assist the reader in understanding Southern Company’s current valuation and historical operating achievements, I offer the following live fully functioning historical F.A.S.T. Graphs on the company. Furthermore, to get maximum benefit from this exercise, I offer the following tips on how to utilize and navigate the live graph. At the top of the graph, there are orange rectangles representing different historical time frames. For example, you can click on the orange rectangle 10Y and the graph will automatically draw a graph over 10 calendar years. Therefore, you can quickly move from one time frame to the next and evaluate changes in earnings growth rates and historical normal P/E ratio valuations over each respective time frame. There is also a scrollbar at the bottom of the graph that allows you to focus on any historical time frame of your choosing. At the bottom of the graph, there is a long orange rectangle that allows you to take the graph apart or rebuild it by simply clicking on any of the words. For example, if you click on the word “Price,” monthly closing stock prices will be taken off of the graph and you can replace them by simply clicking on the word “Price” again. You can do this with all of the items located in the orange rectangle. But most importantly as it relates to the thesis of this article (valuation) the graph also has a built-in performance calculation feature. Simply point and click your mouse on any price point on the graph (the black line) until a red dot appears. Then simply move your mouse to any other price point on the graph and click it and a pop-up will appear with the calculation of the performance over the time frame you chose. To erase the calculation, simply point and click on your second red dot and you will be ready to perform another calculation. Note: all these calculations are based on purchasing and holding one share of the company’s stock. I suggest the reader utilize this calculation function feature in order to evaluate the effects that valuation has on long-term performance. You can measure periods of time from high valuation to low valuation (when price is above the orange valuation reference line), from low valuation (when price is below the orange valuation reference line) to high valuation, etc. As you perform these calculations, notice the effect that various levels of valuation have on long-term performance over time. I hope you have fun performing these various calculation exercises, and I hope they reveal and solidify the important effect that valuation has on long-term returns when investing in utility stocks. Southern Company’s Income Advantage The following detailed performance report on Southern Company since 1996 illustrates the significant income advantage it has provided shareholders compared to an equal investment in the S&P 500. Total cumulative dividend income from Southern Company would have been almost twice as high as the index would have provided. However, due to the low earnings growth rate that Southern Company (and utility stocks in general) has generated, higher yield came at the expense of capital appreciation. Nevertheless, in contrast to long-term bonds held to maturity, Southern Company did produce some capital appreciation in addition to its high dividend income generation. (click to enlarge) Reinvesting Dividends in High-Yield Southern Company Levels the Playing Field The above historical performance report on Southern Company validates the income advantage that a blue-chip utility stock investment can provide. However, for those investors focused more on total return, a low growth high yield utility stock like Southern Company can level the total return playing field – if you reinvest your dividends. As the following performance report on Southern Company with dividends reinvested each quarter illustrates, the high income advantage remains. On the other hand, the capital appreciation (total return) advantage that the index held without reinvesting dividends disappears. With dividends reinvested, the total return on Southern Company and the S&P 500 end up in a virtual dead heat. I believe this validates the power and protection that high-quality high-yield dividend paying stocks offer. This is especially true when a low growth high yielding utility stock like Southern Company is originally invested in when valuation is sound. On that note, I would like to add that both Southern Company and the S&P 500 were soundly valued at the beginning of 1996. Therefore, the return comparisons over this time frame are apples to apples from a valuation perspective. Additionally, the virtual tie in total return between Southern Company and the S&P 500 happened even though Southern Company only grew earnings at 2.5% while the S&P 500 grew earnings at 6.1% over the same time period. (click to enlarge) Additional supporting fundamental metrics on Southern Company Returns on invested capital (ROIC) is an important consideration when evaluating utility stocks. After hitting a low point in the last fiscal quarter of 2014, Southern Company has been steadily improving each quarter in 2015. I consider this a comforting accomplishment. (click to enlarge) In concert with an improving return on invested capital, Southern Company’s bottom line has also been steadily improving throughout 2015. Southern Company’s net profit margin per quarter (npmq) in 2015 has increased from 7.04% to 17.6% in their most recent quarter ending in September 2015. (click to enlarge) Southern Company’s revenues for quarter (revq) have also been improving throughout 2015. Importantly, revenues had recovered to 20-year highs in 2014, and 2015 is on track to be even higher. (click to enlarge) But perhaps most importantly, since I’m attracted to Southern Company for its dividend yield, cash flow per quarter (cflq) strongly support dividends for quarter (dvq). Southern Company is a Dividend Challenger on fellow Seeking Alpha author David Fish’s CCC lists that has raised its dividend for 15 consecutive years. Moreover, southern company has paid a dividend every quarter since 1948. (click to enlarge) Summary and Conclusions I consider Southern Company a strong and healthy utility stock that can currently be purchased at a sound and attractive valuation. At current levels, its dividend yield is approaching 5%, and I believe this represents an opportunity for investors in need of current income. Consequently, I would recommend purchasing Southern Company as long as its yield remains above the 4.5% level or better. In today’s low interest rate environment, a current yield above 4% with the potential for modest capital appreciation to fight inflation looks attractive. Southern Company, like most utilities, is not offered as a high total return opportunity. Instead, I suggest that is most suitable for those investors, including retired investors, that are looking for high current income and reasonable safety. Disclosure: Long GAS Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Buy Dominion Resources For A Nice Dividend And High Analyst Price Targets

Merrill Lynch has a price target 17% above current price of $67.9. Analysts are getting generally more positive on utilities after a year of relative underperformance. The company is one of the safest investments in the market right now. In his now legendary book, The Intelligent Investor, Benjamin Graham writes that the goal of a conservative investor is to look for investments that are likely to provide safety of principle and an adequate return. His disciple, Warren Buffett has put it slightly differently saying, “The first rule of investing is don’t lose money. The second rule is don’t forget the first rule.” Utility companies in general are a good place to look for this type of conservative investment, and it doesn’t get any safer than Dominion Resources, Inc. (NYSE: D ). D is one of the nation’s largest utilities with a market cap of over $40 billion and rock solid fundamentals. In addition to the company’s great fundamentals is the fact that analysts are lining up with price targets higher than the current price across the board. Merrill Lynch recently set a price target of $80 a share. While this is one of the higher targets, the mean target among a relatively large sample of 17 brokers isn’t far off at $78. Both of these figures provide generous upside to the stock, especially for a utility company that usually trades within a tight range. Research firm Guggenhiem also rates the stock a “buy”. D recently posted quarterly YoY earnings growth of 12% with a profit margin of almost 15%. This is a much higher margin than the industry average of 8-10%. With a forward P/E of 17, the company looks fairly valued. While 17 is slightly higher than average for a utilities company, in this case the higher multiple reflects the high quality of the company. As mentioned above, there aren’t very many utility companies that have 12% margins are growing the bottom line by 15%. This helps to make the 3.7% dividend sustainable. The company’s ROE of 14.54% is also quite strong for a utilities company, so it appears as if D is outperforming the industry pretty much across the board. As if all of the above weren’t enough to convince the conservative investor in the value of D as a safe long term bet, the stock has been picked as a top dividend stock by the Dividend Channel’s “DividendRank” report . The lowest the stock has traded in the last 52 weeks is $64 a share, which is only $4 below the current price, which is a technical indicator that points to short term upside. So by almost any measurement the stock is either fairly valued or undervalued. I rank the stock a strong “buy” for the investor looking for long term safety of principle and an adequate return. And of course we can collect the nice dividend while we wait.

Are Utility Stocks In A Bubble?

