In January, the price of Southern Company stock was $53 per share, perhaps giving people some pause that the price of the Southeastern electric giant was drifting towards expensive territory. In January, the P/E ratio of Southern was 24, which is moderately concerning because this is company that has a long history of trading around 16x earnings for investors. This does not mean that Southern investors should have contemplated selling—after all, the company has compounded wealth at 15% annually since 1981 and you still got to collect 4% of the market price as a dividend, but it was the kind of price that should make you feel hesitant about making a large, substantial cash purchase in new shares (particularly if you care about how your stock performs compared to the S&P 500 in general over the next five years).
While you do not want to get in the habit of overpaying for companies, some types of companies carry much larger consequences for overpaying than others do. If you overpay to buy Nike, Disney, or Visa, it is not the end of the world because those companies are growing at rates between 13% and 16% per year. Even if the P/E ratio comes down a bit, you still continue to build wealth at a nice 8-12% annual clip (subject to how expensive the stocks were at the time you bought them, and how cheap the stock gets subsequently).
With utility companies, the notion of “growing your way out of it” isn’t really on the table because these companies usually only grow 4-6% per year. The high dividend is a strong defense, but would be not enough to deal with a sharp rate hike that took the price of the stock from 24x earnings to 16x earnings (by the way, it is not necessarily rising interest rates that cause deep problems for slow growing dividend stocks but rather rapidly rising rates that would make safe bond yields once again superior to the yields of stodgy utilities and the like).
The story has changed in the three months since then, with shares of Southern coming down to $44 each for a P/E ratio of 15.7 (Southern makes $2.80 per share in profits). The reason why the company’s stock price has fallen in the past three months is because its two largest projects are expected to cost significantly more than was initially projected. It had to spend $1.2 billion in additional costs at its Mississippi electricity plant because it was expected to be operating by May 2014 but is now expected to get running in June 2016. Not only has that meant that Southern hasn’t been able to expand from its 7% market share of Mississippi’s consumer electricity, but it has racked up extra construction costs to bring this project to fruition.
A similar story is playing out in Georgia, as some power plants that were expected to come live in 2017 now won’t be in operation in 2019. This delay is going to cost the company about $750 million, and explains why a company with a history of very stable profits (and as a consequence, very little short-term movement in its stock price) has seen its stock come down about $10 per share.
In spite of these costs, it is expected that the growth of Southern company will continue this year. It made $2.80 per share in 2014 profits, and is expected to make $2.85 per share this year. The issue is that Southern has been dogged by unusual events since right before the last recession. In 2008 and 2009, Southern didn’t have a chance to raise electricity rates during the recession (quick note on how utility rates work in most states: a utility provider like Southern will ask for a rate increase around 8% or 9%, citing inflation, higher operating costs, and the need to improve safety. A board of regulators will hold hearings and talk about needing to protect consumers, and will usually grant rate increases in the range of 4-6% depending on economic conditions. As is the case with most things, it is much easier to secure rate increases during good economic times rather than during recessions).
About 84% of its retail revenue comes from providing electricity to households in Georgia and Alabama (the break down is 50% from Georgia, and 34% from Alabama). In 2008 and 2009, Southern was able to get fresh approval for new rate hikes, and consequently, profits barely budged at Southern. It made $2.28 in 2007 profits, saw profits dip a tiny bit to $2.25 in 2008, and then hold steady at $2.32 in 2009. The usefulness of utility companies during recessions is that profits and dividends don’t plummet, but they also don’t usually advance either. Southern investors saw the $1.60 dividend in 2007 go up to $1.66 in 2008 and then $1.73 in 2009, and it is nice to own things that send you more money during rough patches in the economy.
The pace of growth packed up a bit in the years that followed, as Southern found itself making $2.67 per share in profit in 2012, performing in line with historical norms. The rate increases were starting to come, and there were not unusually high capital costs or delays that impaired the profit growth. The higher costs with its new plants started to pile up, and the profits have only moved up to $2.80 per share during the period between the end of 2012 and now.
In 2008, Southern found itself paying out 75% of its profits to shareholders as dividends. Management indicated a desire to lower that dividend payout ratio to the 60% range, and said that it would raise the dividend by $0.07 annually until it reached that comfort zone. The company stayed true to its promise—the dividend increased $0.07 every year coming out of the recession: $1.73 (2009), $1.80 (2010), $1.87 (2011), $1.94 (2012), $2.01 (2013), $2.08 (2014), and an expected increase to $2.15 annually this year.
Because of costs associated with these cost overruns, the dividend payout ratio hasn’t become lowered as expected. After all, with profits expected to grow from $2.80 to $2.85 this year, and the dividend expected to rise from $2.08 to $2.15, the dividend payout ratio is actually expected to rise modestly this year. The dividend payout ratio this year is 75%, putting the company in the same allocation spot that it experienced in 2009 when it first made the declaration.
For someone who decides to pay $44 and buy some shares of Southern, it is likely that such a person is neither overpaying for the stock nor getting a deal on the company. The P/E ratio is right around the 16x earnings range, which is about what you want to pay for Southern Company when you want to get a fair shake on the stock. The dividend yield is 4.65%, making this the kind of company you use to inventory profits from your private life rather than use to get rich.
As a back-of-the-envelope calculation, I expect investors will mint 0.1 shares new of Southern every two years for every share of Southern purchased today. Your 100 shares of Southern today will turn into around 130 shares of Southern in 2021, which is nice if you are focusing on current income rather than higher growth. If someone wanted high yield and a higher possibility of growth, it would make more sense to look at something like Philip Morris International which is currently yielding 5.09%. Rather than cost overruns, Philip Morris International is dealing with a strong U.S. dollar and trouble growing tobacco volumes in Russia, but will likely revert to 7-9% earnings per share growth over the coming five to ten years (whereas the expectations with Southern Company will likely be in the 3-6% annual growth range).
Southern Company is useful for investors that are more concerned with protecting their money rather than building wealth, and have the first priority of modestly increasing purchasing power while assuming the minimal risk of loss possible in the stock market. That is the role of Southern Company—it gives you higher than typical starting dividend income, but it grows slowly. It will probably perform within a percentage point or so of the S&P 500 over longer periods of time, but the primary benefit is that Southern investors get twice the dividend yield compared to what you would get investing in an S&P 500 Index Fund.
Originally posted 2015-03-19 10:00:47.