About three months ago, I wrote that Southern Company (SO) was about to raise its dividend and thus offer a nearly 10-year high dividend yield. Since my article, the stock has rallied 17% and thus its dividend yield has dropped to 4.6%. However, the stock is still 25% lower than its peak before the coronavirus crisis whereas the S&P is just 8% off its all-time high. As the stock of Southern will benefit from depressed interest rates for the foreseeable future, income-oriented investors should lock in its yield before it drops further.
Southern incurred several delays and cost overruns in the construction of its two Vogtle nuclear plants until two years ago. Consequently, the cost of the project more than doubled from the initial estimate, and the first of the two reactors will come online more than five years later than initially expected.
On the other hand, Southern has drastically improved its project execution in the last two years. During this period, it has not incurred any delays or cost overruns. However, the project is likely to be negatively affected by the coronavirus crisis. Southern reduced the workforce at the two nuclear plants by 20% in April to address the risk of coronavirus, which had infected 28 workers at the site. Management stated that it still expected the nuclear units to come online in 2021 and 2022. However, the reduced workforce is likely to somewhat delay the project.
Moreover, an engineering manager of the Vogtle Monitoring Group recently testified that the project is highly unlikely to meet its deadlines while its cost is likely to increase further. Even worse, the analysis of the project was completed in mid-March, before Southern reduced its workforce at the site by 20%, and hence the analysis did not include the impact of the pandemic on the project. Overall, despite the guidance of management for no further setbacks, the nuclear plants are likely to incur further delays and cost overruns. Nevertheless, as the first nuclear plant is 90% complete, future setbacks are not likely to be as significant as they were in the past. To cut a long story short, Southern will incur some extra costs in this major project but it will be able to absorb them without any problem.
Most companies will be severely hurt by coronavirus this year, as the pandemic has caused a severe global recession. Southern is not absolutely immune to the virus, which has somewhat reduced the electricity demand from commercial and industrial customers. However, this decrease in demand will be partly offset by higher residential demand, as people stay at home much more and thus they consume more energy at home.
Overall, the pandemic is likely to have a minor effect on the results of Southern, which has proved remarkably resilient during economic downturns. Analysts expect the company to grow its earnings per share 1% this year, from $3.11 to an all-time high of $3.14. This is a testament to the resilience of Southern, as extremely few companies will be able to grow their earnings this year while most companies will incur a slump in their earnings. It is also remarkable that Southern has missed the analysts’ consensus only once in the last 13 quarters.
The spread of coronavirus has not affected the growth strategy of Southern. The company has kept its 5-year capital investment plan of $40 billion intact and still expects to grow the earnings per share at a 4-6% average annual rate in the long run. In the last decade, Southern has grown its earnings per share at a lower (3.0%) average annual rate, primarily due to the issuance of new shares. However, management does not expect to issue new shares over the next four years and hence it is likely to meet its aforementioned guidance. This mid-single digit growth rate is certainly attractive for a utility stock, given also its resilience during downturns.
Southern has grown its dividend for 18 consecutive years. Even better, it has not cut its dividend for 72 consecutive years. It thus has an exceptional dividend record, which can be attributed to the reliable and predictable cash flows that result from the regulated business of the utility.
Southern is, currently, offering a 4.6% dividend yield. As shown in the chart below, the current yield is only slightly higher than the average yield of the stock over the last decade.
However, it is important to note that interest rates have dropped to historic lows due to the severe recession caused by the pandemic. In addition, unemployment has skyrocketed in the last three months, from 3.5% in February to 13.3% in May. It may take several years for the unemployment rate to return close to its level before the coronavirus crisis. As a result, the Fed is likely to maintain depressed interest rates for many years.
The depressed interest rates favor Southern in two ways. First of all, as income-oriented investors struggle to identify decent yields in the current environment of zero rates, the dividend yield of Southern becomes more attractive. If low interest rates persist for years, income-oriented investors will rush to buy utility stocks and thus they will provide a tailwind to the stock price of Southern.
Low interest rates also benefit Southern thanks to the low cost of refinancing debt. Southern has $7.0 billion of debt maturing until the end of 2022. While the company will probably pay off a portion of this debt, it is also likely to refinance a meaningful portion of this debt. As the new debt will be issued at a lower rate than the mature debt, the interest expense of Southern will decrease and thus it will greatly benefit the company.
Southern has an appreciable debt load. Its net debt (as per Buffett, net debt = total liabilities – cash – receivables), currently, stands at $81.5 billion. This amount is approximately 23 times the annual earnings of the company and hence it is certainly material. On the other hand, as a regulated utility, Southern enjoys predictable and reliable cash flows and hence it is not likely to have any problem servicing its debt. This holds true even under the most adverse economic conditions, as the company has proved resilient in all the past recessions.
Moreover, Southern has a dividend payout ratio of 74%. While this ratio may seem too high for some stocks, it is certainly reasonable for a utility stock that enjoys reliable cash flows. Given the healthy payout ratio and the manageable amount of debt, Southern is likely to continue raising its dividend in the upcoming years.
The stock of Southern has retrieved approximately half of its coronavirus-driven losses in about three months. However, it is not too late to buy this utility stock. Southern is still 25% off the high posted before the pandemic and is offering a 4.6% dividend yield. As soon as the market realizes that depressed interest rates will remain in place for years to help the unemployment rate to revert to a healthy level, income-oriented investors will rush to purchase Southern for its attractive yield. Overall, Southern is offering a safe and attractive yield as well as significant upside potential, with limited downside risk.
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.
This content was originally published here.