Summary Utility stocks have benefited significantly from extremely low interest rates over the last 5+ years. Yield-starved investors have chased the sector, and utilities’ high debt loads have benefited from lower financing costs. The utilities sector plunged over 3% on Friday with expectations rising for the first Federal Funds rate hike in nearly 10 years. We look at the sector’s current yield relative to history and how it performed during the last period of tightening. Utility stocks pay some of the safest dividends around and typically sport much higher dividend yields than the market, reflecting their low growth prospects and making them a favorite source of income for retirees living off dividends . Many dividend investors wonder if favorite utility stocks like Duke Energy (NYSE: DUK ), National Grid (NYSE: NGG ), NextEra (NYSE: NEE ), Dominion Resources (NYSE: D ), and Southern (NYSE: SO ) are in a bubble today after benefiting from extremely low interest rates for more than six years. Utilities were clobbered on Friday after strong employment data strengthened the likelihood that the Fed would raise interest rates next month for the first time since mid-2006. The fear is that many investors flooded into higher yielding stocks like utilities because they could not earn enough safe income from the very low yields bonds offer today (see below). Once bond yields begin to rise as the Fed gradually raises its target interest rate, these investors might sell their stocks to purchase bonds. Source: Simply Safe Dividends , Federal Reserve Bank of St. Louis As seen below, we have been living in unprecedented times over the last seven years, with the Fed’s target interest rate remaining just above zero percent. It has never been this low for this long before, so there is plenty of uncertainty regarding how an eventual interest rate increase, as early as December, will impact markets and yield-sensitive sectors like utilities. Have these safe haven sectors been artificially inflated by the Fed’s easy money policy? Will they pop when interest rates begin to rise? Source: Simply Safe Dividends, Federal Reserve Bank of St. Louis Many dividend investors are clearly worried. On Friday, November 6th, a strong US payroll report came out. The Fed watches employment figures and inflation to determine its stance on interest rates, and the strong jobs report signaled that a rate hike in December was now almost a certainty. This would be the first rate increase since 2006. Immediately, many dividend aristocrats and utilities sold off hard. The XLU utility ETF finished the day down more than 3.5% despite the S&P 500 finishing about flat. Clearly the knee-jerk interest rate trade is to sell higher yielding, slower growing companies like utilities in favor of interest rate beneficiaries like banks (the Financials sector was the strongest performer on Friday) and more cyclical growth companies that would benefit the most from an improving economy. Before diving into utilities in particular, let’s take a step back and look at the S&P 500’s dividend yield relative to its history and the Federal Funds Target Rate. As seen below, the S&P 500’s dividend yield sits just below 2% today compared to the Federal Funds Target Rate of 0.25%. If we were living in a dividend stock bubble that could be popped by rising interest rates over the next few years, we would expect the market’s dividend yield over the past several years to be extremely low relative to history. Source: Simply Safe Dividends, Federal Reserve Bank of St. Louis However, this is clearly not the case. The last time interest rates were exceptionally low was during 2003 when they sat at 1% for several quarters before tightening significantly to 5.25%. During 2003, the market’s dividend yield hovered around 1.5%, 25% lower than today’s dividend yield. We can also see the market’s extreme euphoria during the tech bubble when the S&P 500’s dividend yield dipped to 0.98%, half of today’s yield. Perhaps most interesting is the period from 2004 through mid-2006 when the Fed tightened interest rates from 1% to 5.25%. The market’s dividend yield increased around 20%, from 1.5% to 1.8%, but both of these yields are still lower than the market’s yield today. While certain parts of the market are likely more vulnerable than others during a period marked by rising rates, the entire class of dividend paying stocks does not appear bubbly relative to the last 20+ years of market data that we can observe, especially relative to current interest rates. What about the utilities sector? The Conservative Retirees dividend portfolio we oversee has meaningful exposure to utilities and REITs. As you can imagine, Friday wasn’t a great day. While we don’t lose any sleep over our holdings’ abilities to continue paying and growing their dividend payments, we remain mindful of the portfolio’s overall total return potential (income and price return) and continuously look to minimize our downside risk. If utilities and REITs are in a bubble, we should seek returns elsewhere until conditions normalize as a result of rising interest rates. The chart below compares the annual total return of the S&P 500 (blue bars) and the Utilities sector (red bars). The Federal Funds Target Rate (green line) is also displayed to highlight periods of rising and falling rates. Many investors are quick to assume that higher yielding dividend stocks like utilities will be major underperformers over the next five years as interest rates gradually rise. Source: Simply Safe Dividends, Federal Reserve Bank of St. Louis However, we can see that during the last period of rising rates, from 2004 to 2006 when rates increased from 1% to 5.25%, the utilities sector actually outperformed the S&P 500 in each of those years! Despite four straight years of outperformance relative to the market during 2004-2007, utility stocks still significantly outperformed during the 2008 market crash. 2014 was a huge year for the utilities sector, which returned about 30% and easily outpaced the market. Many investors have predicted higher interest rates in each of the past few years, but the Fed has continued delaying, helping utility stocks outperform. However, December 2015 could finally vindicate those expecting higher rates. Not surprisingly, the chart above also shows that utility stocks have return -8.1% YTD, significantly trailing the market’s 3.7% return and reflecting investors’ expectations for a rate hike next month. With rates looking set to move higher, will utility stocks need to meaningfully drop in value to keep their dividend yields relatively attractive for investors? While we can’t predict the future, we can compare the dividend yield of utility stocks today to their yield throughout history. The chart below does just that while overlaying the Federal Funds Target Rate (red line). Utility stocks, as represented by the XLU ETF, closed Friday with a dividend yield of 3.7%. This yield is higher than the 3.4% yield utility stocks had in 2003 when interest rates were 1%, and it’s also higher than the 3.4% yield utility stocks topped out at in 2006 when rates peaked out at 5.25%. Source: Simply Safe Dividends, Federal Reserve Bank of St. Louis The utility sector’s dividend yield has been in a downward trend since 2009, but its current yield appears quite reasonable relative to the last decade and historical interest rates. Once again, we don’t see signs of a bubble here despite Friday’s price shock. Finally, we compared the Utility sector’s dividend yield to the S&P 500’s dividend yield over the last decade. The chart below shows the difference between the two yields. A figure of 2% would mean that the Utility sector’s dividend yield was 200 basis points higher than the S&P 500’s yield (e.g. 5% yield compared to a 3% yield). A lower yield gap suggests that utility stocks could be expensive relative to the market. While the yield premium has come down meaningfully since peaking out at 2.4% in early 2011, its current reading is about in line with where it traded prior to the rate increases that occurred from 2004 through mid-2006. Interestingly, the yield premium fell during this time as utility stocks outperformed the market. Unless cyclical growth stocks really take off and leave utility stocks behind, it’s hard to imagine the yield premium returning to 2.4%. Source: Simply Safe Dividends How Interest Rates Actually Impact Utility Stocks Beyond historical dividend yields and interest rates, remaining focused on companies’ fundamentals is the key to long-term investing success. For this reason, it is important to understand why interest rates are very important to utilities’ actual businesses (not just fickle investor sentiment). First, utilities maintain extremely large debt loads. Constructing and maintaining power plants and infrastructure to deliver electricity and gas are extremely costly activities. The stable cash flows generated by utilities alleviate some of their credit risk, but the regulatory environment in each operating region plays a big role in a utility company’s health. Some companies are able to gain regulatory approval to increase the rates charged to customers to finance the large construction projects and higher borrowing costs they undertake, while others must absorb more of these costs themselves if customers cannot afford higher rates, lowering earnings. Many utilities have benefited from lower interest rates over the last 5+ years, allowing them to cheaply improve their infrastructure and refinance high interest rate debt to improve cash flow generation. Improved cash flow and the lower cost of debt has also enabled some utilities to acquire businesses in non-regulated industries to gain exposure to faster-growing businesses over the past few years, perhaps reducing the sensitivity of their businesses to interest rates. While rising rates make other yield investments relatively more attractive and could gradually increase utilities’ borrowing costs, it is important to remember why interest rates generally rise in the first place. The Fed will only raise rates if it believes the US economy is strengthening and inflationary pressures are gaining steam. In such an environment, consumers are doing well and are more able to afford higher energy prices. For utilities operating in regions with favorable regulation, this means they have a greater ability to pass on their higher borrowing costs resulting onto consumers through higher energy bills, protecting and growing earnings. As we previously showed, during the last tightening period from 2004 through 2006, utility stocks actually outperformed the market in each year! It’s far from a certainty that rising rates over the next few years will be worse for utilities than the rest of the stock market. So, Are Utility Stocks in a Bubble? While the plunge in higher yielding, slower growing companies such as utilities was painful on Friday, it is important to keep the big picture in perspective and remain resistant to swings in market sentiment. Given the world’s fragile state, the Fed seems likely to very gradually raise interest rates, assuming it does indeed start to act in December. Whether rates rise or fall, owning a portfolio of reasonably priced companies that earn solid returns on capital and grow their cash flow (and dividends) over long periods of time will always be a winning strategy. That is what we try to do with our Top 20 Dividend Stocks portfolio , which includes several REITs and utilities. From a historical point of view, dividend stocks do not appear to be in a bubble, but they could decline in the initial months surrounding an interest rate increase like they have in the past . Utilities’ dividend yields also appear reasonable, and these stocks actually outperformed the market during the last period of rising rates from 2004 through 2006. While anything can happen and we are coming off of an unprecedented period of low interest rates, we do not see a bubble today and believe that most utility stocks will continue providing stable income and reasonable downside protection for many portfolios, even if they continue experiencing near-term price volatility.